FX Watch – Impact of yuan devaluation

by: Roy Teo

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We have downgraded our Asian currency forecasts for this year by another 2-3%, as the recent devaluation of the Chinese yuan has negative implications for other Asian currencies. This is because other Asian countries’ exports will become relatively less competitive. Overall, we expect the Singapore dollar, Taiwan dollar and South Korean won to be more vulnerable to a weaker yuan, while the Indian rupee should be less impacted. We have added the Singapore dollar into our high conviction list as we expect a cumulative underperformance against the US dollar of around 8% by the end of 2016.

 

 

More headwinds to Asian currencies outlook

Earlier this month we downgraded our outlook for Asian currencies due to weaker economic fundamentals (for more details, please refer to our FX Watch – Weaker Asian FX published on 6 August). As we have recently downgraded our Chinese yuan forecast by 4% (from 6.30 to 6.55 by the end of 2015), a weaker yuan is likely to have negative implications on other Asian currencies as elaborated below.

 

SGD, KRW and TWD more sensitive to CNY

The Singapore dollar (SGD), Taiwan dollar (TWD) and South Korean won (KRW) are more sensitive to movements in the CNY as these economies have a larger export exposure to China as a percentage of domestic GDP. Indeed, exports from Singapore and Taiwan to China are equivalent to more than 15% of domestic GDP in 2014. Given Hong Kong’s large export exposure to China, we expect the Hong Kong dollar (HKD) to ease towards the upper bound of trading band of 7.85 against the US dollar over time.

 

Export similarity with China: HKD and THB vulnerable

According to a study by the IMF, exports from Hong Kong, Thailand, South Korea and Indonesia have higher export similarity to China exports. Hence with the exception of HKD (which is pegged to the US dollar), central banks in these economies are likely to directly or indirectly weaken their currencies to support exports. As we expect further weakness in the CNY, the Japanese yen and the euro, the KRW is most vulnerable as South Korea exports have the highest export similarity to China, Japan and the euro area.

 

Exchange rate valuation impact

According to the BIS metrics, the CNY represents more than 25% of the KRW and TWD nominal effective exchange rate. Hence due to a weaker CNY, the KRW and TWD exchange rate valuation will be more expensive ceteris paribus. This will impact South Korea and Taiwan’s export price competitiveness. The impact is expected to be more pronounced if both the euro and yen are also taken into consideration. On the other hand, the CNY accounts for 15-20% of other Asian currencies’ trade weight.

 

Asian currency forecasts downgraded

Taking the above into consideration, we have downgraded our year end forecasts for SGD, KRW and TWD by another 3%. Due to a lower trade exposure to China and export competition with China, we have lowered our forecasts for the Thai baht (THB), Indonesian rupiah (IDR) and Indian rupee (INR) by 2%. Though the INR is less exposed to a weaker CNY, we expect sentiment in the INR to remain weak due to the contagion effect from other Asian currencies, which account for around 40% of INR weight in the nominal effective exchange rate.

 

For the KRW, SGD and the IDR we expect a cumulative fall of between 8-10% this year and next year versus the US dollar. We have added our bearish SGD view to our list of high conviction FX picks as it is widely traded and has a lower cost of carry.