How Long Will Asia's Currencies Remain Weak?

by Matthew Circosta, Moody's Economy.com, 23 August 2010

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topics:
Risk Management

tags:
baht currencies peso renminbi ringgit rupee rupiah Taiwan dollar won yen

Global risk aversion has eased following the peak of Europe’s debt crisis in May.
Asian currencies, which are most exposed to global trade, have recovered in sync.
Still, the region's riskier currencies are weaker this year amid strong haven demand for the yen.
Positive economic fundamentals support an appreciation of Asian currencies in the long term.

Cautious optimism appears to be playing out in Asian currency markets. Demand has recovered in recent months. Yet, the region’s currencies are still broadly weaker this year, even though growth fundamentals support solid appreciation. Europe’s debt woes, slower U.S. growth, and China’s tightening have investors flocking to safe yen-denominated assets, boosting demand for the Japanese currency.

The Asia-Pacific region's economic expansion is moderating at a still-robust pace, while recoveries in the U.S. and Europe are faltering. The contrasting growth rates suggest an increasing divergence in monetary policy between Asia and the West. Accordingly, wider interest-rate differentials place an upward bias on Asia’s currencies. Although it has been a slow climb back, sustained appreciation should occur once risk aversion has fully receded. Until that happens, however, currency markets are poised to ebb and flow.

Risk appetite has improved markedly since Europe’s sovereign debt situation escalated in May and June. Back then, the Chicago Board of Operation Exchange’s volatility index had soared to 46, the biggest spike since the peak of 81 at the height of the financial crisis in late 2008 and early 2009. The VIX—a volatility indicator in global equity markets often referred to as the fear index—improved only marginally in June as turmoil in Europe forced policymakers to enact austerity measures to rein in large debt burdens. Despite having continued its downward trend, the current VIX level of 24 is still above the 20-year average of 20, suggesting risk aversion remains elevated.

Asia's currencies have begun a slow climb back as risk aversion eases. China’s yuan—at 34% of Asia’s currency index—has led the charge as authorities resume its appreciation against the U.S. dollar. The South Korean won (at 14% of the index) and Indian rupee (6%) have also driven the index higher as interest rate increases boost the attractiveness of assets in these currencies.

Similarly, the Indonesian rupiah (3%) has enjoyed solid money inflows. Having one of the region’s highest interest rates, 6.5%, improves demand for the currency even though policymakers have not tightened monetary policy so far this year. After aggressively hiking interest rates in recent months, Malaysia’s ringgit (6%) is outperforming most currencies in the region. In Thailand, rising interest rates, and the prospect of more to come, have supported solid gains in the baht (5%).

But while Asia’s currencies have strengthened, elevated risk aversion has kept them down around 1% for this year. Dragging on the index are the Philippine peso and Taiwan dollar. The Philippines has yet to raise interest rates, so the peso has not been attractive. Meanwhile, Taiwan’s small nudge to rates has not been enough to increase investor enthusiasm. However, Taiwan's economy grew faster than expected in the second quarter, so interest rates could soon rise again, which would likely put upward pressure on the currency.

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