World Better Able to Weather Possible China Devaluation

The threat of a Chinese currency devaluation has hung over the world like a giant red shadow for more than a year, and the fears were rekindled this week in the wake of Brazil’s financial turmoil.

But according to several traders, investment bankers and economists, the global financial system--and Asia itself--is far better equipped to weather a Chinese devaluation now than it was even six months ago.

While no one would welcome another shock to an already shaky world system, several fundamental changes during the last few months have significantly reduced the chance of a regional meltdown, analysts say.

They include a stronger Japanese yen, lower interest rates across Asia, healthier foreign reserves, higher stock prices and lower expectations by investors, all of which arguably would mute the reaction to such a devaluation.

“The bottom line is, the markets are now in a better position to deal with a Chinese devaluation,” said Darrel Whitten, strategist with ABN Amro. “International confidence in [the region] is increasing.”

The big concern has been that a devaluation of the Chinese yuan could set off a round of retaliatory devaluations--a sort of financial arms race--leaving chaos in its wake with no one enjoying a competitive advantage after the dust clears.

Among other effects, that could send U.S. imports into the stratosphere and plunge American exports to new depths, finally bringing a halt to a U.S. economic expansion that keeps refusing to slow down.

To be sure, not everyone agrees that the financial system is now relatively inured to a China shock. Some suggest that arrogance, not better defenses, is behind the markets’ cavalier response to Brazil’s recent devaluation.

“The nonchalance with which the financial markets took Brazil’s devaluation is amazing, especially in the U.S. with all its banking exposure,” said Ron Bevacqua, economist with Merrill Lynch Japan. “The way the financial markets blew it off suggests hubris or overconfidence.”

But the changes in the world are real. Among them has been the appreciation of the yen, which at 114 to the dollar is now about 22% stronger than the 147.26 level reached on Aug. 11.

This helps nations hardest hit by the Asian crisis--including Thailand, South Korea and Indonesia--because they need to export their way back to health. A stronger yen makes that easier in part because Japan is more likely to buy their exports.

Beyond that, a stronger yen makes Japan’s formidable exporters less competitive in U.S., Asian and European markets. Thus consumers shopping at their local Wal-Mart, for instance, would be more likely to buy a cheap Daewoo-model VCR from South Korea than a sophisticated, but now more expensive, Sony from Japan.

Thus the hardest-hit Asian nations can earn hard currency faster, which gives them the resources to implement painful reforms and provides a better buffer should a Chinese devaluation occur.

“A weak yen and a devalued yuan were seen as the worst of all worlds,” said Peter Morgan, economist with HSBC Securities. “Now the yen is quite a bit stronger.”

Struggling Asian nations have also seen their fundamentals improve on several other fronts, theoretically strengthening their ability to weather more shocks.

Interest rates have come down sharply across most of Asia. South Korea’s 90-day rates are now 6.8% compared with 10.5% last September and over 20% shortly after its currency, the won, fell off the table in late 1997. In Indonesia, 90-day rates are now 38% compared with 52% four months ago.

Lower interest rates help spur economic activity. Consumers have an incentive to buy more houses and cars or run up their credit cards. And companies are more apt to spend on new widget-making machines and factories, both of which require more workers.

Hard-hit Asian countries also have begun restructuring their corporate and financial systems, tackling their debts and building up foreign currency reserves, all of which puts them in better fighting form in case of setbacks like a China devaluation.

South Korea’s reserves are now at a record $52.51 billion, up from just $7.26 billion in late November 1997. It has even repaid $1.06 billion of the bailout funds it received from the International Monetary Fund.

Thailand has seen similar progress. “Our current account surplus is rising by roughly $1 billion a month, and it’s been growing like this for the past 12 months,” said Kongkiat Opaswongkarn, president of Thailand’s Asset Plus Securities. “We’ve gone from almost nil to close to $30 billion.” In fact, Opaswongkarn believes Thailand would now be able to ignore a relatively modest China devaluation.

Most Asian countries also enjoy greater investor confidence than a year ago. Sovereign debt ratings have been raised in most countries in the region.

In just one example, Standard & Poor’s this week raised South Korea’s foreign currency rating one notch to investment grade--to BBB- from BB-. And the Institute of International Finance predicted this week that foreign direct investments in Asia’s five hardest-hit economies will reach $18.7 billion this year, more than double 1998’s level and close to the $19.7 billion pre-crisis high.

Stock markets also are well above their lows. Compared with a year ago, Indonesia, the Philippines, South Korea and Thailand are all up between 8.47% and 25.74%. And most currencies in the region, with the exception of China’s and the Hong Kong dollar, are no longer linked to the dollar, creating more firewalls if China made a move.

When the Asia crisis first struck, most regional currencies were pegged to the dollar. This kept their value artificially high despite underlying structural problems. Speculators took advantage of this and attacked them in sequence, like knocking off targets. Now that most float freely, however, they are able to adjust incrementally, reducing the chance of a major chain reaction.

“There are now a lot more floating exchange rates out there,” said Robert Subbaraman, Southeast Asia analyst with Lehman Bros.

Perhaps the greatest mitigating factor in case of a China devaluation is lowered expectations. Investors hate big surprises, which they got when Thailand, South Korea, Singapore and Indonesia devalued in rapid succession after years of stability.

Now, however, investors are more aware of the risks, the “irrational exuberance” is long gone and the downside is far more limited.

On the China front, all the talk of devaluation has given market players a chance to weigh their options and make contingency plans.

A company with an auto plant in China that expects a devaluation, for instance, could take its profit out of China now and hold off any planned factory expansions until after the fall so its investment would go further.

Investors say this was borne out in Brazil, where the devaluation was anticipated. So far, at least, the impact has been limited to that country and Argentina, in contrast to earlier Asian and Russian devaluations.

“There’s been a lot of speculation about China, so the impact of any devaluation would be lessened,” said Joe Prendercast, London-based global currency analyst with Credit Suisse First Boston. “It would be more like Brazil and less like Thailand.”

But even those who see less risk say that weathering a China shock is one thing while sailing through it is quite another.

“The situation is less fragile today than a year ago,” said Marcus Noland, analyst at the Institute for International Economics. “Nevertheless it’s [still] fragile.”