Higher US rates trigger Asian FX divergence

How long can the divergence between the performance of north Asian and south Asian currencies continue?

Factors driving the divergence between the performance of north and south Asian currencies will have less of an effect due to the renewed upswing of oil prices, say economists in the first issue of HSBC's Asian Currency Insight. This means that Asian currencies enjoying an upswing may not for much longer.

Why the divergence?

Rising US interest rates increased the burden of debt repayments in debt-laden countries such as Indonesia, Thailand and the Philippines. Whilst the hike was not positive for north Asia, strong global growth associated with the rate hike continued to boost the performance of strong industrial exporters like China.

"In short," say HSBC economists, "the rise in US rates acted as a catalyst for investment flows out of the weaker Asian countries and towards China and the north."

The slippery slide

Asia is still relatively dependent on oil as a source of fuel, therefore increases in oil prices plus recovery-fueled inventory rebuilding in Asia has resulted in increases in net imports. Such increases in net imports of oil and oil related products materially affect balance of payments deficits, state HSBC, and that puts the currencies at risk.

"From a balance of payments viewpoint, the greatest risks are to the rupee, peso and baht," write the economists.

How will central banks respond to the oil shock? HSBC doubts there will be any aggressive tightening in monetary policy in stronger economies such as Korea, Taiwan or Singapore "even if they prefer greater stability in foreign exchange rates". This is because there is no overall inflationary pressure, which will encourage action from the central banks.

Export slow down

In addition, HSBC economists expect a slowdown in exports due to lower external demand from a slowing US economy. Further, strong GDP growth rates in Asia have masked the underlying weakness of domestic demand. In Indonesia, Malaysia and Thailand, domestic demand has outstripped GDP growth so far this year, but the rebound was off a very low base.

An export slowdown is expected to be detrimental to the Korean won and New Taiwan dollar. "An export slowdown would make continued corporate restructuring in Korea much more difficult," the report says. "For Taiwan, faced with the hollowing out of its economy as traditional manufacturing industries move to China and with problems in its financial services sector unresolved, export earnings are essential," they continue. Year-end targets are: W1,100:US$1 and NT$31:US$1.

Change in foreign investment flows

Finally, HSBC economists see the flow of portfolio capital from foreign investors contributing to and continuing the weakness of Asian currencies. "Looking ahead, it is hard to see an immediate reversal in the flow of funds back into Asia." The reasons cited are a tightened US monetary policy and US dollar favoring short-term interest rate spreads, investors still need to be persuaded that growth prospects in the region justify the heightened risks in Asia, and a possible negative sentiment causing lower confidence and therefore weaker capital flows into the region.

Not all bad news...

"It is possible that the near-term selling pressure on Asian currencies will provide a cheap entry point next year," says HSBC. But the key currency to watch is the Yen:US dollar movement which historically has been an important trigger in the rise and fall of Asian currencies. They predict that a renewed demand for capital in Japan due to a recovering economy will mean a break in the Yen: US dollar exchange rate, moving it beyond the 100 level. When this break occurs, they predict the primary beneficiaries will be north Asian currencies.