Emerging markets should beware Japan

A few weeks ago, Russell Napier of CLSA (one of the gurus speaking at our conference next month) suggested to me that the weak yen might at some point trigger an emerging markets currency crisis. Last week, a note came through from Albert Edwards at Soc Gen suggesting much the same thing. Both are famous bears but both have also had good records of spotting the dangers other market participants prefer to close their eyes too.

It is also worth remembering, as Albert points out, that “yen weakness was one of the immediate causes of the 1997 Asian currency crisis and Asian’s subsequent economic collapse.” Then a weakening yen and rising dollar put pressure on the many countries in Asia that in one way or another pegged their currencies to the dollar (their exports became less competitive relative to Japanese exports as the yen fell and the dollar rose).

That, along with a variety of other factors (this is one of the things academics have on their ‘argue about forever’ lists) led to devaluations across the board (starting with Thailand) and in turn put huge stresses on the many banks (and other companies) in Asia that held debt in dollars (in local currency terms their debts soared). It also meant hefty imported inflation – as currencies weakened, import prices rose). Could it happen again?

The yen has certainly weakened and looks set to weaken significantly more: most people – us included – are convinced that the Bank of Japan is really committed to its 2% inflation target and it is perfectly possible that it will lose control and massively overshoot 2%.

Albert expects “accelerating QE [quantitative easing] to undermine the yen further and the market to anticipate this.” Note that Japan’s big insurers have begun to suggest that they will be upping their foreign bond holdings from now on (so selling yen in the process). 

So who gets hurt as a result of this? As many have pointed out, things have changed since the 1990s. China rather than Japan is now the world’s second largest economy and there “has been a dispersion of supply chains across different countries in Asia that complicates the issue of relative currency competitiveness.”

At the same time, currencies are not pegged to the dollar as they once were. You might also think that Asian countries’ high levels of foreign exchange (FX) reserves will allow them to protect their currencies if needs be (they use the reserves to buy their own currency, upping demand and preventing falls). 

But Albert isn’t having any of this. “High levels of FX reserves are no protection”, he says. “If they are sold to prop up Asian currencies, this will only impart a further deflationary monetary squeeze. Boom will turn to bust.” And “when I see a sharp rise in China’s real exchange rate (up 10% in the last two years) and a deteriorating balance of payments, it rings alarm bells.

China is not the most vulnerable of the emerging-market currencies to the weak yen, but this conjunction could easily trigger a currency crisis if growth is crushed.” Albert doesn’t say which he thinks is the most vulnerable, but it is probably fair to say that the South Koreans aren’t exactly thrilled by what they call its potential “unintended negative side effects“. 

• It is also worth emerging-market bulls noting that Japan’s QE isn’t doing much for equities in the rest of Asia either. See the chart here showing a huge rise in equity inflows to Japan, matched by falls to the rest of Asia.