China’s Covid drama finds Asian FX ready for prime time
As threats hit Asia from outside and within, the region’s currencies are looking impressively ready for prime time.
Between the US Federal Reserve’s tightening cycle in Washington, questions surrounding Covid-19 decisions in Beijing, and the yen’s bonkers gyrations, Asia’s 2023 still looks wildly uncertain – and potentially chaotic.
Optimism about China reopening trade dominated markets this week as President Xi Jinping bows to the biggest protests since 1989. Investors are cheered, though it’s unclear how Beijing might respond to a jump in infection rates. And if China does decisively exit from “zero Covid,” might the Fed hit the brakes anew to head off bigger inflation outbreaks?
The good news is that Asia’s currencies are having a moment that seemed unlikely amid the worst of the Covid turmoil in 2020 and the 2013 “taper tantrum” trauma that shook the region.
“A broader set of Asian economies have relatively strong foreign-currency balance sheets and are not at risk of immediate financial distress,” says economist Brad Setser at the Council on Foreign Relations. “Many have been able to rely on their local currency bond markets to finance fiscal deficits, limiting their direct financial vulnerability to swings in the dollar.”
Explanations are many, though today’s stability in exchange rates is the culmination of heavy lifting since the 1997 Asian financial crisis. Governments worked to strengthen financial systems, make currencies more flexible, build up ample foreign-exchange reserves, increase the independence of central banks and reduce economies’ reliance on exports for growth.
Take Thailand, which was able to brush off global turmoil earlier this year with more than US$250 billion in FX reserves. It also serviced a manageable-relative-to-GDP $30 billon in external debt.
Indonesia, which nearly collapsed in 1997-98, a high ratio of its $80 billion of international sovereign bonds are denominated in non-dollar currencies, principally the Japanese yen.
India’s financial system, meantime, is far more robust than in 2013. Back then, the mere whiff of possible Fed “tapering” panicked emerging markets everywhere. Morgan Stanley included India and Indonesia in its “Fragile Five” list of economies on the brink along with Brazil, South Africa and Turkey.
At the time, then-Bank of Korea governor Kim Chong-soo said the “ghost of 1994” was keeping him up at night. The reference was to the last time the Fed tightened aggressively, which also sent the dollar skyrocketing. That pulled untold billions of dollars out of Asia. Over time, it made currency pegs in Bangkok, Jakarta and elsewhere impossible to defend and helped set the 1997 Asian crisis in motion.
Yet New Delhi entered 2022 with roughly $650 billion in foreign reserves, more than double what it held in 2012. Its external debt, most of it owed to multilateral development banks at lower rates, was a manageable $125 billion.Post-Covid relief
The bottom line is that “many, though not all, developing Asian economies are less vulnerable to a repeat of the 1997 crisis,” Setser says.
That’s even with the Covid-era run-up in government stimulus efforts to safeguard growth. Economist Sergi Lanau at the Institute of International Finance noted that fiscal shortfalls will be larger next year than in 2019 almost universally. Despite sizable deficits, he says, “we do not expect severe fiscal stress, but see limited emerging-market fiscal-policy space in the post-Covid era.”
At many points in 2022, Asian corporate bonds outperformed comparable US indexes. Generally speaking, notes analyst Chester Liaw at UOB Asset Management, “many Asian countries also tend to be well correlated to economic trends and sentiment within the wider global community.”
That sentiment is swinging toward the post-Covid era. Liaw explains that export-dependent economies like South Korea and Taiwan are “particularly sensitive to global developments.” It follows that any decline in US and European bond yields – or increase – plays out quickly in Asian bonds. “They therefore offer an effective way to hedge against a substantial decline in global risk sentiment over the coming months,” Liaw explains.
A decisive Chinese shift toward reopening – one that withstands any coming jump in Covid cases – would be a “risk on” signal for traders to put assets prices higher and yields lower.
Yifei Ding, a portfolio manager at Invesco Fixed Income, says that “emerging-market Asian sovereign credit fundamentals may not be as weak as what the market fears right now.”
He notes that “high levels of inflation in most of the developed world and the interest-rate hiking cycle around the globe is certainly putting downward pressure on the growth outlook for Asia’s domestic economies. Yet at the same time, many factors are working in Asian sovereign issuers’ favor.”
As China exits the Covid era, Ding notes, “this could improve economic activity in neighboring Asian countries. Also, unlike other commodity-exporting EM countries where fiscal revenue has benefited from high commodity prices, most Asian sovereign issuers are not commodity exporters, so their fiscal policies have not been as expansionary as their other EM peers in the past two years or so.”
Going forward, Ding says, rising interest rates mean the funding costs are higher for Asian governments looking to borrow hard currency debt. However, aside from Sri Lanka, which has already defaulted, Ding says, “the short-term external bond maturities for most other Asian countries do not pose high default risks in the short run given these nations have learned from the 2013 taper tantrum and have built up comfortable foreign exchange reserves.”Strong dollar
Caveats abound, of course. Setser adds that despite huge progress, “few countries will be able to escape the fallout from the dollar’s current strength. A broader overshoot of many currencies that amplifies concentrated pockets of debt difficulties and complicates the fight against inflation globally remains a real risk.”
Economists point to a few risk factors for Asia in 2023. One is complacency. Asian leaders and central-bank heads overestimate today’s relative balance-sheet strength at their own peril.
Japan is another. The yen’s wild gyrations this year could be a 2023 phenomenon too. In March, Bank of Japan governor Haruhiko Kuroda will be retiring. Where his successor takes Tokyo’s ginormous bet on quantitative easing next is anyone’s guess.
The status of the so-called “yen-carry trade” is in complete flux. The BOJ’s ultra-low rates since the late 1990s – and even more assertive QE moves since 2013 – made Japan the world’s largest creditor.
It became funding central. Global investors would carry those yen funds over into higher-yielding bets from the US to South Africa to Poland to India. That’s why when the yen suddenly zigs, assets from stocks to bonds to real estate to cryptocurrencies zag a world away.
BOJ board member Naoki Tamura raised eyebrows last week when he said “it would be appropriate to conduct a review at the right time, including the monetary policy framework and inflation target.” That moment, he said, “could arrive soon, or be a little later.”
China’s reopening process, meantime, remains a work in progress. This week, Xi’s government announced changes to pandemic policies. Among the new guidelines is allowing for home quarantine, reduced testing requirements and phasing out the obsessive use of health QR codes to enter most public places.
How tolerant will Beijing authorities be to a surge in Covid cases? How quickly will Xi’s U-turn on importing more effective vaccines from abroad increase China’s collective immunity? Might Xi’s about-face lead to even bigger protests as it dawns on China’s 1.4 billion people that they have real power? All investors can do is stay tuned.
Finally, there’s the dollar. Its great strength this year papered over all manner of financial sins in Washington. One is US government debt bumbling past the $30 trillion mark. Another: the ranks of Republicans about to take control of the House of Representatives are threatening to play politics with the US debt ceiling. A similar ploy in 2011 led to Standard & Poor’s downgrading US government debt.
Economist Robert Carnell at ING Bank says that for all the effort that goes into forecasting Asian exchange rates, the past year showed that “apart from some short-lived deviations, dollar strength was the principal driving factor” and “provided perhaps the best clue as to both direction and magnitude.”
To be sure, there were other drivers in 2022. Energy dependence concerns were pivotal after the Russian invasion of Ukraine. At the time, Carnell notes, the Indian rupee and Thai baht cratered, while the Indonesian rupiah, Malaysian ringgit and Australian dollar outperformed.
Differing inflation experiences, coupled with how much the respective central banks leaned against it, also held great sway. Carnell notes that more “interventionist economies” like India, Indonesia and the Philippines absorbed price pressures through fiscal buffers. That softened the blow relative to more market-oriented economies, including South Korea.
Yet “in the end, though, perfect foresight of where” the dollar “was going would probably have been a better indicator than a full understanding of any of these other factors, and looking forward to 2023 we see few reasons why this should be much different over the coming 12 months,” Carnell concludes.
One of the more intriguing developments of 2022 is that Asian governments that once obsessively pursued weaker exchange rates are engaging in a “reverse currency war.” Now, the Fed’s rate hikes have officials from Beijing to Jakarta struggling to support currencies to avoid importing increased inflation.
This effort is helped by the growing confidence with which global investors view Asia’s currencies increasingly ready for prime time. It has been a long time coming, but Asia’s FX renaissance may have arrived.