A Grand, Simultaneous Financial Bust: Asian Contagion II


Globalism changed the economic order of things.

Most relate globalism to free trade. However, the greater effects of globalism can come via the opening of capital flows among countries — both when capital surges in and when it surges out. This is now the case for a large number of developing countries.

You might ask why countries would be inclined to block foreign capital inflows given that they finance investment, pump up financial prices, and generate wealth. That was understood by most, except for a few socialist countries not wanting to be tainted by capitalism despite its benefits.

However, the bigger pre-globalism propensity was to restrain capital outflows. And ironically, without the ability to exit, few foreign investors were willing to enter with their capital in the first place. Globalism changed that by causing countries to relax constraints on capital outflows. Predictably, foreign investors themselves relaxed and enjoyed the greater returns available in faster growing, smaller economies.

So the elimination of capital outflow barriers increased the tendency of foreign investors to partake in offshore speculation, with the biggest beneficiaries being the developing countries.

Foreign capital freed these countries from dependence on local savings and local banks to finance investment. And when foreign capital flowed in, it financed investment in plant and equipment for manufacturing that was leveraging low-cost labor, especially China. Foreign capital also financed office developments, infrastructure, and residential condos making the skylines of places like Panama City look like this. 

Foreign capital provides jobs and income, but it becomes problematic because it is seldom applied at a steady and measured pace in proportion to the opportunities. During the Great Recession, the Fed’s QE provided investors with a large liquidity pool disproportionate to the onshore investment opportunities, so a good deal of that liquidity gushed into off-shore investment.

And much of that went to the commodity and energy industries, which, at the time, were supply-constrained and expensive. These include Brazil, Indonesia, Russia, South Africa, Chile, and Peru among others, as well as some developed country plays in Australia, West Texas, and Canada.

In investment booms fed by outside (and not very discerning) capital, animal spirit-driven developers keep on borrowing and building to be absorbed by the market before their competitors, and the unrestrained booms that follow result in over-building, excess production, inventory build-ups and, in turn, soft prices, debt defaults, eventual bankruptcies, and penny stocks. 

That much is true for any domestic boom and bust, but now there is a foreign twist when the projects are debt-financed from offshore sources that typically require repayment in US dollars.

Hence, foreign-financed investment has a built-in currency crisis in the making when settlement takes place because it drives the price of the US dollar upward and the local currency downward. Predictably, it comes at a time when the boom is over-built, leaving investors scrambling to generate revenue, and commodities continue to be sold at very low prices in order to cover the rising cost of dollar-debt repayment.

There is a rush to extinguish dollar debt before a property is lost to foreclosure, which, in turn, leads to major multiple market reactions – all downward. The selling of commodities at ultra-low prices creates an adverse currency movement for the affected country. For example, see the correlation (below) of the declining price of copper relative to Peru’s Sol and Iron Ore relative to the Australian Dollar. 

This strong currency decline then causes unrelated companies, individuals, and even governments to sell most anything denominated in local currency and use the proceeds to purchase US dollar-denominated assets. The debt repayment wave deteriorates into a generalized capital flight and a currency collapse for the involved country.

Basically, the bright shining buildings shown above are still standing and shining, but in the economic and financial dimensions, all prices are falling down.

This is the basic scenario that followed the early days of globalism in which there was an over-build of manufacturing capability in the cheap labor countries of Asia in the 1990s. The consequence was a bust phase known as the Asian financial crisis that unfolded in 1997. The return of capital to the lender that spilled over to most emerging nations was therefore known as the “Asian contagion.”

What occurred were falling prices of everything: over-built goods, currencies, physical capital assets, as well as the financial claims to these assets.

This scenario is being repeated today in the great commodity boom of the last few years. Not only are the commodity prices falling but so, too, are the foreign currencies and foreign and domestic stocks and bonds that have financed the commodity boom. This also affects those financial entities that hold claims to commodity-related securities in their portfolios.

As a result, oil, coal, copper, and iron ore all are selling in the area of 70% less than when the facilities were built only two years ago. The price bust, the currency bust, the financial price bust, and the capital goods bust are in a grand, coordinated bust.

The bust phase includes China’s over-expanded manufacturing sector that gave rise to the commodity boom in the first place. 

Meanwhile, the question becomes: Can the US economy continue to grow in the face of this? 

There are adverse implications for US companies attempting to export goods (in the face of a relatively expensive dollar) to a developing world in recession. The foreign sales and earnings of these companies are being hurt, and that hurt is being registered in the US equity market. But meanwhile, American companies and consumers are benefiting from the cheaper import and energy cost savings. Indeed, the service sector is holding up the US economy.

When the dust settles, US companies will leverage the cheap prices of foreign-made goods and increase their profit margins. Indeed, Dell Computer back in the late 1990s became a break-out company that benefited enormously from the first Asian Contagion because it was outsourcing production to the countries whose currency was most affected.

Distressed prices of foreign currencies and assets will become a high return opportunity for the US dollar investor willing to patiently wait it out.

Subsequently, one must keep an eye on commodity inventories. When inventories start to work their way down, there is a bottoming-out of commodity prices, which, in this slow growth environment, could take some time. This will likely be measured in years, but no doubt its day will come.

The reversal of cheap currency in the EMs will set a bottom and bring capital back to those countries with a rush. At that time, all the prices that have fallen together will all rise in unison.

So it seems that two decades into globalism, we are finding that global capital flows — first gushing in and then gushing out of relatively smaller countries — add a new dimension of volatility to financial markets with a foreign currency twist. These are relatively long cycles, so investors must be patient. In the meantime, producers in developed countries will benefit from rising profit margins thanks to cheap foreign outsources. 


The views expressed are those of the author and not necessarily The University of Texas at Austin.

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

Leave a comment

We want to hear from you! To keep discussions on-topic and constructive, comments are moderated for relevance and for abusive or profane language.
Login or register to post comments