Why the contagion is spreading among emerging Asian markets: HSBC's Frederic Nuemann

EXPERT OBSERVER

It all feels a little 'contagious'. Among emerging markets, that is. For a while, one could point to specific challenges in specific economies. But in recent weeks, the sell-off has spread, and not always with good justification. Indonesia is a case in point: fundamentals look sound - certainly no less so than, say, a couple of years ago - yet the currency has slid to a 20-year low.

Contagions come in different guises: economic, financial, psychological -- though in reality, they combine elements of all three. Even if more insulated than others, emerging Asia is still exposed on all these fronts. The best prophylactic is usually swift tightening, both monetary and financial. If the current turmoil lingers, the region will have to deliver more of it. And that'll dent growth.

Your economist has been making the rounds of late, in Asia and Europe, gauging investor sentiment. It's been a rough summer for many, no doubt. But one hardly registers a sense of panic. Views remain differentiated, and Asia on the whole is still seen as relatively robust.

The headlines, though, remain challenging. And as veteran emerging market investors well know, pressures can swiftly spread, exacerbated by markets that are thinner and less liquid than those in the developed world.

So it's worth revisiting, in principle, what can cause 'contagion'. Three dimensions matter - overlapping and reinforcing each other, of course, but nonetheless conceptually distinct.

Economic contagion occurs when real sector linkages between markets prompt stress to spread. Here, Asia is less exposed to potential turmoil in other emerging markets. But common themes are on investor minds nonetheless: a slowing China, foremost, would hurt emerging markets everywhere. Evidence of strengthening Mainland demand would thus do a lot to stabilize EM sentiment.

Broadly, trade tensions between the US and China are also frequently cited - both in terms of cooling Chinese demand, and in terms of the broader threat the dispute presents to global trade. Here, Asia is especially exposed, via supply chains that tie into China and the broader dependence on global trade.

Financial contagion refers to investor positioning. In the simplest case, should an EM investor face redemptions, but difficulties of getting out of positions in the most hard-pressed markets, he or she could be forced to liquidate positions elsewhere, including in economies with sound fundamentals.

For the moment, this doesn't appear to be the case. But the point is that emerging Asia could be affected by this even if the fundamentals of many economies in the region appear comparatively robust.

Psychological contagion is perhaps a little harder to define, but material nonetheless: a given market sells off even if there are no obvious economic or financial linkages to others. Apart from simply frayed nerves, this can be caused by a 'paradigm shift', where, say, investors suddenly question to wisdom of investing in emerging markets at all.

Contagion, of any form, is best prevented with swift and early action. In emerging markets, this usually entails tighter macroeconomic policy (and, if needed, structural reforms).

If the current market jitters persist, more may be needed across emerging Asia as well. Less so, of course, in countries with robust current account surpluses than in others. But even a strong balance of payments position, if the stock of non-resident liabilities is sufficiently large, doesn't obviate the need for some tightening.

Here's to the headlines turning a little more soothing soon.

Frederic Neumann is the Co-head of Asia Economics Research at HSBC