Asian Currencies Buoyed By Strong Growth, Rising Reserves

Strong regional growth, rising central bank reserves and the prospect of a currency policy shift led by China all augur well for a continued rally in Asian currencies this year. Moreover, the current lag in interest rate cycles between the U.S. and Asia could boost the carry trade for Asian currencies as traders buy currencies where interest rates are just beginning to rise to more neutral levels and sell those, like the U.S. dollar, where rate tightening may be nearing completion.

Strong global growth continues to fuel demand for Asian exports, leading to higher expected returns on Asian assets and rising capital inflows into the region. Even as the rate of growth in the U.S. slows, increasing signs suggest the shift will be a soft landing. Overall growth in the other economies that matter most to Asia – Europe, Japan, China and India – should remain above trend in the near term.

Barring any negative shocks, Asia’s export-driven growth in the first half of this year should spur domestic demand in the second half. This is likely to be particularly marked in Japan, where structural changes, improvements in the labor market and renewed corporate investment are expected to sustain recovery and restore the country’s role as an engine for pan-Asian growth. Stronger regional growth will mitigate Asia’s sensitivity to exchange rates, preparing the ground for greater tolerance for currency appreciation in the region’s economies.

Another important factor is the rapid rise in central bank reserves, especially in China. By the end of 2005, China’s international reserves totaled US$818.9 billion, compared with Japan’s US$828 billion – a 34.3% jump for China, compared with Japan’s 0.6%. Japan and China account for 40% of global reserve assets. Recent comments by China’s State Administration for Foreign Exchange saying it would “actively explore more efficient use of our foreign exchange reserves” have been interpreted as suggesting China’s foreign reserves have surpassed the levels deemed necessary for liquidity needs.

Surging reserves can not only prompt protectionist rhetoric in the U.S., but also impair domestic monetary policy as a tool for managing growth and price stability. Currency politics with the U.S. could heat up as mid-term elections in the U.S. approach. There have been signs that the U.S. Treasury could name China as a currency manipulator in its April report if China does not show greater accommodation in revaluing the renminbi. While appreciation in the renminbi could impair job creation, there is the danger that China could lose more jobs if an undervalued currency spurs protectionism in lucrative markets like the U.S.

Scaled-down interventions by the Bank of Korea and the Central Bank of China in Taiwan led to slower rises in reserves last year. A slowdown in the pace of reserve accumulation in China would be positive for the renminbi and possibly other regional currencies.

Nevertheless it is unlikely that China would diversify away from the dollar in any meaningful way in the near term. Recent comments from Chinese authorities suggest it is more likely that they would diversify away from U.S. Treasuries rather than dollar assets, as they search for ways to enhance their return on investment. This could lead to higher demand for agencies and mortgages which contain explicit or implicit government support but provide a spread relative to U.S. Treasuries.

Apart from U.S. pressure, China has shown a willingness to pursue a more flexible currency policy as its money supply has surged to keep the currency’s exchange rate low. This could have significant repercussions for the entire Asian region since China leads the way in terms of competitive manufacturing and, by extension, currency policy. Continued appreciation in the renminbi could catalyze policy shifts across the region as other Asian economies are able to allow their currencies to appreciate without losing competitiveness.

Other Asian banks are likewise beginning to embrace a more dynamic view of exchange rates. This will not only help correct current imbalances but also improve the region’s competitiveness by encouraging companies to focus on higher value-added products rather than relying on low margins and cheap currencies.

At the same time, potential changes in monetary policy in Japan could provide momentum to the gradual appreciation of currencies across the region. As the Central Bank of Japan gets closer to abandoning its close-to-zero interest rates, the yen could begin to rise, taking other Asian currencies higher as well.

Rally’s Effects

While stronger currencies are perceived as harmful for growth and corporate profits in a globalized region such as Asia, the economic impact might be less than many investors fear. It takes a fairly significant currency move to noticeably affect exports as price elasticity is small, especially in the short run. Currency strength will help hold down inflation since in principle a stronger currency lowers import prices, dragging down the prices of other tradable goods and enabling interest rate policy to remain supportive of domestic demand in Asia, which could develop as a major theme in the years ahead. This is especially important as energy prices remain high.

However, significant revaluations could cause a marked decline in the trade surplus and a large slowdown in growth. Currency appreciation can upset trade balances by slowing exports and boosting imports. A decline in net exports would slow economic growth, particularly in open economies. Assuming no offsetting fiscal or monetary policies, estimates show that Asian economic growth would fall by 10-20 basis points in the first year after a 1% trade-weighted revaluation (see chart below).

Impact of 1% Trade-Weighted Appreciation on GDP Growth 


Of course prospects for Asian currencies would change dramatically in the event of a significant slowdown in external demand with its multiplier effect on domestic demand and regional growth. This could occur in the event of a renewed and prolonged jump in oil prices dampening global consumption, while another burst of emerging market growth could well pressure commodity markets. And there is still the possibility that an avian flu pandemic could have devastating effects on the global economy.

Still all the evidence so far points to a sustained rally in Asian currencies over the next few years as the region continues to develop as one of the most important engines of global growth in the 21st century.

Contributor Sean Flannery is Chief Investment Officer, North America, for State Street Global Advisors. He is based in Boston.