The economic slowdown in China and accompanying volatility in its financial markets is wreaking havoc in many parts of the global economy as the country’s demand for commodities and other manufacturing inputs wanes. Many countries in East and Southeast Asia are on the front lines of this shift and were immediately affected by the devaluation of the yuan. In this Knowledge at Wharton interview, Wharton finance professor Franklin Allen outlines the risks hanging over the region and global economy.  

An edited transcript of the conversation appears below.

Knowledge at Wharton: I want to welcome Wharton finance professor, Franklin Allen, who is also a professor of finance and economics at Imperial College in London. He is also executive director of the Brevan Howard Center there.

I want to discuss how the situation in China, particularly the devaluation, is affecting East and Southeast Asia. We see the uncertainty in China as having widespread effects. Commodity prices are down, and countries that supply commodities and other goods to China, like Indonesia, are feeling the effects. Many Asian currencies are at multi-year lows against the dollar — the Malaysian ringgit, for example, is down 23% against the dollar this year. Other Asian exporting countries are responding in kind.

For some, this brings back bad memories of the late 1990s Asian financial crisis. Now, many of those countries have made important changes to guard against the kind of problems they had back then. More have floating currencies, larger foreign exchange reserves, better banking rules and debt insurance. Still, the pressures seem to be mounting. What are the risks of an intensifying currency war or a financial crisis?

Franklin Allen: First of all, the devaluation [in China] itself of course was not very big. It was 3% or so, but it did have a big trigger. There is a sense that we don’t really know what the exchange rate should be. The real issue is what are capital flows going to be like once they start reducing capital controls. That is the big uncertainty.

This move — one of the reasons it may have had so much impact is that people realize that [the Chinese] are serious about globalizing, and becoming part of the global financial system. The IMF has been asking them to move towards a freer float and many people have been asking the same thing. This was a sign that they were going to do that and suggests that over the next year or two, or few years, they are going to really change the way they interact with the global economy.There are worries about how that is quite going to play out that helps trigger so much of the turmoil that we saw.

It is a very different situation than it was in the mid- to late 1990s, and I don’t know how things are going to go from here going forward. A lot depends on what happens with interest rates in the U.S., and not just in terms of whether it [a rate increase by the Fed] is now, or three months from now, or six months from now, or whenever they start raising rates, but it is about how far is that process going to go, how much money is going to float back from emerging economies in to the U.S. And if the Europeans eventually get through with their quantitative easing, how much will go back to Europe.

These are all big uncertainties, and that is why markets are so volatile at the moment. We just don’t know how big these changes are going to be, whether it’s [increases by the Fed] just going to be 25 [basis points] now, 25 six months from now, and then very, very slow increases, or quite how it is going to play out…

Knowledge at Wharton: It is not just that China devalued … but also that their slowing economy … is affecting the amount of commodities and other inputs that they are sucking in from other countries, and so businesses slowing in these countries. But does this harken back to the [Asian financial crisis of the] late 1990s? Are any of those fragilities still around, or is this a normal adjustment process?

Allen: I don’t think it is so much a normal devaluation, I think there is a whole range of things happening. Things could go badly wrong, but I don’t think that they will go wrong the same way that they went wrong before in terms of the problems with too much dollar debt issued by corporations and governments in many of these Asian countries. But there are a lot of risks out there.

“As interest rates rise, and valuations fall, that is always worrying for financial stability. But it depends very specifically on what banks hold, and what the other financial institutions are doing … and there is a lot of uncertainty about that.”

I think we are in a different kind of world: China is slowing down, and many of these economies that were driven by China’s voracious appetite for raw materials and agricultural products, those things are not going to grow in the same way that they have in the past. Money is going to go back to the U.S. probably, as interest rates there go up. All of these things are combining to cause these changes in exchange rates, and so on.

We don’t have a good sense exactly where the problems might be, but they may well be out there.

I think as interest rates rise, and valuations fall, that is always worrying for financial stability. But it depends very specifically on what banks hold, and what the other financial institutions are doing, and so on. And so there is a lot of uncertainty about that.