Asiamoney: What happens to Asian currencies with a recovering America?

Asiamoney, February 2013

The world looks brighter in 2013. The US is recovering, and dodged the bullet of the fiscal cliff; Europe, for the moment, is calm; China appears to have avoided the feared hard landing; even Japan looks relatively robust.

But what does a more optimistic global environment mean for Asian currencies? Does a strong dollar automatically mean weaker Asian currency performance against it? Does a sense of stability mean nobody needs safe haven currencies like the Singapore dollar anymore?

The answer depends on the currency, but some broad conclusions are clear. “It means that Asian exporters should do well,” says Nick Verdi, FX strategist at Barclays Capital. “We’re seeing that already in Chinese and Taiwanese trade data. The way we are thinking about global FX markets is in terms of diminishing tail risks: whether it’s about a hard landing in China, the US fiscal cliff or the risk of a Eurozone breakup, those risks are diminishing against a backdrop of ample global liquidity. The ingredients are in place for carry currencies in particular to do well.”

In this environment, the nuances of individual currencies are not going to be particularly evident as the global macro situation drives performance.

“In the first half of this year at least, there is probably not going to be a lot of differentiation between Asian currencies,” says Craig Chan, head of FX strategy for Asia ex-Japan at Nomura. He sees some underperformance in Indonesia, discussed below, but beyond that it appears a rising tide will lift all boats. “We’re going to get continued global stimulus, have a Chinese recovery and will continue to see capital inflows come into Asian equity and bond markets.”

[Subhead]Regional winners

Still, some variations in performance are inevitable, and different houses have different views on the outperformers. Verdi at Barclays expects the ringgit and Indian rupee to do well, followed by the Philippine peso and potentially the Korean won.

Malaysia appeals as a currency play, offering a relatively high yield. “And in terms of fundamentals, it is unlike some north Asian currencies in that it is increasingly driven by domestic demand, which gives it a fairly balanced growth picture,” Verdi says. Foreigners hold 38% of ringgit local bonds, he adds, with scope for further flows as Malaysia gets a big pipeline of investment projects underway. Its role as a commodity exporter is also potentially positive for the currency.

For Sameer Goel, head of Asia rates and FX strategy at Deutsche Bank, the Philippine peso is one of the best candidates for outperformance. “What we like the most is that it is driven by very strong structural current account surpluses,” he says. “They run a trade gap, but on the other hand have very strong remittance flows from overseas Filipina workers sending money back, which finances growth in the local economy.” The strength of the services sector, particularly the growing BPO industry, also helps. “In addition to that, we have seen money come in in portfolio flows into debt, and those flows are very robust and strong. So even though currency appreciation comes with its own disadvantages,” notably export competitiveness and reducing the peso value of the remittances that come in, “because it is built on a base of underlying fundamental flows that are not speculative in nature, we tend to have more faith.”

For Tan Teck Heng, emerging FX strategist at UBS Wealth Management, “we recommend holding currencies with stable fundamentals.” In practice that means Korean won, Singapore dollars and Chinese yuan. “The easy choice is China. In terms of risk-adjusted returns, volatility is extremely low, so even if it doesn’t appreciate a lot it is one of the most stable currencies around. So if you hold an asset like a corporate bond denominated in this currency, you get good risk-adjusted return potential.” He likes Singapore dollars – an unusual view among FX strategists – because of the official policy to allow it to strengthen on a trade-weighted basis to counter imported inflation.

And the Korean won – the best performer in Asia in 2012, gaining about 9% against the dollar compared to 3-4% on average for most others – is attractive because it is well exposed to gains in the global environment, being, like Taiwan, heavily export driven. “We like it in particular because of its attractive valuations: about 10% below the levels it was trading at against the US dollar prior to the Lehman crisis,” says Tan. “Other currencies have reached multi-year highs. In terms of upside potential, won is in a good position.”

[Subhead] China slows the pace of change

All eyes continue to be on China, although the pace of opening has slowed somewhat. “It’s taken a little bit of a pause,” says Chan. “I don’t sense there has been a big push in liberalisation. It doesn’t surprise me, as you have the transition of leadership taking hold, and beyond that policymakers have been focusing on preventing a slowdown in the economy for much of the second half of last year.” He doesn’t expect to see major change until after the formal handover of power in March. It’s worth noting that Nomura as a house is expecting slowed momentum in the Chinese recovery in the second half of the year; it expects 7.2% growth by the year end, compared to a market view of around 8%.

Still, even if liberalisation is no longer the national priority, changes are taking place, most recently a widening of the band within which the Chinese currency trades against the dollar, from plus or minus 0.5% to plus or minus 1%. Additionally, the offshore RMB market has continued to flow, while liberalisation has gathered pace in the domestic interest rate market, “providing more of a suite of products you can use to hedge currency movements,” says Goel at Deutsche. Additionally, in December the government removed a cap on sovereign wealth funds and central banks investing in Chinese financial assets. Previously, says Tan at UBS, funds such as GIC and Temasek in Singapore, or Norges Bank in Norway, could invest only up to US$1 billion into China. “This limit has been removed,” says Tan. “Now they can theoretically invest unlimited amounts of funds into China. That is an effective way to open up the Chinese markets, because it essentially allows people to hold more of the Chinese currency.”

What next? “Our view is they want more two-way volatility in the currency,” says Verdi. Although last year, as concerns grew about a hard landing in China, the currency ceased to be the one-way bet it had often appeared to be and began to show some volatility, more recently it has returned to the familiar pattern of sitting at the bottom of the band as China has received far more inflows than outflows. “There has been speculation they may widen the band further, but we think it is a little early for that,” says Verdi. “If they do, it will precipitate further near-term currency appreciation, when what they really want is two-way volatility. The direction is all one way.” Barclays expects a year-end exchange rate of RMB6.10 to the dollar.

Goel at Deutsche does expect a widening of the band this year “to allow greater flexibility of the spot price around the official fix.” He also expects the fix itself to move lower by two and a half to three per cent. “ The impact is likely to be felt more in the offshore CNH version of the currency than the onshore, because CNY spot is not accessible.

And Tan, who points out that about 10 to15% of total China trade is now being settled in the domestic currency, expects the rapid pace of take-up of this approach to continue. “They are allowing more and more settlement countries,” he says. “For example, since August Taiwan has been allowed to settle trades in the Chinese currency, and Singapore and London are starting to gain more traction in being able to settle trades in yuan. I’m optimistic this is going to continue.”

[subhead] The one under performer

If there’s a consensus underperformer, at first glance it’s a surprising one: Indonesia, the market darling of recent years. Chan at Nomura, for example, turned negative on Indonesia last August.

It’s chiefly about the current account deficit in Indonesia – one of very few in the region (India being another example). In August a series of measures was announced to address that deficit, and among them was a weak rupiah. “There was quite an explicit preference from Bank Indonesia that it wanted a weaker currency to help with the current account deficit,” says Chan. “Before then, for the past two years you had a central bank consistently advocating a preference for a stronger currency. That stance has completely changed.”

On top of that has come a growing annoyance about the regulatory environment. “Investors are talking a lot about negative regulation,” Chan says. They vary from reductions of foreign ownership in the mining sector and banks, taxes on mineral exports, and potentially a ban on new contracts for gas exports. “There has been a huge swing in policy,” Chan says. While that has not yet had much impact on bond flows, “it has been more evident on the FDI front. It’s not very healthy and it suggests the regulations are starting to bite a bit.”

Finally, attention is beginning to turn to Indonesia’s next elections, in 2014, particularly since the part of incumbent Susilo Bambang Yudhyono has not yet identified a credible candidate. “Indonesia is not exactly my favourite story,” Chan says.

[subhead] Who needs safe havens?

In difficult times in recent years, there has been a lot of discussion about safe haven currencies. And after the Swiss franc was pegged to the euro last year, attention turned in particular to the Singapore dollar. What happens to the safe havens when there’s no longer such a flight to safety? “As the tail risks have been chopped off, the necessity for these safe haven flows has reduced,” says Chan. “If the flow is beginning to ebb a bit, these currencies will face a bit of pressure.” Opinions vary, though, about which states constitute the safe havens. Chan says Singapore, Korea and even Malaysia have benefited from safe haven flows, although he says Singapore has “been the favourite in terms of the safe haven play,” with Korea more of a structural reserve diversification play.

Verdi agrees that “we are seeing an unwind” of safe haven currencies, most clearly with Swiss francs, sterling and yen. “The Singapore dollar is underperforming and is losing some of its shine as the world takes on more risk, but part of that reflects the move lower in the yen because the Singapore dollar is managed on a trade-weight exchange rate basis. Also Singapore’s economy is close to technical recession: export growth is weak and core inflation barely elevated.”

Goel at Deutsche is unwilling to see the Singapore dollar’s subdued performance as being purely about the safe haven theme. “I have my reservations about clubbing Singapore in the same bucket as the Swiss franc and Japanese yen,” he says. “The Singapore dollar definitely benefited from the safe haven flows, but the money coming in was from a much wider base than the European money that fled to the Swiss franc,” he says. “The Singapore dollar also attracted money because of its healthy sovereign balance sheet. While some of this money might reverse as risk appetite improves, the Singapore dollar should concurrently be able to benefit to some extent from the economy’s high growth beta.”

Generally, though, the theme of money leaving safety and tentatively embracing risk holds true. “It is setting up to be a year in which investors do move out of safe haven assets and start to look at risky assets in a more discerning fashion,” says Verdi. But by and large, that’s to Asia’s advantage. “Flows into Asia will accelerate this year. The thrust of our view is that we are moving away from this risk-on, risk-off environment, and that should be reflected in Asian FX.”

If Asian currencies do continue to thrive, then sooner or later it will begin to become problematic for the central banks of those countries. “Intervention could be stepped up significantly in the second half of the year is capital inflows continue,” says Chan, who notes that yen depreciation will be more significant in prompting this.

But for the moment, most strategists see that as some distance away; inflation and pressure on exports are not yet concerns in countries that have now spent years trying to deal with stalled global growth.

“There are three reasons we are staying positive about Asian currencies,” says Goel. “Firstly, we’re more optimistic about the world, with the cycle turning and exports bottoming out; secondly, we think portfolio money will keep coming in, especially in equities; and third, central banks in Asia will find themselves more and more comfortable with allowing appreciation in the currencies.”