HSBC Research_Asian FX: Running For Cover
HSBC Research_Asian FX: Running For Cover
Despite US treasury yields having stabilised in the last week, Asian currencies have remained under significant pressure, whereas G10 currencies have, by and large, been more resilient. What is it that still makes EM Asian currencies so particularly vulnerable? And is there a turning point in sight?
One of our preferred methods to evaluate the potential vulnerability of a currency is to look at the FX cover ratio. We track the ratio of FX reserves plus the current account balance relative to the total size of short term external liabilities. We believe this ratio goes quite a long way towards explaining the divergent paths amongst EM Asian currencies.
Chart 1 shows the FX cover ratio for five EM Asian economies. The ratios for the INR and IDR have declined quickly in recent years. Unsurprisingly these were the first two currencies to weaken significantly against the USD as the market started to factor in tapering expectations. But note how fast the decline in the FX cover ratio has been for the MYR and THB as well.
To be fair, the size of the FX reserves is much larger in EM Asia now, than say, a decade ago. In some cases the size of these reserves is not far off all time highs. Unfortunately, the ammunition has not increased as fast as the liabilities. External liabilities have been fast rising in all four countries, which incidentally also run some of the biggest fiscal deficits in EM Asia. Meanwhile rapid capital inflows during the past few years have, for instance, led to higher foreign ownership of the (now much larger) local bond markets. As a result, these four currencies have been pushed into a corner.
Worsening current account positions is another reason for the declining FX cover of the INR, IDR, MYR, and THB. China's growth slowdown this year dealt a blow, as commodities exporters such as Malaysia are now struggling with falling commodity prices, as well as reduced quantities. Meanwhile, these countries have seen import demand remaining resilient due to a combination of fiscal expansion and loose monetary policies.
In contrast, the KRW and the PHP look much better supported both relative to the region and their respective histories. Although foreign bond positions have increased in both, current account balances have stayed more resilient, while external debt has fallen in Korea and been stable in the Philippines. For the SGD and TWD (not covered above due to a lack of data on bond positions), their highly robust current accounts leave them looking more resilient. The RMB also looks comfortably covered at the moment, with FX reserves still many times the size of the country's external liabilities.
A factor left out of the above discussion is foreign equity exposure. We have chosen to leave this out of our calculation for the FX coverage ratios. While the size of these exposures is large in some cases, such inflows have appeared to be relatively sticky in the past. That said, equity outflows do remain a potential risk for some EM Asia currencies.
So will the INR, IDR, MYR and THB see the light at the end of the tunnel soon? Or do they still have room to weaken further? In the short run, there is no obvious light at the end of the tunnel. Some Asian currencies are still expensive in broad valuation terms (see Asian FX Focus: The price is right? 6 August 2013). With the exception of the INR, which has moved closer to undervalued territory with its recent weakening, and the KRW and TWD, which have been persistently undervalued, most other EM Asian currencies have not seen enough adjustment yet. The RMB's stability has stood out, but even there, our metrics suggest that the currency is no longer significantly undervalued.
Moreover, economic data continue to throw out fewer upside surprises in EM Asia than in developed markets. China data have printed some positive surprises over past weeks, but doubt remains as to how long this re-stocking process can support growth. A bigger issue of a gradual de-leveraging also remains in the background. Many Asian economies have experienced strong credit growth over the past few years. But increasingly growth has looked less impressive. If the data remains weak compared to expectations, investors may look to reallocate away from Asian assets until yields or valuations are more attractive. In turn this would keep Asian currencies on the back foot.
And finally a more medium-term concern is whether the trade cycle can turn quickly enough to support some Asian currencies. We need to see more subdued import growth for some and higher export growth for others. However, it will likely take some time before the recent round of currency weakness has a significant impact on trade flows, in particular considering most economies' credit growth and hence domestic demand remains strong by historical standard.
But it is not all bad news. Despite the fast deterioration in FX coverage, we would note that external debt as percentage of GDP is still below the level deemed dangerous by the IMF. This time round, the weakness in Asia's balance sheet is domestic leverage rather than the external balance. As yet it is unclear whether the international community will back a multilateral package designed to support struggling EM currencies. We would keep an eye on the 5-6 September G20 leaders' summit and the ongoing suggestions voiced by various EM central banks for further clarity.
We remain cautious towards Asian currencies. The deficit currencies (INR, IDR) will continue to underperform but the MYR, THB and (to some extent) PHP will follow although to a smaller degree. The CNY, TWD and KRW will be more supported by their current account surpluses and comfortable FX reserve coverage. The SGD's strong external position should largely offset rising bank leverage onshore, allowing the currency to do better than others in ASEAN. Asian FX differentiation will persist but collectively Asian currencies are not out of the woods.