FX Watch – Asian FX vulnerable?

by: Roy Teo

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The SGD and HKD are most vulnerable to slower growth in the euro area…

Exports of East and Southeast Asia, Asia’s traditional manufacturing hubs are vulnerable to slower growth in the Eurozone and a decline in price competitiveness as the euro weakens. Hong Kong and Singapore are the most vulnerable countries given their large total export exposure to the EU as a percentage of their GDP.

…though their large trade exposure to the US should mitigate downside risks

However the impact of slower economic growth in the eurozone and a weaker euro on Asia through the trade channel should not be exaggerated as the Eurozone share of developing Asia’s exports has declined from 15.6% in 2007 to 14% in 2011. Furthermore the negative impact is likely to be mitigated given that both Singapore and Hong Kong are also highly exposed to the US which in our view will continue to grow strongly in the coming years. The US dollar appreciation against Asian currencies will also improve the export price competitiveness of Asian countries.

Japan and South Korea have similar exports to euro area

The impact of a weaker euro on Asian exports is more evident for Japan and South Korea given they have more similar exports to the euro area than other Asian economies. With the Japanese yen also on a weakening trend, we judge that exports from South Korea will be most impacted within the Asian region given that since the beginning of this year, the won has appreciated by 8% and 3% against the euro and yen respectively. As such the discomfort of the South Korean Finance Ministry and central bank with the strong won will likely increase.

Asian currencies tend to track euro weakness in the medium term…

We have carried out two correlation studies to show the short term (30day rolling since 2013) and medium term (90day rolling since 2011) relationship between Asian currencies and the euro. Due to limited data for the Chinese yuan up to late 2010, we have started the medium term correlation study from 2011. Both studies result in similar conclusions for most Asian currencies. The Singapore dollar (SGD), Indian rupee (INR) and South Korean won (KRW) are more vulnerable to declines in the euro with a stronger relationship in the medium term. This is due to several factors as highlighted above: large trade exposure to the euro area, a relatively high euro weight in the currency basket (see graph). On the other hand, the JPY sensitivity to the euro is only evident in the short term given high export similarities, while the medium term direction is more driven by the direction in long term yields in the US (to be elaborated in the next section). The direction in the euro also has little impact on the Chinese yuan in the short term given that the yuan is still heavily managed by authorities. However given that the euro constitutes almost 20% of the yuan currency basket, the yuan is not immune to weakness in the euro over a longer time frame.

…and are vulnerable to higher yields in the US

The decline in euro area government bond yields has had spill over effects on global long term yields. This has supported risk sentiment in Asian currencies given their relatively higher returns. Nevertheless most Asian currencies are more highly correlated with long term Treasury yields in the US. We  expect US Treasury yields to rise in the coming two years as the Fed tightens monetary policy. This will have a negative impact on Asian currencies’ performance against the US dollar. Once again the Chinese yuan is the least sensitive to the direction in yields in the euro area and the US given that the exchange rate is not fully liberalised.

Healthy external balance to limit weakness

Given that we expect euro weakness to persist well into 2015, does this pose huge downside risks to Asian currencies and in particular the SGD, INR and KRW? We expect the weakness in these currencies to be mitigated as the external balance of Singapore and South Korea are healthy with high foreign currency reserves and current account surpluses. Hence authorities have sufficient ammunition to defend volatility and weakness in the currency if necessary. An improvement in global growth should also support both the SGD and KRW given their high export to GDP ratios. Downside risks in the INR should also be limited as economic growth in India improves, inflation declines and current account deficit narrows. Furthermore authorities have rebuilt the country’s foreign currency reserves in the past year, which will provide greater defence against volatility in the INR. However we expect the Japanese yen to weaken substantially as the divergence in economic outlook and monetary policy between US and Japan widens. In addition more outward investments from domestic investors, the government pension fund and local insurers are likely to weigh on the yen.