The global sell-off in financial markets following the devaluation of the Chinese currency has led to a debate on whether a replay of the 1997 Asian crisis is in the offing. There are certainly parallels with the scenario then: China had devalued its currency in 1994, damaging the export competitiveness of the Asian tigers - Thailand, Indonesia, Malaysia and Korea. By 1997, as China emerged as a strong competitor to these economies, many of them bore huge external debt burdens that became difficult to service with a large fraction of fickle short-term loans that exited at the first sign of trouble. As contagion spread through the region, their currencies collapsed. The fact that China did not, as was feared then, go in for further devaluation finally stemmed the crisis.
Today, the concern is related primarily to the slowdown in China and its impact on the rest of the region, which is now more tightly integrated with the mainland through trade and investment linkages. China's move to devalue its currency is being seen as a last-ditch attempt to support its export-oriented industries and further depreciation is not being ruled out. In other words, it has exposed the fragility of the Chinese economy and the risk of knock-on effects to the region that has become hugely China-dependent. External indebtedness in China and the Asia-Pacific region continues to be high, as government and businesses have taken advantage of low interest rates in the developed markets.
Despite the similarities that exist, much has changed since the 1997 crisis. Asian policy-makers have learnt important lessons from past mistakes and taken measures to protect their economies. For one, their currencies are no longer pegged to the dollar as they were in 1997. That forced central banks to draw on their foreign exchange reserves to defend their currencies, which became difficult as capital outflows intensified. Following this bitter experience, most countries have done two things: build up their foreign exchange reserves and abandon the dollar peg.
Even Malaysia, remembered for the capital controls it imposed during the 1997 crisis, has ruled out such an intervention. Despite its currency being the worst performer in the current sell-off, the government and central bank have reiterated their decision not to impose capital controls or move to a less flexible currency regime. During periods of currency depreciation, a key vulnerability invariably arises from the level of external debt held by the country. Repayment of foreign currency debt, especially if it is short-term in nature, becomes more expensive in local currency terms.
Foreign currency indebtedness is still a problem and so is the high level of short-term debt, which has increased in most Asian countries compared to 1997. However, as a percentage of foreign exchange reserves, short-term external debt has dropped sharply. The decline is most dramatic in the case of Indonesia where it was nearly 200 per cent in 1997 but has fallen to around 50 per cent. Other economies have seen similar declines in their ratios and have kept their powder dry to fend off a major attack on their currencies. India is actually the exception. Its short-term debt, including government securities held by foreign investors, has risen sharply compared to 1997. However, it remains manageable at around 26 per cent of its foreign exchange reserves.
Last, and more importantly, checks and balances have been placed in the banking sector and there is greater financial sector oversight that was lacking in the 1990s that allowed the exchange rate crisis to become more systemic. Ultimately, whether the current sell-off morphs into a crisis will depend on whether China's banking system is able to sort out its problems of excessive lending to industries that may not be creditworthy. If it cannot and resorts to further devaluation then Asia might see more pain. However, one must not forget that China too is sitting on mounds of external debt. Thus devaluation could spark off a major exodus of this debt. This might harness the yuan and ensure some stability in the region.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is Principal Economist, CII
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