Beyond the recent meaningless gyrations in stock markets in Asia lie nascent problems of inflation and slowing growth, and the ubiquitous one of managing capital inflows. The recent Asian Development Outlook 2010 Update published by the Asian Development Bank mentions that 71.5% of the goods produced in Asia are bound for destinations outside the continent, after accounting for supply-chain linkages. Hence, Asia’s external dependence is still high. Prima facie, there is a case for exchange rate management. However, Asian central bankers must be wary of walking down that well-trodden path.
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First, there is no dearth of empirical evidence that export demand is a bigger function of domestic demand and income growth in importing countries than it is of exchange rates. Second, while resistance to currency appreciation might appear to be a legitimate and forceful response to the plight of exporters and those employed in the export sector, imported inflation through higher commodity prices and weaker (or not-as-strong-as-they-should-be) currencies affects all, including employees in the export sector. Third, real effective exchange rate (Reer) appreciation through nominal currency appreciation is better and damages competitiveness less than Reer appreciation through inflation. Four, exchange rate strength might and should be used as a catalyst to accelerate domestic reforms that would enhance productivity in the economy. Exchange rate management is easier, but cost reduction through productivity enhancement is more durable.
Bearing in mind these general principles has become especially important lately, since export and/or production data out of Asia have begun to signal at least a cyclical slowdown, if not anything more serious than that. Japan, Korea and Taiwan—three export powerhouses— have witnessed pronounced slowdown in industrial production and/or exports. Let us first take Japan. In 2010, except January and April, Japan has experienced only export contraction every month. Unsurprisingly, industrial production has also turned down. It has contracted sequentially in the four months to September. The Small Business Confidence Index has declined in September and October. This index has a long and stable correlation with Japanese stock indices.
While Japan’s finance ministry downgrades assessment of industrial production and the economy, the Bank of Japan has produced upbeat estimates for growth and inflation for the next two years, claiming that it is taking into account the impact of the special asset purchase measures that it has announced in its most recent meeting. It is unlikely to cut much ice with market participants. The yen is headed higher against the US dollar in the near term. The euro, whose recent strength has belied the rising vulnerabilities in the euro zone, might also decline further against the yen. Though Japan would protest—and it has already intervened at least once in the last one month—its Reer suggests that the yen is not overpriced. If anything, it is lower than what it was in 2000, based on the JPMorgan real effective exchange rate index.
In the case of Korea, exports appear to have peaked in June. Since then, it has been volatile, while exhibiting a slowly declining pattern. The decline may accelerate in the coming months going by the back-to-back decline in August and September. Korean unemployment rate jumped to 3.7% in September from 3.4% in August, and indices of business confidence in both manufacturing and non-manufacturing sectors declined. Output in the service industry contracted on an annual basis for the first time this year in September, while the rise in the leading index slowed. These data appear to vindicate the decision of the Bank of Korea not to raise interest rates. Unfortunately, the rate of inflation in consumer prices (CPI inflation), too, has accelerated. From a level of 2% in October 2009, it has risen to 3.6% in September 2010. “What should the Bank of Korea do and why?” can become a good examination question for economics majors.
India’s industrial production too has become more volatile of late, and has been mostly disappointing. Its wholesale price inflation is at 8.6%. While it is in single digits, it cannot be considered low. For all its limitations, the urban CPI inflation rate is still well over 10%. In the meantime, Indian stocks have received $24.7 billion of investment (net) from foreign institutional investors. At least 60% of it has come in the last three months alone. The dilemma facing the Reserve Bank of India is no less acute than that of the Bank of Korea.
As in late 2007 and early 2008, stock markets appear thoroughly disconnected from the underlying reality, and not just in the developed world. The difference lies in the prospect for subsequent recovery from any correction, and that is better for emerging nations. What stands between poor or negative investment returns from global stock markets in 2011 and investors is the strong empirical regularity that the third year of the presidential cycle in the US has invariably been good for US stocks. For better or worse, I know the weight I would assign to this fact versus the fundamental factors discussed here. You must make your own choice.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org