FX Watch – Disinflation to weigh on Asian FX

by: Roy Teo

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  • We are more negative on Asian FX due to disinflationary pressures from lower commodity prices…
  • …this means monetary policy divergence against the US will widen
  • Headwinds to Asian currencies remain despite stronger global growth outlook
  • We expect Indian rupee to outperform the Indonesian rupiah
  • We are more bearish on the Chinese yuan…but it will still be the most resilient among Asian currencies

More bearish on Asian FX

Since our last update ‘Weaker Asian FX in 2015-16’ on 3 December 2014, crude oil prices have declined by more than 30%. With the exception of Indonesia, most Asian economies in our coverage are net commodity importers and economic growth should benefit as a result of recent declines in commodity prices. However, compared to last month we are now more bearish on most Asian currencies. In this note, we explain why.

Monetary policy divergence against the US to widen

Sharper than expected drops in food and energy prices will result in a larger disinflationary impact in Asia given that they account for 30 to 70% of CPI basket compared to about 20% in the US. With the exception of Indonesia, inflationary pressures have been below the central banks’ target and this trend is expected to persist in the short term as the full effects of lower food and energy prices filter through. As a result, market speculation that central banks need to ease monetary policy further will continue to weigh on Asian currencies. Indeed, we expect central banks in China, India, South Korea, Thailand and Singapore (slower pace of S$NEER appreciation) to ease monetary policy later this year. Asian currencies are expected to underperform as monetary policies in the region remain low, while that in the US tightens later this year.

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INR to fare better than IDR

Inflationary pressures in Indonesia and India are expected to decline in 2015 given that food and energy prices account for more than 50% of CPI basket. However, headline inflation in Indonesia rose in late 2014, given the recent removal of fuel subsidies. We maintain our view that the Indian rupee (INR) should outperform the Indonesian rupiah (IDR) for the following reasons. First though Indonesia is expected to benefit from lower energy prices, headwinds for the economy have built given that it is a net commodity exporter. There is also less flexibility for the central bank to ease monetary policy to support economic growth as inflation remains above target. Second foreign direct investments into Indonesia’s oil and gas sectors may decline as the outlook in these sectors deteriorate given the slide in both oil and gas prices. Given Indonesia’s current account deficit, the IDR will be vulnerable. Third, foreign investors’ ownership in government bonds have risen from 31% in the middle of 2013 to above 39% in November 2014. Hence the IDR is more vulnerable to reversal of capital flows when investor sentiment is less favourable. Last but not least, foreign currency reserves in India are at healthier levels.

KRW, TWD and SGD to benefit most from commodity price declines and stronger global growth…

The South Korean won (KRW) and Taiwan dollar (TWD) will stand to benefit the most from recent commodity price declines given that these economies’ net commodity imports are more than 5% of GDP. Given their high exports to GDP, the KRW, TWD and Singapore dollar (SGD) are also expected to be supported as global economic growth picks up this year.

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…weaker EUR, JPY and higher US yields mean gains not sustainable

Gains in the KRW and TWD may not be sustainable due to headwinds from weaker euro (EUR) and Japanese yen (JPY). This is due to our view that lower energy prices will result in a greater challenge for the Bank of Japan (BoJ) to achieve its 2% inflation target in 2 years. As a result, we maintain our view that the BoJ will need to further increase monetary stimulus this year, exerting further pressure on the JPY. The ECB is also expected to expand monetary stimulus and we envisage that the EUR will weaken towards 1.10 against the USD later this year. Given the high export similarity of South Korea and Taiwan vis-a-vis Japan and the Eurozone, we doubt that the central banks will tolerate further gains in their domestic currencies in order to maintain export price competitiveness.

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In addition, the KRW and TWD are also trading at multi-year highs against both the JPY and EUR. Furthermore, both the KRW and TWD are more vulnerable to slower growth in China given their larger trade exposure. We have kept our KRW forecasts unchanged given that the market has almost priced in a rate cut, consistent with our view. On the other hand, we have lowered our TWD forecasts because the TWD is trading at the strongest level against its trade weighted basket of currencies since 2006. We suspect that the central bank will be more active in defending further gains in the currency. We have also become more bearish on the SGD due to our view that the Monetary Authority of Singapore will slow the pace of S$NEER appreciation in April. The SGD is also the second most vulnerable Asian currency after the JPY to higher yields in the US. As the market is underestimating the timing and pace of rate hikes in the US in our view, the SGD is expected to underperform more as the Fed starts to tighten monetary policy in the middle of this year.

More bearish in Chinese yuan…to remain resilient

We have also become slightly more bearish on the Chinese yuan given its sharp appreciation against its trade weighted basket of currencies in the last two months of 2014. We doubt that Chinese authorities will be comfortable with the pace of currency gains given that net exports will be a welcome tailwind to the economy as the rebalancing strategy continues. Nevertheless, we maintain our view that the yuan will remain one of the more resilient Asian currencies in the next two years versus the USD. 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. China’s trade balance should also benefit from lower commodity prices, as it is a net commodity importer. 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.

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