History points to Asian FX rally fizzling out

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Non-Japan Asian (NJA) currencies have appreciated versus the US dollar and currencies of their main trading partners in October. But the historical pattern of monthly appreciation/depreciation suggests that this Asian currency rally may start losing steam in coming weeks, with currencies eventually weakening modestly versus the US dollar.

This historical pattern is partly due to the seasonality of current account flows, the ebb and flows of capital attracted/repelled by valuations and central banks’ management of their currencies. I see few reasons why it will be materially different this time round.

Inflows into Asia are unlikely to accelerate given lingering foreign investors’ concerns about regional and global economic growth, the start of the US Fed hiking cycle and country-specific vulnerabilities including sensitivity to commodity prices and elevated foreign debt.

Furthermore, while Asian central banks may not purposefully weaken their currencies, they may have the room and incentive to lean against further appreciation: overall, Asia inflation is low and falling, exports are weak and FX reserves have fallen in the past six months.

EM currencies and equity markets have strengthened in the past month, following months of weakening. Specifically, Non-Japan Asian (NJA) currencies have appreciated versus the US dollar (see Figure 1) and the currencies of their main trading partners, bar the marginally weaker and Philippines peso (see Figure 2).

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The drivers for this rally likely include:

  1. Faster-than-expected GDP growth in Q3 in China and Korea;
  2. A delay to the US Federal Reserve hiking cycle;
  3. Signs that the European Central Bank is willing to beef up its existing quantitative easing and potentially cut its deposit rate;
  4. The Indian and Chinese central banks’ willingness to cut policy rates in order to support economic growth alongside FX intervention to support their currencies; and
  5. Foreign inflows into Asia attracted by cheap valuations.

While forecasting the path of each of these variables is fraught with difficulty, history suggests that the rally in Asian currencies may start losing steam in coming weeks.

Indeed Figure 3 shows that in the past five years NJA currencies (excluding CNY) have rarely appreciated or depreciated vs the USD by more than about 3% month-on-month. I estimate that this GDP-weighted basket of Asian currencies has appreciated by about 3.3% month-on-month in the past week. Based on precedent, I would expect that pace of appreciation to slow to around zero percent in the next few weeks, before turning to depreciation (red line in Figure 3).

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Of course this does not imply that Asian currencies will actually weaken versus the USD near-term, merely that the pace of appreciation will slow. Indeed, based on the above forecast for the pace of appreciation/depreciation, Asian currencies should appreciate modestly versus the US dollar in the next couple of weeks before depreciating slowly (see Figure 4).

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Notably, the historical pattern for the Chinese renminbi is not altogether different although the quasi-peg to the USD dollar for periods of time has resulted in far less volatility, with the monthly pace of appreciation and deprecation rarely exceeding 1% (see Figure 6). The one notable exception of course was the renminbi’s devaluation in August which resulted in a pace of monthly depreciation exceeding 3%.

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Moreover this pattern is similar if Asian currencies are measured against their main trading partners’ currencies (including the euro, sterling, yen etc…). Indeed, Asian currencies’ nominal effective exchange rates (NEERs) tend to appreciate and depreciate at a pace confined to reasonably narrow bands, with the more volatile currencies (IDR, MYR) trending in wider bands.

There are a number of explanations for these patterns, including the seasonality of current account flows, the ebb and flows of capital attracted/repelled by valuations and central banks’ management of their currencies.

I see few reasons why it will be materially different this time round. For starters, inflows into Asia are unlikely to accelerate given lingering foreign investors’ concerns about regional and global economic growth, the start of the US Fed hiking cycle and country-specific vulnerabilities including sensitivity to commodity prices and elevated foreign debt.

Furthermore, while Asian central banks may not purposefully weaken their currencies, they may have the room and the incentive to lean against further appreciation: overall, inflation is low and falling, exports are weak and FX reserves have fallen (see Figure 7).

  • Malaysia and Indonesia may have a compelling need to lean against currency appreciation, but less room to do so given still high CPI-inflation.
  • India has recorded weak exports while WPI-inflation remains firmly in negative territory (although the increasingly used CPI-inflation measure paints a somewhat more balanced picture). The central bank’s FX reserves were up about 16% year-on-year in September but they remain modest relative to imports.
  • Singapore’s exports have also shrunk while inflation remains well below the medium-term average, which may provide both the incentive and the room to fade the pace of SGD appreciation.
  • The case for the Philippines to slow, let alone reverse currency appreciation is perhaps a little less compelling as exports have held up reasonably well, inflation is still in positive territory and the BSP’s central bank FX reserves are up versus a year ago.

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  1. Signs of deflation provide room to fade currency appreciation

The fall in CPI-inflation in NJA weakens the case for a stronger currency’s disinflationary drag (see Figure 8). As I argued in More EM central banks to join rate-cutting party (30 September), in countries where real policy rates remain historically high, there is scope for further monetary easing in the form of policy rate cuts and central banks leaning against sustained and/or rapid currency appreciation.

However, Figure 9 shows that in Indonesia and particularly Malaysia CPI-inflation in Q3 was at the high end of a three-year range while in China it was near the middle of the range. For Malaysia, and to a lesser extent Indonesia and China, the central bank’s scope to slow let alone reverse currency appreciation may thus be somewhat more limited.

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  1. Weak Asian exports are incentive to protect currency competitiveness

The US dollar value of NJA exports was down 9% from a year ago in September (see Figures 10 & 11), with the modest rebound mainly driven by a bounce in Korean exports. While domestic consumption and services are faring better (in China and Korea for example), policy-makers may want to protect the competitiveness of export sectors which are major contributors to growth and importantly employment.

 

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  1. Modest currency intervention could replenish FX reserves

Adjusted for currency valuation effects, namely the depreciation of the euro, yen, sterling and Australian and Canadian dollars versus the US dollar, the USD-value of Asian central bank FX reserves has fallen in the past six months (see Figure 12).

Specifically, in the past year, FX reserves have fallen in Malaysia and Indonesia (depressed commodity prices), less so in China (capital account outflows), as depicted in Figure 13. These countries’ central banks may want to use the current bout of currency strength to replenish their FX reserves. FX reserves have been broadly flat in Singapore and Thailand and actually increased in Philippines, Korea, Taiwan and India.

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Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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