AT A TIME when the US dollar has weakened against most currencies and gold prices have surged, a question for Asian investors is what the implications are for Asian currencies. We believe that the conditions are falling in place for Asian currencies to experience a significant appreciation next year.
The US dollar has to decline, long term
First, we need to clarify what the picture for the major currencies is likely to be. As we argued in an earlier commentary, we see both the role of the US dollar as a reserve currency as well as its value diminishing over time. Events since we wrote that have strengthened that view. Even though the US economy is now recovering from the worst recession in decades, the sustainability of the rebound is suspect. More than that, the economic fundamentals of the US economy have deteriorated — its fiscal and public debt position is much worse, some key publicly owned financial institutions are in worse shape (eg Fannie Mae and the Pension Benefit Guaranty Corp) and its long-term growth potential is now judged by the International Monetary Fund to be significantly lower in future. In addition, the US political system’s capacity to rationally and effectively resolve critical challenges is in question, as anyone who has followed the healthcare debate or the push for effective financial reforms will attest to. There are no two ways about it: The US dollar will depreciate over the longer term. Of course, there will be episodes when it will become over-sold and then rebound sharply — but the overall trend will be inexorably down.
Not sustainable for just a few currencies to bear the burden of adjustment
If that is the likely scenario, then the question is which currencies will need to appreciate in order to facilitate the depreciation of the US dollar. So far, the burden of adjustment has been — probably unfairly — borne by freely floating currencies such as the euro, yen, pound sterling, Canadian dollar and Australian dollar. Of late, several emerging-market economies that allow their currencies to float relatively freely — such as Brazil and Russia — have found that their currencies are appreciating at a rate that could undermine their competitiveness. The US dollar has depreciated against several Asian currencies such as the Korean won, Indonesian rupiah, Singapore dollar and Malaysian ringgit but some of these currencies are still mostly weaker against the US dollar than a year ago. Other Asian currencies — especially of course, the Chinese renminbi (RMB) — have remained flat against the US dollar in the past year. This configuration — where some currencies in the world bear most of the burden of US dollar adjustment — is simply unsustainable.
There is indeed growing impatience with China and other Asian countries’ unwillingness to allow some appreciation of their currencies against the US dollar. More trade-related complaints are being filed against China in the World Trade Organization (WTO) — and not just by the US and Europe. For instance, Mexico joined the US and the European Union to ask the WTO to establish a dispute-settlement panel and investigate China’s restrictions on exports of nine key raw materials.
This irritation with China and Asia is likely to intensify. Developing economies are increasingly concerned about the implications of being one of relatively few economies that allow their currencies to float — they are receiving growing inflows of speculative capital making bets on currency appreciation that they are uncomfortable about. Increasingly, they are reacting more forcefully to such inflows. Russia just issued a warning to speculators that it might make the rouble more volatile to deter speculation, for instance, and Brazil has imposed a 2% tax on capital inflows.
Asian currencies will come under pressure to appreciate
As 2010 progresses, we think that inflows into Asian assets will rise hugely as excess liquidity around the globe searches for returns and finds the Asian growth story compelling. This will put upward pressure on Asian currencies. Sure, central banks can resist this — but only through intervention and more reserve accumulation, which may not be wise. If reserves are accumulated in US dollars, Asians would be investing in a depreciating asset. If reserves are accumulated in euros, the only other serious alternative to the US dollar, it would only serve to strengthen the euro beyond the Europeans’ threshold of tolerance.
That means that Asian policymakers may have to allow their currencies to appreciate. However, if China does not appreciate its RMB, it will not make sense for others to do so — the impact on their competitiveness would be very damaging. The key, therefore, is China. Right now, the Chinese seem adamantly opposed to RMB appreciation but we can see this policy stance changing by early to mid-2010:
- The Chinese will shift policy when domestic economic conditions argue for it. We believe the Chinese economy will go into over-drive by late 2010 as the massive monetary and fiscal injections work their way through the economy. As policymakers become less concerned about sustaining economic growth, they will be more willing to contemplate policy changes such as RMB appreciation. Policymakers also know that currency appreciation can help hold back any emerging inflationary pressures.
- Once the immediate threat to economic growth has receded, the Chinese policy
concerns will also begin to focus more on longer-term economic strategy. Over the longer term, China will have to move up the value chain and increase the role of domestic consumption in its economy. Both these essential changes can be helped along by judicious currency appreciation. A stronger currency will incentivise companies to move into highervalue activity since it will not be so easy to compete with a strong currency in low-value goods. Moreover, a stronger currency would make imports cheaper and effectively raise living standards, promoting domestic consumption.
- China also will realise the downside risks of keeping an undervalued currency in the face of rising anger among trading partners. At some point next year, they are likely to judge that the risks of continuing to upset major trading partners would offset the risks of a stronger RMB. They know that their exports will be the main targets of any slide towards greater protectionism.
Conclusion: What will the trajectory of currencies be?
So, it is quite likely that the RMB will start to appreciate again next year, allowing other Asian currencies to also rise. How this will unfold is not entirely clear, but we think the most likely scenario will be a one-off modest revaluation of the RMB followed by gradual appreciation, where that appreciation is calibrated against a basket of currencies, similar to how Singapore manages its exchange rate. Once the RMB starts to rise, most Asian currencies will likely appreciate as well. Investors need to be prepared for this eventuality.