This ended up being a lot longer than I thought it would be – mostly because I have barely slept for the last few days amd I’ve lost track of time from staring into excel spreadsheets. Anyhow, here is more analysis than I set out to write, complete with candy-colored charts!
Bloomberg mused that some countries, China and Taiwan in particular, might be particularly well-shielded against a US interest rate increase, especially on a currency outlook. Neat analysis, can we take it further? Well, starting from structuring the countries according to their various types of debts and then adding on equity market capitalization for major liquid indices in the countries gives a pretty good idea of where we are at using a rough balance-sheet view of how the countries’ financing looks. Then I pull a “quick and dirty” and place foreign exchange reserves on top of the aggregate financing total, essentially considering the currency reserves “retained earnings” and “cash” at the same time. They do act as a line of defense against tumult in global markets, a part of them can readily be used (except for in China’s case, I think a few people would really get scared if FX reserves drop for them) to meet other demands, and it is the effect of surplus cash being used to build reserves in this case, so it feels like abuse of notation that kinda works. So what do the charts look like after these additions then?
“Capital Structure” of Asian economies, entries scaled to GDP
The equity market data is yanked from the WFE as per usual.
A few things immediately become rather clear:
- Including equity and capital reserves equalizes the playing field vastly. India and Thailand get to play quite a bit of catch-up to the others to clock in around 300% as well, now looking rather similar to China and Malaysia.
- Taiwan goes into a league of its own! Massive equity markets near 170% of GDP plus 87% of forex reserves? Boom!
- In fact, the foreign exchange reserves are above 23% of aggregate financing, ex-FXR.
- The equity market financing puts it above Korea in capital raising. how much further can you go?
- China lags behind. Sure, we are not using the Hong Kong equity market as part of China here (it deserves special separation) but still, even including the HKSE just adds a bit over US$2 trillion to equity market capitalization, and wouldn’t even put it past Malaysian relative equity capitalization.
- As was mentioned yesterday, equity investors are not particularly important at all in China! Add “Foreign Exchange Reserves” to the list of priorities you fall in after.
- Chinese FXR doesn’t look nearly as big after adjusting for the size of the economy anymore!
- In fact, what happened to the second biggest foreign exchange reserves in the world? Oh, they got eaten up by 400% debt? Yuck…
- This chart would seem to indicate that percentage-wise, India, Japan and Korea will see the most problems of capital outflows on currency performance. (I’ll get back into more detailed analysis later).
- Japan has 5.2% currency reserves to aggregate financing, and 26% to the annual GDP.
- Korea has 7.9% currency reserves to aggregate financing, and 28% to the annual GDP.
- India has 6.2% currency reserves to aggregate financing, and 17% to the annual GDP.
- Malaysia, China and Thailand form a “currency reserves similarity cluster” around 15-17% of aggregate finance and 42-44% of annual GDP. It’s hard to tell them apart on a scatter plot that includes the other four economies…
- Care needs to be taken to evaluate Japan, India and Korea however, as their fundamental economics are very, very dissimilar. More later.
Now, as I’ve alluded to, should the Fed raise rates and force capital to flee to the US in search of the higher returns in a stable liquid economy, this seems to imply capital flight from the economies that might really impact Korea, Japan and India, each having less than 8% reserves to aggregate financing and FXR as a smaller fraction of their economies. I can buy it having an impact, exactly how big of one and what type I think is up for debate.
Japan, given its very strong short position on its own economy can probably benefit from this, and in their larger absolute value terms Japanese foreign reserves seem more resilient. Will capital flight cause capital shortages in Japan, forcing equity sell-offs and potentially even making debt riskier? I highly doubt it, especially as a yen decrease might bring in some more inflation locally, push stock- and property markets higher and inflate away some more debt. Japan has a very large short position on the yen, and the stock market is not a very large domestic consideration compared to other asset markets. This looks like it might even set off a positive capital markets spiral in Japan and lead cash to be put to good use.
Korea is in a slightly worse position, but as was shown yesterday, there are large similarities between the Japanese and Korean population wealth mechanics, and a wider currency drop in the region might just add some more fuel to the economy. A relatively more important stock market and corporate debts however, might temper the joy and really make this one a tougher nut to crack. One could worry about long term effects to the economy if companies are getting a harder time to go to the bond markets (which could take a hit and make up more than half of corporate financing in Korea) but in the long term we all get problems anyway. effects will most likely be good for the economy in the short run.
India is by far the worst case. The high inflation in the country isn’t gonna get any better if import prices surge, and they are also running a trade deficit already! “Thankfully”, there are a lot of equities to sell on a relative basis, so at least that will shield bonds if not too much of that is held up in foreigner’s accounts. Still… if a currency sell-off starts, and others are selling assets denominated in rupees to put them to safety somewhere else, potentially in another currency, that looks like a very bad case of interlocking “positive” feedback loops to me, in a self-enforcing spiral of sell-offs.
Thailand might be another decent place to go short, or Malaysia given the slightly smaller economy and smaller equity markets.
China, Taiwan and Hong Kong look like better places to park long bets on equities or collect bond yields should this migration of capital materialize in the 6-month to 1-year time frame, and yesterday’s analysis of the Hong Kong and China markets might inspire you to move in already. I’m not saying that the Taiwanese stock markets are any less volatile these days, or any larger on a relative basis – there is still a very big risk of losses impacting you here – but as a long-term investor I feel comfortable going in to places where the trader in me would die from guilt-by-association.
In evaluating risks for the local currencies, I so far have yet to go into the major issues: market size! Yes, all currencies bar the yuan are but leaves in a US$4 trillion daily stream of currency transactions, but even the slightest of interventions have massive impacts. So let’s re-draw the chart above, but now with the width of the respective bars representing GDP of the home country. thus very visually recovering the actual values of different entries by the block chart area:
GDP-adjusted-by-multiplication sensitivity analysis:
- China’s FX reserves really become a lot more identifiable, and blows everything else out of the water for sheer size.
- India “catches up” to Taiwan here, making up with GDP where good fundamentals were in short supply.
- Thailand and Malaysia immediately look a lot more vulnerable to capital flight!
- Taiwan doesn’t look completely like it gets away from all of that mess, but the FXR and link to China, as well as generally good trade data looks set to keep this economy from cracking completely should the currency movements become violent.
This idea outlines the processes involved in actually moving the economies, but how much are these economies actually connected to those processes, and at the mercy of trade and external loans going against them?
Total trade and external loans:
Japanese trade is really not that big of a deal, but the external debt looks pretty bad. The question then is how much of the aggregate financing numbers can additionally be absorbed, and how much value is generated in the economy thanks to inflation. Still, a lot of capital market financing is available, and the foreign exchange buffer is pretty strong should it be needed. The slow burn of any sell-off probably means that inflation and asset price increases can absorb any debt exits by foreigners. An added benefit is that around 94% of government bonds are domestically held, implying that roughly 15% of GDP-equivalent is debt held by the JGB market. This this leaves around 40% most likely on financial firm- and corporate balance sheets, which should likely mean that these companies are still net beneficiaries of any fall in the yen and associated inflation.
Korea gets off better on debt, but has a much larger chunk (3x) of GDP in trade compared to Japan. This is probably good and would mean that Korea can gain outsized benefits from any decrease in the value of the won, while not risking too much debt sell-off and thus safeguarding the currency reserve.
Malaysia is essentially an extrapolation of the trade- and debt writing on Korea. They are very exposed to trade, being the only country that punches over the 10% of GDP total trade mark at roughly 13%, but also relatively low external debt. Malaysia will be exposed to the rest of the world through its trade, and trade weakness might lead some speculators to test the waters on ringgit shorts, but the relatively good FXR should hopefully be enough to hold the “barbarians” off a bit to not force economic damage.
China probably has the biggest shield to external influences overall, with low external debt and not a huge reliance on trade proportionally to GDP: Investing success in China will be largely dependent on local factors and a massive currency reserve.
Thailand and Taiwan are marginally more sensitive than Korea on both accounts. Taiwan has a better currency reserve backup, and the top short might thus be Thailand from a trading perspective as it is a small economy with just decent currency reserves, high trade and significant amounts of external debt. This external debt is also relatively significant on the total debt holdings of the country (representing roughly 25% of all debt of the country, its consumers and corporations) and could cause internal dislocations in the debt markets.
India looks overall like the second-most shielded (after China) but it hides the fact that external debt makes up almost 20% of total debt and that the country really shouldn’t have either more inflation or anything that makes its terms of trade any worse. Still it is a big economy, and its numbers will therefore become bigger and more stable, but it also means righting the ship after anything goes wrong will take a lot more effort.
If monetary accommodation disappears in the US and gives way to policy tightening, I will evaluate:
- Short term shorts in the ringgit, baht, and yen,
- Long term shorts of the rupee, the SENSEX, and low-performing exporters on the TAIEX (exports will become more difficult since the Taiwan dollar will follow it’s US counterpart closely due to the management of the currency).
- Short term longs on the TOPIX, KOSPI and their Malaysian equivalent due to the trade numbers giving a lot of upside in any economically favourable environment.
- Long term longs on the Shanghai Composite, due to other factors overshadowing anything in this analysis, as well as heavy-volume Chinese goods importers in Taiwan.