CURRENCIES have been extremely volatile in recent weeks, with the US dollar abruptly reversing strong gains and allowing Asian currencies to recover some lost ground in the past week, before once again rebounding. On the whole, we believe a continuation of US dollar strength is still likely — even if the outlook for the eurozone and Japan does improve faster than markets expect. For Asia, we are likely to see a renewed bout of currency weakness against the US dollar over the next few months.
The US dollar will continue appreciating because the US economy will re-accelerate.
In essence, US growth will rebound faster this year than the pace of improvement in economic growth in the eurozone and Japan.
While the first quarter of this year has been terrible for the US and some other countries, we see this setback as temporary. Once a rebound gets underway, in the coming months, financial markets will revise their currently complacent views on the pace of monetary tightening in the US over the next two years.
There are several reasons we see the US slowdown as temporary, mainly because the American economy has been hit by a series of one-off shocks:
• The prolonged labour strikes at West Coast ports hurt supply chains and slowed manufacturing production as well as associated logistics activities;
• Another quarter of severe winter weather also depressed consumer spending and construction;
• Moreover, there has been an asymmetric effect of lower oil prices — capital spending related to the oil sector has been cut drastically and quickly, hurting overall investment in the US economy. But the undoubted positive impact of lower oil prices on boosting non-oil sector investment takes a while to come through as companies need time to review their projections and conceive new strategies to take advantage of the boost to growth from lower oil prices; and
• The readings we are getting on US consumer spending also suggest that Americans have decided to initially save more of the gains from falling oil prices for now rather than rush into new spending — and that, too, curtails the beneficial impact of lower oil prices.
Into the second quarter, these drags will dissipate as the growing strength in jobs and wages translate into stronger consumer spending. The upside from lower oil prices will also become more evident. Fundamentally, credit, labour and housing markets are recovering in the US, entering into a mutually reinforcing cycle of higher growth.
Divergent central bank policies will also support the US dollar
The corollary of a stronger-than-expected US economy has to be a faster-than-expected pace of monetary tightening in the US. Although Federal Reserve chairman Janet Yellen’s statement on March 27 gave a strong impression that the Fed would move cautiously on raising rates, it was also clear from the statement, as well as those of several of her colleagues in the Fed, that rates would rise this year and the pace of increases would depend on the strength of the labour market.
Most of Yellen’s colleagues believe it would be a mistake to move too slowly on rate normalisation, as the risks to financial stability would then grow. We believe that over the course of the second and third quarters, employment and wage growth will be sufficiently strong to persuade the Fed to tighten policy faster than currently expected.
A modest upside surprise in eurozone economic growth is possible if political risk can be contained, but we do not think this will be sufficiently robust to cause the European Central Bank (ECB) to shift away from its quantitative easing (QE) strategy.
Even as the eurozone turns around, ECB is only too aware that the recovery is fragile, held hostage as it is to unpredictable risks, such as growing concerns over Greece and the political backlashes against austerity that could result in potentially troublesome political changes in Spain and Portugal towards the end of the year.
Similarly, while the Japanese economy is likely to regain some momentum, persistently low inflation means that the Bank of Japan will maintain its aggressive QE. That really does seem to leave the US dollar as the only game in town.
Political risks: Safe-haven flows could also favour the US dollar
As this article is being written, negotiators in Switzerland are feverishly working to complete an agreement to resolve Western objections to Iran’s nuclear programme. If some form of accord does emerge, it would alleviate one key risk that has hung over the Middle East for some time. However, other risks are growing around the world that would sustain flows of capital seeking a safe haven in the US dollar:
• First, civil wars are intensifying relentlessly in the Middle East. Civil strife in Yemen is now effectively a proxy war between Saudi Arabia and Iran, with a growing chance of this conflict expanding into a wider regional one pitting several Arab nations against Iran and its allies. At the same time, the civil wars in Libya, Syria and Iraq continue, with an uncomfortable chance of spilling over into other countries, such as Lebanon and Jordan;
• Second, Europe remains volatile even if the conflict in Ukraine no longer commands the headlines. Sanctions imposed by the US and western European countries are hurting Russia, where the recent assassination of an opposition leader has deepened domestic divisions; and
• Third, while it still looks unlikely, a British exit from the eurozone is no longer impossible. The British parliament has just been dissolved for an election on May 7. Opinion polls suggest a tight race between the Conservatives and Labour, the two parties that have dominated British politics for close to 100 years. But these polls also show that smaller parties can now pull in enough votes to deny either the Conservatives or Labour the chance of forming a majority government. Should the Conservatives become the single-largest party, the likelihood is that they will form a coalition with the anti-European Union UKIP party. A referendum on continued membership of UK in the European Union would be held by 2016 — which, given the anti-European mood of voters, could well result in the UK’s leaving the EU. Should financial markets see a rising risk of such a scenario, the British pound would come under substantial pressure, while money would flow into the US dollar.
So, what are the implications for Asian currencies?
Asian currencies are likely to operate in a rough environment and face downward pressures for the rest of this year.
• First, as financial markets adjust their expectations for US monetary normalisation, we could see a re-allocation of capital out of emerging Asian assets back to the US, as growth and interest rate prospects there look better;
• Second, a long period of ultra-low rates has probably created distortions in Asian economies which will become more evident as liquidity tightens in Asia. For instance, the stock of short-term debt, much of it denominated in US dollars, has soared in Asia, particularly China. There are concerns that such debt was used to fund projects which yield returns in local currencies, a currency mismatch that could cause problems for companies as they struggle to repay in strengthening US dollars out of local currency revenues. Moreover, real estate and other prices also inflated hugely across Asia — as rates rise just as the supply of new residential, commercial and office space is increasing, real estate prices could fall, hurting growth and potentially increasing bad loans as well;
• Third, China’s economic prospects appear murky. The economy is clearly decelerating despite the government’s stimulus efforts. Domestic new orders appear to be contracting, suggesting further weakening, requiring more aggressive policy measures. Indeed, People’s Bank of China governor Zhou Xiaochuan noted that the country’s economic growth rate had tumbled “a bit” too much and that policymakers have scope to respond. We are likely to see much more aggressive rate cuts and reductions in banks’ reserve requirements. We do not see the Chinese authorities weakening the renminbi, though — China wants the International Monetary Fund to decide soon on including the renminbi in its SDR basket and would want to demonstrate the strength and stability of the currency for that reason; and
• Fourth, several countries continue to have current account deficits or other political or economic challenges which cause financial markets to wonder how their currencies would perform. For example, Indonesia’s current account deficit is still close to 3% of GDP, while there are concerns over the fiscal position in Malaysia as a result of the fall in oil prices. Thailand’s economy appears to be slowly turning around, but political risks remain high. Singapore’s economy continues to show signs of weakening while its real estate sector is already deflating, prompting speculation on whether the Monetary Authority of Singapore might shift away from its policy of a modest appreciation of the trade-weighted value of the Singapore dollar.
One critical factor that will affect the relative performance of Asian currencies will be the credibility of central banks. So long as Asian central banks are seen as pursuing monetary policy rigorously, their currencies are likely to be relatively safe. The experience of India is instructive — Reserve Bank of India governor Raghuram Rajan’s conduct of monetary policy and his success in persuading the government to give the bank the mandate to focus on combating inflation has stabilised the Indian rupee.
Conclusion
In short, currencies will be volatile but the bottom line remains that the US dollar will strengthen, causing Asian currencies to weaken a tad.
Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy
This article first appeared in Forum, The Edge Malaysia Weekly, on April 6 - 12, 2015.
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