- Weakness in the yen and euro and higher US Treasury yields to weigh on Asian currencies
- External imbalances and foreign reserves have improved since 2013
- The impact of the reversal of capital flows and bond redemptions are manageable
- Chinese yuan also weakens versus USD in 2015-16, but remains relatively resilient
External factors to weigh on Asian currencies
Our view that Asian currencies will underperform the US dollar in 2015 has not changed. We expect this underperformance to continue well into 2016 for several reasons. Inflationary pressures in Asia are likely to remain relatively contained in general. This is in part because we expect energy and food prices to remain relatively subdued (although we expect downward cost push factors to fade). These developments are likely to weigh on inflationary pressures in Asia more than in the US given that both food and energy prices constitute a larger part of the CPI basket in Asia. On balance, we expect monetary policy tightening in Asia to lag the US. Narrower interest rate differentials are likely to result in less demand for Asian currencies in carry trades. More importantly, the market is significantly under-estimating the timing and pace of rate hikes in the US in the next two years in our view. This will provide a catalyst for a stronger US dollar. Our correlation studies show that the Singapore dollar, Thai baht and Indonesian rupiah are the most vulnerable to higher yields in the US.
Another external factor that is likely to weigh on Asian currencies is ongoing weakness of the currencies of key partners and competitors in export markets. The euro and Japanese yen constitute about 30% of most Asian currencies. Several Asian economies also have a relatively high export similarity with the eurozone and Japan. As we expect the euro and the yen to decline further in the next two years, some countries may favour policies to weaker their own currencies as well to maintain export competitiveness and market share.
Foreign held bonds redemption risk
In 2015 and 2016 a total of USD 390 and USD 355 billion worth of corporate and government bonds held by foreign investors will mature in several Asian countries. In 2015, the bulk will mature in the second and third quarter, a period when we expect the US Federal Reserve to begin raising rates. This may potentially trigger an outflow of capital from Asia.
Exports dynamics and foreign reserves
Nevertheless, the above mentioned headwinds for Asian currencies should not be exaggerated. In fact, Asian economies will profit from a strong US economy in the next two years. In addition, the impact of potential capital outflows will likely be mute because Asian central banks have sufficient foreign currency reserves to manage volatility in their currencies. Foreign holdings of corporate and government bonds in foreign currency are also smaller at about 20% of debt due to mature in 2015-16. In addition, some of the more vulnerable economies look better placed. For example, both Indonesia’s and India’s foreign reserve balances are at healthier levels than last year. Furthermore, we also expect economic fundamentals in Asia to remain strong and this should provide confidence to foreign investors.
Indonesia and India’s external imbalances have improved
The Indonesian rupiah and Indian rupee were the most vulnerable Asian currencies during the tapering dry run in the middle of 2013 due to their external imbalances and unfavourable growth inflation dynamics. Since then, their external imbalances and inflation outlook have improved substantially. In India, prudent monetary policies, gold import restrictions and the substantial drop in oil prices have driven the current account deficit down. Within emerging Asia, Indonesia may now look relatively vulnerable to a (sharper-than-expected) Fed exit. However, the recent reduction of energy subsidies and rate hikes by Bank Indonesia could help to reduce external deficits. This should strengthen investor confidence and hence reduce the country’s vulnerabilities somewhat. We also expect the current account deficits in both countries to remain below 3% of GDP and real interest rates to remain positive. Nevertheless, both currencies remain more vulnerable to reversal of capital flows compared to other Asian currencies given their current account imbalance.
Chinese yuan appreciation trend against the USD has ceased…
The Chinese yuan’s appreciation against the US dollar has ceased this year. We expect the yuan’s underperformance against the USD to continue in 2015 and 2016 for several reasons. First, China’s growth is expected to slow from 7.7% in 2013 to just below 7.5% in 2014 and 7% in 2015 and 2016. Against that background, divergence in monetary policy and narrower interest rate differentials will provide less support to the yuan. The PBoC surprised financial markets in late November by cutting policy rates. It is now taking resort to broader monetary easing strategy, in contrast to the targeted stimulus it provided over the past half year. Further ‘measured’ easing steps (some rate cuts, tweaking of reserve requirements and loan-to-deposit ratios) may well follow in the coming months, in our view, certainly if financing costs fail to come down. We have penciled in two 25 bp cuts (to 5.1%) of the benchmark lending rate in the first half of 2015. On the other hand, the Fed is likely to raise the Fed funds rate to 3% by the end of 2016 to cool the US economy, which is projected to grow at above trend rates in the next two years.
Second, as the Chinese economy shifts towards a more consumption led model, the trade and current account surplus as a percentage of GDP are expected to decline further. This will provide less support to the yuan. Third, outward direct investment flows are projected to exceed foreign direct investment in 2015. Fourth, we think that the yuan is closer to equilibrium after appreciating by about 9% against its trade weighted basket of currencies since the second half of this year. It is unlikely that Chinese authorities will be comfortable with further strong gains in the currency at a time when the euro and yen are depreciating. Both currencies constitute about 35% of yuan’s trade weighted currency index. Last but not least, we judge that the central bank is less tolerant to speculative flows, which have led to strong gains in the yuan in 2013 despite other Asian currencies’ underperformance last year. This was evident in the first half of 2014 when the PBoC engineered a weaker currency to warn speculators that the currency is not a one way bet. Furthermore as the authorities seek to rebalance the economy from an investment to consumption model, a drag on exports from a strengthening currency would be undesirable.
…to remain resilient against strong USD trend
Nevertheless, we expect the yuan to remain one of the more resilient Asian currencies in the next two years versus the US dollar. This is because the currency is still heavily managed by the Chinese authorities through the daily fixing rate and 2% trading band on either side of the fixing rate. In addition, demand to use the currency as a trade settlement and reserve currency is increasing. This source of demand for the currency is more stable and is expected to increase as the share of trade settlement in the yuan compared to China’s total foreign trade is still relatively small. Central banks are also likely to diversify more of their foreign currency reserves into the yuan, because they seek to align with their country’s bilateral trade flows with China. Furthermore, we think that the central bank has a preference for a relatively stable currency as they continue to liberalise their interest rate and exchange rate regimes. Last but not least, the central bank has large foreign currency reserves to defend volatility in the currency. To conclude, we expect the yuan to gradually ease lower towards 6.25 and 6.30 against the USD in 2015 and 2016.