Asiamoney FX: Asia’s treasurers face a juggling challenge

Asiamoney FX report, February 2011 

The global financial crisis brought great volatility to foreign exchange markets, Asia included. And, while that volatility has eased, it hasn’t gone away. Treasurers in Asia today need to juggle widespread optimism about the direction of Asian currencies with a global market that continues to throw up surprises. 

The picture generally in Asia is very positive, if you’re in a position to benefit from local currencies rising against the dollar, euro and yen. “Rarely in my life have I seen such a unanimous view as this,” says Adam Gilmour, head of FX and derivatives sales for Asia Pacific at Citi. “There is an absolute consensus that Asian currencies are going to strengthen and that Asia economically is going to outperform the western world.”

Gilmour is with the consensus. “It’s very hard to have a different view from that, but you cannot expect it’s going to be a one way flow: a lot of things will happen this year that will continue to prompt volatility in Asia.”

At the heart of strategist thinking on Asian currencies is the near inevitability of capital flows into the region. There are a host of reasons for this, most obviously the drivers of world economic growth. “The GDP output gap between Asia and the rest of the developed world is about 5% now,” says Gilmour. Asia is much more productive than the west right now – and, having headed into economic recovery earlier, that’s a gap that will get bigger before it gets smaller. Inflationary pressures, widely discussed in terms of food prices in Asia this year, are likely to increase and possibly to spill into core inflation – another prompt for flows.

Also, as Asian central banks normalize interest rates, that is leading to wider interest rate differentials with western markets where those rates continue to be low to support economic recovery – and, in an era of quantitative easing in the US and sovereign-impacted credit easing in Europe, this is another gap that is likely to get bigger before it gets smaller. This differential supports flows chasing yield. Additionally, Asian currencies are widely thought to be undervalued, not just by strategists but by G20 policy makers, and while the headlines on this point focus largely on the Chinese renminbi, it applies to a wide range of Asian currencies.  And portfolio managers, both in private sector mutual funds but also pension funds and investment arms of the state, are tending to rebalance their Asian holdings along GDP lines rather than market cap, which very much supports flows into Asia – as do risk-weighted adjustments to holdings that now consider Asia, emerging or not, to be a much safer proposition relative to Europe than it used to be.

While these flows are broadly welcome, it’s been consistently clear for a year or more that they are also generating nervousness among Asian policymakers. Capital controls have been talked about with increasing urgency from Korea to Indonesia to India, as the prospects of sudden outflows, and the impact on market stability, take the sheen off otherwise positive market performance. The recent stock market drop in Korea, when 2.7% was knocked off the Kospi stock market benchmark in the last half hour of trading by foreigners selling heavily as options positions expired, amplified this sentiment.

Put simply, increased inflows always mean increased potential volatility, because by definition what floods into a market can flow out again just as swiftly. While some flows reflect long-term buyer interest, some will be speculative and flighty. When central banks and regulators get nervous about these prospects, they tend to increase regulatory intervention, which can itself be a source of additional volatility. Also, although flows now generally reflect a much more appetizing risk environment in Asia, money does tend to behave predictably when there is a shock (like another European sovereign debt problem) – it flees emerging markets, even if the problems that caused the shock are in the developed world.

There’s also the impact of the US and European economies to consider – since those blocs are on one side of most relevant Asian cross-rates, their economic behaviour is clearly relevant to Asian forex. If the US ends quantitative easing and begins raising rates, that will flow through into foreign exchange markets. “I would not be surprised if the US economy starts to pick up at a greater pace than people think as the year progresses, and that could have a material effect on dollar-Asia,” says Gilmour. “If we start seeing US interest rates moving higher, that could dramatically change the way dollar-Asia moves.” And in the background there’s also the risk of political instability, most obviously between North and South Korea.

Capital controls are discussed in more detail in another feature, but state engagement in flows and currency movements do represent something of a wild card in trying to predict where currencies will go. “I get the sense that the rate hike cycle is only part of the resolution central banks are using for their heightened inflation fears,” says Craig Chan, Asia FX strategist and executive director at Nomura. “In fact, an increasing number of them are looking at all available tools, including FX.” This is most evident, and most frequently discussed, in Korea, where the government and the Bank of Korea have both been vocal recently about waging war on inflationary pressures. It’s also interesting in Indonesia. Last September, Chan was writing about “continued intervention from authorities to prevent the currency from appreciation,” but now, “I think things are beginning to change, I really do. Inflation expectations are beginning to rise quite significantly, and after half a year of them intervening to stop currency appreciation I think they’re getting to a point where policy could change. That’s a theme that’s becoming more broad-based in Asia as a whole.”

Treasurers are analyzing these twin shifts – positive outlook, with volatility – and adapting their approaches accordingly. “One clear trend we are seeing over the last couple of years is an increased emphasis by corporate treasurers to establish a clear and definitive hedging policy,” says Sushir Lohia, managing director and head of corporate FX and rates for Barclays Capital in Asia. These policies, which a corporate treasury will then follow for, say, the next financial year, are sufficiently official to have been approved by the company’s board of directors. “Once you have a well drafted hedging policy, with clearly defined hedge ratios, hedge horizons and hedging tools that can be used – such as cash products or options – as a corporate treasurer you are in a good position to capitalize on extreme market movements,” says Lohia.

“It’s not an easy time to be a corporate treasurer,” he adds. “They are often evaluated with the benefit of hindsight while at the same time expected to outperform their peer group and the market benchmark. We’ve seen around the region that corporate treasurers without a clear hedging policy tend to freeze in volatile markets – they would rather do nothing than do something and be proved wrong.

But let’s say a treasurer has a hedging policy that specifies that you can hedge between 30% to 60% of imports or exports, with the hedge horizon not exceeding three months, with a target hedge rate of the FX rate prevailing at the start of the reporting period, and with not more than 30% of the hedges being executive through FX options, Lohia says. “In volatile markets, a corporate with such a well defined hedging policy would spring into action and execute as per the hedging policy when the target market levels are reached.” Banks like Barclays are spending a lot of time helping companies develop these hedging policies, and are also often asked for peer group comparisons, within a sector or a country. There is also an increasing willingness to adopt global best practices.

“Three years ago, many Asian corporate treasuries did not have a structured approach to risk management,” says Lohia. “There is a strong preference now to have a definite policy so that hedges can be executed as unemotionally as possible.”

Within those approaches, other trends are apparent. Bankers report hedge ratios increasing over the last two years to remove uncertainty from the market. Also, partly for accounting reasons but increasingly reinforced by market volatility, treasurers are tending to shorten the tenors of hedge positions. Lohia says that in India, for example, whereas a few years ago hedge horizons would typically exceed 12 months, the preference now is to hedge for one or two quarters. He adds, though, that more generally across Asia hedging behaviour also varies by sector; in areas such as retail and consumer, where hedging costs cannot be passed on to end consumers, the tendency in volatile markets is to increase the hedge tenors.

The role of options in hedging FX volatility changed through the financial crisis; in particular zero cost options as a hedging tool all but died out through 2008 and 2009. “But over the last 12 months we’ve seen a re-emergence of corporate activity in using short-dated FX options,” says Lohia. Typically these zero-cost structures take the form of range forwards, participating forwards and seagulls. “We strongly believe that given the downside risk, the benefits of purchasing option hedges far outweigh their cost over the long term,” he says. He warns, however, that the tendency in Asia is to focus on zero-cost options, which involve the introduction of some risk in order to achieve the zero cost.

While these approaches are tactical strategies that apply around any company’s import and export business, another trend is evident in overseas borrowings. Asian companies, growing rapidly, have been highly active in international loan and bond markets in recent years, but have tended to leave their borrowings unhedged because of the sense that Asian currencies are rising – which has been a common view since at least the middle of the last decade. Logically, that rising trend ought to make the borrowing cheaper over the duration of a bond or loan. But this approach, too, has changed with the financial crisis. “Over the last five years, while the view remains that currencies are going to appreciate against the US dollar in the long term, we are now seeing an increased amount of hedging of foreign currency borrowings back into local currency, as long as the all-in hedged cost is lower or in line with their local currency borrowing,” says Lohia. “That’s because of volatility and the way Asian currencies weakened during the crisis.

Within the broad view of rising currencies, strategists and managers tend also have specific views on currency plays. Gilmour believes treasurers “should definitely be hedging a reasonable amount of their exposure for the year, keeping some flexibility to sell dollars on rallies.” He says clients are proactively hedging exports in dollars and are also expecting the euro to stay weak this year. Those in commodity industries ought to be particularly attentive, he says, since the FX risk changes as commodities go up and down.

Chan focuses on Indonesia, where “if authorities don’t take the proper action next month [February 4, when Bank Indonesia is expected to raise rates] the rupiah may start to underperform quite significantly as the perception continues to build that BI is behind the curve. If people are concerned about central banks lagging, the current place of focus is Indonesia, where people holding onto long dollar-IDR positions or hedges will have benefitted quite significantly. This might change if BI hikes in February.”

And Dennis Tan, Asian FX strategist at Deutsche, says that treasurers should be selective within their rising-currency view. “We are recommending to go long the RMB, the Taiwan dollar and the Singapore dollar,” he says. “Those are the currencies that will outperform in an inflationary environment, the places where traditionally the central banks allow for faster appreciation.” China is obviously something of a special case, but Tan argues that China tends to follow a certain sequence of tightening: first administrative measures such as telling banks to slow down lending to certain sectors; then liquidity tightening, with higher reserve ratios and the issuance of bonds to soak up liquidity; and third, rate hikes. After that, it allows the currency to appreciate faster – and that’s what Tan believes we will see more of this year. “It’s not about pressure from the US. It’s about the need to fight inflation.”

Taiwan, meanwhile, has seen consistent FX intervention to slow down the appreciation of the Taiwan dollar over the last two years, but Tan says that policy has stepped back since September, with very little intervention at all in December. It’s not a universally held view: Chan notes that performance in the Taiwan dollar has been exceptional for some time now, and “moving into the next two to three months, I don’t see that outperformance continuing to the same extent.” As for Singapore, Tan says the Monetary Authority’s recent decision to steepen the slope of the Singapore nominal exchange rate also points to appreciation.

But in Tan’s view it is not automatically the case that all Asian currencies will behave the same way. “The other side of the coin would be the Indonesian rupiah and Indian rupee, at least in the very near term. I wouldn’t say it’s very drastic downward pressure – it’s not like it’s going to collapse 10% or so – but we will see higher volatility for these currencies because inflation has been much more sticky in these countries, mainly from food but potentially core inflation too. Worries of central banks stepping up rates tightening are hurting investor sentiment there.”

There is a great deal in the mix for treasurers to consider: the oil price, food price, US economic recovery, European sovereign debt, Chinese regulatory policy. None of it’s easy, but it is at least easier when Asian currencies are rising rather than plunging.