As the European peripheral debt crisis deepens, we must consider the potential contagion effects on Asian markets. First, let’s consider the transmission mechanism through the financial markets. Whether a European sovereign actually defaults may be less relevant than the uncertainty it is creating. The current market uncertainty, in and of itself, is already causing a ripple effect across global markets. Is the current withdrawal of capital from Asia's markets really a “flight to quality” or just a “flight home”? 

I once heard a banking executive in Asia liken scared market participants to toddlers who have scraped their knees while out playing: their first instinct is to run home. What we have seen in the last few weeks in the markets is exactly that. It does not matter if the "home" market might be in a precarious state. Their instinct, when faced with great uncertainty, is to run home. So the notion of “flight to quality”—when investors move capital away from riskier investments to potentially safer investment vehicles during volatile periods—can really be better characterized as a “flight home.” For most investors, the flight home means holding cash in their home currency. 

The U.S. dollar, euro, yen, British pound and Swiss franc have all appreciated relative to most Asian currencies in recent weeks since they are base currencies for the majority of global investors. It might seem counterintuitive that the euro has outperformed most Asian currencies when it is Europe that is at the epicenter of the crisis. Specifically, one might wonder why the euro should outperform the currency of a stable country such as Singapore, which stands to lose relatively less from the peripheral crisis than Europe from both monetary and real economic perspectives. However, in periods of risk aversion, as we are seeing today, short-term currency movements have less to do with fundamentals than the “flight home” instinct. 

So if markets act like toddlers over the short term, what are the key drivers over the long term? The impact of the European crisis on global growth over longer time horizons will be the key determining factor on market performance. Small, open economies such as Hong Kong, Singapore and Taiwan will likely be more greatly impacted. Countries with domestic consumption as large drivers of GDP, such as China, Indonesia and India, might be relatively sheltered due to their relatively large internal markets.

While risk aversion may cause markets to overreact in the short term, we believe long-term structural growth should continue to determine long-term growth trajectories. 

(c) Matthews Asia

www.matthewsasia.com

         
 

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