NOW that the dust is settling after China’s surprise devaluation of the renminbi dislocated currency and equity markets all over the world, we can take a step back to see what the long-lasting impact will be. To understand what has happened, we need to start by considering what has really changed in China and then assess how these developments will interact with other global forces and domestic challenges within Asian countries to drive the prospects for regional currencies. 

What has changed in China? 

The People’s Bank of China (PBOC) explained the renminbi move as purely an adjustment to make the currency’s value more market-determined. The central bank also observed that the currency had been overvalued and that with the devaluation, it had moved closer to its fair value. Since the big moves last week, the PBOC has kept the renminbi reasonably stable, suggesting it does not want to further destabilise markets with any precipitous moves.

However, even if the renminbi does not make any big moves, China’s impact on Asia and currencies is likely to be negative, because some things have changed, quite fundamentally. 

First, the renminbi is no longer a source of currency stability in Asia, but itself a source of volatility. The PBOC had kept its value unchanged against the US dollar right through major crises such as the 1998 Asian financial crisis and the 2008 global financial crisis. This provided a critical anchor of stability to financial markets in times of great uncertainty but that anchor no longer exists. 

Second, it also looks like the comfortable assumption that policymakers in Beijing could generally be relied on to get things broadly right and keep the economy humming along may not be valid anymore. Investors have long been aware that China faced some formidable weaknesses, but because they trusted China’s policymakers to be on top of things, they remained confident that the Chinese economy would avoid a serious downturn or crisis. This assumption no longer holds, for two reasons: 

• One reason is that the room for aggressive policy easing is more limited because it could threaten other important objectives such as financial stability or environmental health. The PBOC is wary of aggressive monetary easing because of the explosion of debt that might follow any such easing. Fiscal policy is likely to be used, but with so much infrastructure already built, the scale of such an action will be limited compared to the past. Also, the government wants investment to be less environmentally degrading and so is more cautious about allowing another uncontrolled expansion of investment. 

• More fundamentally, if one looks at policy responses since 2008, it appears that policy itself is contributing to economic woes rather than solving them. The massive stimulus of late 2008/09 is now generally accepted to have been excessive and overly based on an unsustainable explosion of debt, creating so many imbalances in the Chinese economy that there is now a serious risk of a deflationary bust. More recently, the policymakers hit on a strategy of boosting the stock markets in order to support economic growth and aid in corporate restructuring. When the inevitable equity market bust came, the authorities’ panic-stricken measures such as limiting sales of stocks by large investors raised questions as to whether the policymakers really understood financial markets at all.

Indeed, the economy continues to lose momentum despite the authorities’ expanding series of targeted stimulus measures: 

• Investment is growing at its slowest pace in 15 years: For an economy where investment accounts for nearly half of total demand, this is a very serious threat. 

• External demand is no help: Exports contracted 8.3% y-o-y in July 15, helping to drag industrial production growth to a three-month low of only 6.0% y-o-y in that month. 

• Deflationary headwinds persist: Consumer prices rose just 1.6% y-o-y in July while producer prices fell 5.4% y-o-y, a six-year low, in July. Part of this deflation is caused by weaknesses in the monetary dimension of the economy. Despite the best efforts of the central bank to revive credit, new renminbi loans fell to RMB1.48 trillion ($324.6 billion) from RMB1.61 trillion a year earlier. In fact, were it not for the massive government intervention to lend money to securities companies to buy shares after the equity market collapsed, new loans would have fallen even more.

So, considering the poor condition of the Chinese economy, will the PBOC choose to devalue the renminbi a lot more to bolster export competitiveness? Our take is that this is unlikely. The Chinese authorities know that any significant renminbi devaluation will only cause its competitor currencies to depreciate even more, negating any competitiveness gain. Our suspicion is that the move to make the renminbi more flexible was to limit further deterioration in renminbi competitiveness rather than to engage in a futile currency war to regain lost competitiveness. 

What about other global factors?

Aside from China, the other key driver for regional economies and currencies will be the US Federal Reserve Bank’s interest rate policy. Many analysts anticipate the likely raising of policy rates in the US with understandable trepidation. It is not likely that the turbulence in financial markets caused by the renminbi policy change will cause the Fed to alter its course. The recent strength of the US economy makes it almost certain that the Fed will raise rates for the first time in a decade in September. Recent data showed the US services sector at its most vibrant since 2005 and a measure of home builders’ confidence also at a 10-year high, suggesting that the housing sector will drive growth. Factory orders give a tantalising hint that capital spending, which has been underperforming, may be recovering while retail sales have been growing strongly as unemployment fell. Barring a new crisis of some kind, the Fed will raise rates in September, likely lifting the policy rate by a total of 100 basis points over the next 12 months. 

Will this be necessarily bad for Asian economies? Only if markets are taken by surprise by the move — which is not the case since the Fed has been telegraphing its intentions to normalise monetary policy for some time. The most likely scenario of a measured pace of raising rates combined with a firm recovery in the US economy may not be all that bad for Asia. Asian currencies and asset prices have already corrected in anticipation, such that the net effect when the Fed does move may not be so alarming. 

However, risks do remain. One downside possibility is if the US recovery surges and forces the Fed to start tightening more aggressively than expected. In that case, investor confidence would dive, producing more capital outflows from Asian markets, and hurting Asian currencies in the process. Another potential problem is if US dollar-denominated debt turns out to be much bigger than we estimate. As the US dollar appreciates with rising rates, repayment of such debts will become more onerous, potentially leading to non-performing loans and defaults. 

What about domestic headwinds?

In addition to external risks, regional economies also face challenges in both the political as well as economic arenas: 

• At the political level, Malaysia and Thailand are facing political infighting while uncertainty about impending leadership changes is growing in the Philippines (presidential election in May 2016), Vietnam (leadership change next January) and Myanmar (elections in November this year). 

• Domestic headwinds are also hurting economic prospects in much of the region: Falling commodity prices have hurt consumer spending. In Indonesia, Thailand and Malaysia, this has been exacerbated as fiscal reforms necessary for the longer term such as subsidy rationalisation have produced short-term pain for consumers. Other policy adjustments such as a more cautious approach to importing foreign workers have hurt Singapore.

So, where does all this leave regional currencies?

This conclusion is supported by how Asian currencies responded to the renminbi devaluation:

• The Malaysian ringgit, as the worst performing currency in Asia this year, is now seriously undervalued despite reasonably good economic fundamentals. Should there be a swift and lasting resolution to the political problems, the ringgit could turn decisively up. Otherwise, it will remain undervalued and under constant pressure;

• The Indonesian rupiah is also weakening significantly and at around 13,800 to the US dollar, it is at its lowest level since July 1998. While the current account deficit has improved, questions linger over nationalistic policies and the challenges that the reformist President Joko Widodo faces from his political rivals, all of which hurt confidence in the rupiah. 

• The Thai baht has fallen by more than 7% against the US dollar this year and will probably remain under pressure given the poor prospects for the economy following the terrorist attack and the likelihood of continuing political turbulence.

• The Singapore dollar has tumbled against the US dollar, reaching a five-year low of $1.4155 at one point last week. The Monetary Authority of Singapore has maintained its policy stance of a moderate appreciation of the local currency in trade-weighted terms. Thus, given the likely movements of the currencies in the trade basket, the Singapore dollar will probably depreciate modestly against the US dollar, but gain against the regional currencies. However, the economy has been wobbling of late, so there is a risk that the Singapore dollar might depreciate more sharply. We believe there is a rising risk the economy could take a turn for the worse and disinflationary pressures will intensify. 

In short, it is going to be a wild ride for economies and currencies in the region.  

Manu Bhaskaran is a partner and head of ­economic research at Centennial Group Inc, an economics consultancy

This article first appeared in Opinion, digitaledge Weekly, on August 24 - 30, 2015.