Skirting a currency war

Some investors may see Japan’s Prime Minister Shinzo Abe’s attempts to devalue the Yen as representing the beginning of a currency war, but Asia’s economies are unlikely to be the ones that will suffer if that turns out to be the case.

 Countries within Asia are often lumped together as a single investment destination. The rationale is loose in the case of equities, looser in the case for bonds and non-existent in the case for currencies. Japan of course, is the major outlier when considering Asia.

Abe’s gamble

By setting an inflation target of 2%, the Bank of Japan is striving to manoeuvre the economy out of its deflationary impasse, but bond yields would have to rise and the currency to depreciate for that to be viable. Whether such movements can happen in a stable and self limiting manner is a moot point: “The Bank of Japan is playing with fire. I don’t think they fully understand the repercussions what they are doing. Japan could move towards a liquidity crisis when their debt costs become a near term problem due to higher interest rates” says Bryan Carter, EMD portfolio manager at Acadian Asset Management.

Hedge fund manager Kyle Bass of Hayman Capital, who made his reputation by predicting and profiting from the US sub-prime crisis, is even more dramatic, predicting a collapse of the Japanese economy when the yen will go “north of 200 to the dollar”.

Jan Dehn, Co-Head of Research at Ashmore has a more nuanced view: “Abe is taking a gamble of controlled recklessness to jolt Japan out of 20 years of deflationary expectations. It is his only hope to remain in power. It has echoes of Roosevelt’s very successful 1933 New Deal, which broke the deflationary stasis within a year, but it also has echoes of the Weimar Republic.”

Dehn’s thesis is that what we are actually seeing is a phoney currency war. Currencies can be driven by fundamentals in the long term i.e. relative interest rates, growth rates and inflation, and by sentiment: “The fundamentals for Europe, the US and Japan have not changed at all in the last few years and will remain unchanged for a few more years. What is driving currency markets is changing sentiment. That introduces volatility, but is ultimately mean reverting as the fundamentals come back into play.”

In the case of Japan, the gamble is that the 2% inflation target will be enough to stimulate the economy to growth and alter the fundamentals. If that happens, the Yen will see sustained depreciation and Japanese industries will see a recovery of competitiveness.

Asia’s open economies

A depreciating Yen will certainly impact Japan’s major trading competitors, but as David Oliver, EMD portfolio manager at Stone Harbour Investment Partners points out, in Asia, only Korea overlaps significantly with Japan in terms of its trading footprint, with Germany being Japan’s major competitor across a host of industries such as automobiles, technology etc. Moreover, as Dehn argues, a clear distinction can be made between the open economies of Korea, Hong Kong and Singapore, which would be impacted by a Yen depreciation and the other Asian economies which are now essentially driven by the growth of domestic demand rather than exports. But even in the case of prolonged Yen depreciation, Dehn argues that Asia’s open economies are so flexible that they would be able to easily adjust by raising their own productivity.

A Yen depreciation will have much less impact on the rest of Asia:  “The depreciation of the Yen hasn’t really altered our view of continued outperformance of Southeast Asian currencies. For countries such as Vietnam, Thailand and Malaysia, what is more significant is China’s growth rate. We have a 12-18 month horizon and over that period, we still see benign growth in China at levels just over 8% annualised” says Oliver. As he adds, that level of growth will still be a significant driver for commodity exports, such as coal from Southeast Asia.

Dehn’s view is that Abe will not succeed in overcoming deflation, so the current depreciation of the Yen represents changing sentiment which will mean revert as the fundamentals come back into play. What it does do is to add to the general volatility of currency markets, creating noise that can obscure long term fundamentally driven trends. For Dehn, that represents opportunities to increase weightings to Asian currencies in general when they show weakness.

Demographic challenges

Other Asian currencies may not face the extreme disaster scenarios that may be present for the Yen, but some countries, notably China, Korea and Taiwan do face similar demographic issues to Japan when it comes to aging populations. Their growth has been driven by productivity increases as well as by currencies that have been systematically undervalued for years, argues Carter and they compete with each other by structural devaluations trying to keep their currencies competitive against one another. But ultimately, its aging population will make China struggle to maintain an 8% growth rate over the long term.

Aging populations certainly give rise to deep structural issues. Bass likes to enliven his presentations by announcing Japan now sells more adult diapers than baby ones as an illustration of the issues it faces.

Aging populations give rise to higher dependency ratios and a peak to the ratio of working adults to the total populations as the population size declines. Nobel Prize winning economist Sir William Arthur Lewis postulated that as capitalist economies arise out of agrarian societies, they first see an unlimited supply of labour from the subsistence rural economies, which means the economy can expand without increasing labour costs leading to economic development. But once that supply of labour has ceased, and the subsistence labour force is fully absorbed into the capitalistic economy, then wage costs would start to increase with a tighter labour market emerges. Exactly when a country has reached its Lewis turning point is debatable, but what is clear is that Japan, Korea and Taiwan reached their Lewis turning point decades ago whilst China is on the cusp of reaching its Lewis turning point around 2017 or earlier. Wage costs in China are already rising to such an extent that some US firms are relocating production closer to home in Mexico.  

Acadian sees Asian currencies as very much falling into two distinct groups firstly the post Lewis point economies of Japan, China, Korea and Taiwan; and secondly the countries with still young populations such as Indonesia, which has a Lewis point in 2020 alongside Vietnam, whilst the Philippines sees the turning point in 2040 alongside India. The implications are most revealing when it comes to labour force growth rates.

Korea is expected to see a decline in it labour force from 2020 and China is already there, as Carter says: “There is a philosophical question that when a country’s population is declining, should you even have positive growth and should GDP growth be a goal? If the population is shrinking, the only way they can stay where they are is through increasing productivity. But if you wish to maintain growth rates like you have seen in China, that will be impossible.”

Carter argues the aging Asian countries have a strategy of devaluing structurally but they don’t intervene in the way Latin American central banks do: “I recently visited the Korean central bank and they say their intervention is only to reduce volatility, not to reverse a trend. This is a legacy of the Asian financial crisis – they believe volatility will drive away investment. China is similar, they want to see a structural change in the exchange rate but the RMB has been kept undervalued.”

All of these countries are similar in having structural devaluations, as they want to keep their currencies cheap against one another. Carter prefers the currencies of the young Asian countries like Malaysia, the Philippines, Indonesia, Vietnam and Sri Lanka on the basis of lower valuations, lower purchasing power parity effective exchange rates, cheap labour costs etc. But views of currencies in the region can dependent very much on the timescale being considered. Whilst issues of demographics will drive long term GDP growth and currency valuations, as Oliver points out, demographics is not a short term problem.

Conversely, even India looks attractive in the long term although its economy has been held back by the lack of development of its capital markets and it has yet to embrace full market reforms leading to full convertibility of the rupee and much more intense foreign competition in its economy: “It is very hard to make policy changes in India. The status quo becomes institutionalised like it is in the US. It needs a crisis to lead to effective changes in policy” says Carter.

There are certain elements that are conducive to a stable and growing economy and an appreciating currency. Carter sees evidence of central bank independence both de jure and de facto is one, together with a well defined inflation targeting policy. Asia made a lot strong progress in economic reforms during the 1990s when Eastern Europe and Latin America were also opening up. However, the Asian financial crisis froze the reform process. “The reason you see strong positive moves now is that they start from a low base.” In contrast, a lot of countries are moving backwards, with Serbia and the Ukraine in Europe as good examples, whilst in Latin America, Argentina is sinking fast, says Carter.


Central banks’ management

In contrast, Oliver sees some Asian countries would score highly on the list of central bank competency today: “Malaysia’s bond yields are low for a good reason. Its central bank is strong technically and inflation is low largely because central bank policies are credible.”

He also sees Indonesia’s central bank as filled with very capable technocrats and is generally comfortable with its independence. However he adds: “It did concern us when Indonesia’s central bank was trying to manipulate the exchange rate against the dollar. The currency did depreciate throughout the year largely as a result of central bank actions.”

Understanding the interplay between the central banks’ management of long term macro economic trends and short term political instabilities and their impact on currency movements within a one year time horizon is a challenge.

Carter sees currencies such as the Philippine peso and Thai baht will appreciate over time regardless of what happens to Japan, Korea and China: “These countries have structurally much higher growth rates based on contributions from both labour and capital and are playing catch-up.”

But Oliver is more defensive in Thailand less as a result of central bank policy and much more because of the political risk that the country still faces, which Stone Harbor feels is not fully priced in.  

Looking at the relative dynamics of currencies in Asia can throw up many interesting trades if one is prepared to wait long enough. Once we go beyond a one or two year horizon, Dehn sees the fundamentals as changing: “By 2016, we would expect to see a number of profound changes with recapitalisations of European banks, and the completion of the deleveraging process we have been seeing in US households. At that stage, we will see a move out of the safe havens and increased growth in the US and Europe as well as Japan.”

That may be good for the economies and good for their equity markets, but for bond investors, it could well mean disaster as bond yields rise from the close to  zero bubble levels they are currently at. For Dehn, that suggests moving out of the bond markets of the heavily indebted developed countries (HIDCs) and into emerging market local currency debt.

Carter advocates that over a decade, a basket of Thai baht, Philippine peso would outperform a basket with Taiwan dollar and Chinese RMB. Another idea he sees is buying the Indian rupee (which can be done in the form of a no-deliverable forward contract) hedged against the Taiwan dollar: “The dollar side has a negative carry as the Taiwan central bank is subsidising investors buying the Taiwanese currency. So long Indian rupee and short Taiwan dollar gives over an 8% yield, although it is a long term trade as there will be short term bumps.”

What is clear, is that looking beyond the short term volatility in Asia’s currencies exacerbated by the Yen depreciation, means focussing on fundamentals rather than sentiment, and that invariably points to increased weightings in Asia’s emerging markets relative to the HIDCs.