The dynamics of Asia currency

This spring I moved to the New York area, having spent 13 years living in Asia, where I was lucky enough to wear several different hats (academic, central banker and investor). While 13 years is long enough to learn a few things (including finally figuring out the difference between unagi and anago), I remain baffled by the tendency of so many smart and experienced investors to throw out their well-honed analytical tools when attention turns to Asian markets, and Asian currencies in particular.

Ultimately it is fundamentals that drive markets, including those in Asia and yes, including Asian currencies.

As China's financial system develops and its capital account opens, the Renminbi will surely appreciate. The experience of other Asian currencies (e.g., the JPY, KRW and TWD) during their high growth period suggests that over the next decade or so the RMB is not likely to appreciate by a modest 5%, 10% or 20%. Rather it should double, and then double again. The bad news is that rather few investors are in positions that allow for trades with such a long time horizon. In light of this, what do fundamentals indicate about probable movements over the next few quarters for the RMB and other Asia ex-Japan (AXJ) currencies?

Over the short to medium term, currencies are as much driven by fundamentals as are other asset classes. For example, equity analysts typically emphasise earnings growth, dividend yields, balance sheet strength and valuations. An analogous framework for currencies can be applied, emphasising:

❑ Growth. Higher levels imply more profitable investment opportunities, which in turn attract capital flows.

❑ Short-term interest rates. The carry (difference in local short-term rates) has been the most effective factor for forecasting G7 currencies.

❑ External balances (for example, current account deficits require financing via capital inflows).

❑ Valuations. Especially Real Effective Exchange Rates (REERs).

What can this framework imply about the future direction of the RMB and other AXJ currencies?

Chinese growth is likely to slow marginally into 2007 (in response to significant liquidity tightening in recent months by the PBC), with most other AXJ countries slowing somewhat more.

By contrast, the US appears set to slow dramatically, with second-half growth likely to be less than 2.5%. In terms of investment opportunities, Chinese capex growth should exceed 15% this year, more than twice the level expected in the US (and even worse, US residential investment is forecast to shrink). This indicates that growth is apt to remain an unambiguously positive factor for the RMB and other AXJ currencies.

Short-term interest rates remain far too low in China and most other AXJ economies. A useful rule of thumb suggests comparing short-term
rates with growth, which is currently averaging around 7.8% in Asia. Almost all economies have set short-term rates well below growth levels, implying that monetary policy is very loose, which dilutes currencies in the same manner that additional corporate share issuance dilutes stock prices. In particular, loose monetary policy produces a negative carry, roughly 3% in the case of the RMB against the USD, which has been the key factor restraining AXJ currencies.

However, this is expected to be at least partially unwound over the next few quarters as the PBC and other AXJ central banks continue tightening, whereas we expect the Fed to commence cutting rates in the first or second quarter of 2007 (the Fed typically starts cutting five to seven months after the last hike).

External balances are well known, but merit noting because of their extreme, eye-popping levels. China's annual current account surplus is running at 7.2% of GDP, with very little external debt (about 9.6% of GDP) and sky-rocketing foreign reserves of $941bn (€737bn) (roughly 50% of GDP), which are rising by $20bn per month and are set to surpass the trillion dollar mark this autumn. This pattern is repeated in most Asian economies (HK, Singapore, Korea, Taiwan), although at less extreme levels. Similar to companies with bullet-proof balance sheets and very low PBRs, AXJ currencies are extremely well fortified against external shocks, dramatic deteriorations in terms of trade, and other downside risks.

Valuations are highly favourable. Across Asia, REERs range from
cheap to incredibly cheap (including the JPY, which is close to a 20-year low, and the RMB, which hasn't appreciated by a penny in 10 years, in spite of its unprecedented growth record), with the KRW as possibly the sole exception. As is the case with equities, valuations are not key drivers in the short-term, and it may be difficult to distinguish between a great value and a value trap. However, when at extreme levels, valuations should never be ignored.

Given such positive fundamentals, why haven't the RMB and other AXJ currencies appreciated dramatically already? One reason is that, post-Asian crisis, many policy authorities have pursued neo-mercantilist export-driven growth strategies, for which artificially low interest rates and currencies are key pillars.

However, as domestic stresses
build and inflationary pressures increase (while not alarmingly high, Asia's average CPI has risen to 3.4% year on year), most are now raising rates towards equilibrium levels, to achieve growth levels that are somewhat lower, but much more balanced and sustainable. Further, for many Asian economies, it would be folly to allow their currencies to appreciate significantly ahead of the RMB.

The fundamentals certainly suggest that Asian currencies will appreciate against the dollar: Asian economies have huge current account surpluses and are set to grow more than twice as fast as the US in 2006 and 2007.

In spite of this, most Asian currencies have not yet appreciated significantly as Asian central banks have aggressively intervened to keep their currencies weak and exports strong. Shifts in monetary policy are inherently difficult to time, but over the next six to 18 months Asian policymakers will feel the pressure to let their currencies appreciate in order to stave off rising interest rates, creeping inflation and accumulating imbalances.

If that happens, the macro fundamentals strongly suggest that exposure to a basket of Asian currencies (including the RMB, HKD, SGD and MYR, among others) may prove highly profitable.