REGIONAL currencies have been under pressure of late, weakening to multi-year lows against the US dollar and following emerging-market currencies such as the Brazilian real and Turkish lira, which have fallen sharply. Notably, the Malaysian ringgit and the Indonesian rupiah have been breaching multi-year lows in recent days. A confluence of factors appears to be at work — investors pricing in a US Federal Reserve rate lift-off in September, sharp falls in commodity prices, and growing political and economic risks in many emerging economies. The question is whether the falls in these currencies will continue and what the consequences might be.
Some currencies are greatly undervalued, others clearly overvalued
Asian currencies will not be immune to global forces that will tend to depress emerging-market currencies over the coming months.
• First, we see the US economy surprising on the upside, which means the Fed may well be normalising its monetary policy more aggressively than markets currently expect. That means further US dollar strength and, conversely, more downward pressures on emerging currencies, including Asian ones; and
• Second, while China’s economy is likely to stabilise in response to progressively more aggressive stimulus measures, the headwinds remain strong because of industrial overcapacity and the real estate correction. This means China’s imports of raw materials will remain weak, maintaining the downward pressure on commodity prices.
Given this global context, there are two further drivers of currency movements. One is the underlying value of the currency, that is, whether a currency has become so undervalued that it is difficult to see it depreciate further. The second is whether the political prospects and economic fundamentals such as commodity prices could drive even a weak currency much further down.
A useful measure of whether a currency is grossly undervalued is to look at the real effective exchange rate, which measures the total effect of all currency changes and relative cost shifts on a currency’s competitiveness. Studying the changes in REER allows us to better determine which currencies have fallen too far, that is, unjustified by economic fundamentals and that might snap back if conditions improve. Combining this with other important drivers of likely currency changes produces the following conclusions:
• How much renminbi strength is tolerable?
The Chinese renminbi’s REER has appreciated 55% since it was de-pegged from the US dollar in July 2005, substantial by any measure and enough to potentially risk export growth over time — particularly as it continues to hold its value against a rampant US dollar. Many argue that China’s leaders will allow no renminbi depreciation because they are keen to demonstrate the renminbi’s strength and stability to ensure that it is incorporated into the International Monetary Fund’s Special Drawing Rights basket. That decision is likely to be made within the next few months. Once that is done, there could well come a time when policymakers decide that the threat of further appreciation to export growth outweighs the political need for the currency to remain stable. The authorities are already planning to widen the band of fluctuation for the renminbi. Should China’s current economic lassitude worsen, the renminbi could well come under more pressure;
• The Indian rupee seems to be in a better position: Its REER is down around 11% from May 2013, when the taper tantrums in emerging markets led to a huge devaluation of the currency. Since then, the government has addressed the currency’s vulnerabilities — it has shored up its fiscal position by cutting fuel subsidies and its well-respected central bank has gained even greater credibility with the appointment of Raghuram Rajan as governor;
• The Korean won looks risky: It is the big loser from the marked depreciation of the Japanese yen over the past two years. Of late, South Korea has also found that Chinese manufacturers of consumer electronics are catching up with its vaunted champions in that area. The won’s REER has barely fallen in recent months, even as other currencies have depreciated. If the Bank of Japan were to step up its quantitative easing more aggressively, the won would certainly weaken;
• Rupiah under pressure: It has not been a good few months for Indonesia’s rupiah. Confidence in the Indonesian economy has been hurt by several factors — persistently high inflation, a current account deficit that fell but appears set to grow again, the perception of an increasingly nationalistic policy stance, particularly following the recent imposition of big tariff increases on a wide array of imports and signs of resistance to President Joko Widodo’s intended reforms. Despite its depreciation against the US dollar, its REER has edged down only 4% in recent months. With commodity prices falling sharply again, the rupiah remains vulnerable;
• Ringgit may have overcorrected: On pure economic fundamentals, Malaysia’s ringgit is clearly oversold, driven down mainly by political concerns and is consequently almost certainly greatly undervalued. It has a highly credible central bank and a current account surplus, and it has maintained economic growth at reasonable levels compared with most of its peers.
While it is highly unlikely that the authorities might consider re-imposing capital controls, rumours to that effect have rattled the currency in recent days, and will keep investors wary of the ringgit for some time to come. Should the political maelstrom clear and sentiments shift back in favour of Malaysia, we could well see a marked appreciation of the ringgit;
• Thailand needs a weaker baht: There has been little good news in the Thai economy of late, with virtually every indicator — farm incomes, consumer spending, investment, exports and fiscal disbursements for the government’s ambitious infrastructure programme — disappointing. Deputy Prime Minister M R Pridiyathorn Devakula indicated his preference to see the baht depreciate a tad further and many analysts believe that the new Bank of Thailand governor, the highly respected Dr Veerathai Santiprabhob, also prefers a weaker baht;
• The Philippines peso has also appreciated hugely: It is up 49% since July 2005. However, there has been a sea change in the Philippine economy, with its fundamentals vastly better. Moreover, its economy is less driven by manufactured exports, which require a certain degree of currency competitiveness; and
• The Singapore dollar has weakened steadily against the US dollar since the start of the year. Still, the currency’s REER has remained relatively stable throughout the recent period of global currency volatility. The central bank instituted a looser policy stance in January, shifting to a more modest pace of currency appreciation than in the past. More recently, it has reaffirmed this stance of moderate appreciation and does not appear likely to shift towards a weaker currency.
What impact will weaker currencies have?
Weaker currencies should boost exports and, so, be positive for economic growth. However, currency depreciation can also raise inflation rates. Moreover, where countries have borrowed heavily in foreign currencies such as the US dollar, financial stresses could rise. Putting all these factors together, a pattern of winners and losers emerges:
• Indonesia appears to be most vulnerable: It has a high proportion of US dollar-denominated debt, while its external debt service ratio is also among the highest in the region. If the rupiah fails to hold up against the rising US dollar, the debt burden in rupiah terms could increase. Another concern is that the pass-through from currency depreciation to consumer inflation could be significant. This will limit Bank Indonesia’s ability to cut rates to support an economy that is losing momentum. In the meantime, its export-oriented manufacturing sector has lost traction in recent years, which means the boost to exports from currency depreciation may not be so great;
• Malaysia could see an export rebound: Malaysia remains an export power house, so the substantial gain in the ringgit’s underlying competitiveness should help, particularly in the context of the recovery in global demand that we see. It does, however, have a high ratio of short-term external debt to foreign reserves, at 77%, and its external debt-to-GDP ratio is also elevated — but these are likely to be manageable, which means Malaysia could be a net beneficiary; and
• China, India, the Philippines and Thailand all have elevated proportions of US dollar-denominated debt, which could prove to be a drag, should their currencies depreciate against the US dollar. The Bank for International Settlements has raised a red flag on the huge increase in China’s debt that is denominated in foreign currencies. It has also warned that the true scale of China’s external debt could well be under-estimated, arguing that offshore subsidiaries of Chinese corporations had been acting as “surrogate intermediaries”, raising foreign currency debt that may not have been fully captured in national statistics.
The bottom line: Currencies to remain under pressure, risks persist
Overall, it looks like most Asian currencies remain at risk of continued depreciation as the US embarks on monetary normalisation. As a result, countries with high foreign debt could see some degree of stress.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in digitaledge Weekly, on August 10 - 16, 2015.