Asia rising

Illustration: Figtree Design

Asian currencies continue to rise against the USD

By Herbert Poenisch

The unimaginable happened when in early August this year the MYR-US$ exchange rate dipped below RM3! The good news is that this is happening not only in Malaysia but in most countries in the Association of Southeast Asian Nations (Asean) region (see Figure 1). Relatively speaking, comparing Malaysia to our peers, we are not too exposed. However, compared with the major markets in advanced economies, where the USD is used as an invoicing currency, Malaysian goods and services are becoming more expensive and thus less competitive. What are the factors behind the appreciation of various Asian currencies against the USD and what are the implications for the future?

Measuring exchange rate changes
There are various ways to measure the magnitude of exchange rate changes. The most obvious ones are the bilateral exchange rates, such as the MYR versus the USD, the EUR or the RMB or CNY. This information is readily available but it offers only part of the story. True enough the MYR/USD sort rate is the most relevant bilateral rate, and others such as the MYR/CNY are increasing in importance [1].

As Figure 1 shows, the bilateral exchange rates of regional currencies have appreciated significantly against the USD, with the IDR, the KRW and the SGD leading, the MYR and THB somewhere in the middle and the CNY at the bottom. In relative terms this means that the MYR has not appreciated as strongly, compared with other currencies in the region. If you take into consideration the relative inflation performance, one arrives at real bilateral exchange rates. As Malaysia’s performance has been better than its regional peers’, its real bilateral appreciation has been less than other currencies, thus cushioning the impact on the nation’s competitiveness.

Figure 1: Regional currencies performance against USD, Jan 2009 – 2 Aug 2011.
Source: Bank Negara Malaysia, based on Bloomberg data.

What has been described intuitively can be calculated mathematically by weighing the partner currencies [2], giving us the nominal effective exchange rate (Neer) as well as their inflation rates, giving us the real effective exchange rate (Reer). The picture which emerges adds more precision to the intuitive picture; the appreciation of mid-2011 has been reversed since then, but can return any day.

Driving forces
The driving forces for protracted exchange rate changes exist in the current account of the balance of payments and the capital account (which is mainly determined by capital flows). The current account which reflects the underlying fundamentals determines the trend of the exchange rate, the capital flows add the “froth” which shows up in the market exchange rate. The daily market rate tends to overshoot the fundamental rate in both directions (see Figure 2).

Figure 2.
Source: Amporn Sangmanee, Bank of Thailand, 2011.

Malaysia is fortunate that its current account has shown persistent balance of payment surpluses, determined largely by the export of commodities and increasingly by the export of manufactured goods. The Economist estimates that this surplus will amount to approximately 12% of gross domestic product (GDP) in 2011 – Malaysia is one of the world’s champions on that score! Capital flows into Malaysia have spiced up the underlying trend leading to spikes in the nominal exchange rate.

The whole of Asia has been working hard and has been rewarded by consistent large current account surpluses compared with deficits in advanced markets (see Figure 3). An open question is how long this can continue? International financial organisations such as the International Monetary Fund (IMF) and the Group of 20 (G20) devote major efforts to the sustainability of these imbalances. However, any progress has been hampered by disagreement over the causes of these imbalances.

Examining the diverging balance of payment trends in advanced markets and in emerging Asia (which triggers capital flows) highlights two types of factors at work. The push factors are determined by the economies originating capital flows and the pull factors are determined by the recipient side, largely those prevailing in Asia.

Figure 3: Current account balance.
Source: Bank of Thailand, based on IMF World Economic Outlook, April 2011.

First and foremost among the push factors is the sluggish growth in advanced economies and their generous policy response; in the US and Europe, monetary and fiscal policies have been extremely loose to stimulate growth. This has led to an increase in the global money supply. If you add the funds at the disposal of international banks and institutional investors, these amount to more than US$100tril, all searching for yields. Governor Zhou Xiaochuan of the Peoples’ Bank of China calls this “the wall of money” flooding emerging markets, especially Asia, which attracts half of the world’s capital flows. It could be compared to a “financial tsunami”.

But why is it coming to Asia? First of all the growth prospects are much better here and so are the expectations of profits and higher yields. Secondly, investors expect not only higher interest rates (called carry trade) but also appreciating currencies. The risk is that the volatile capital flows can easily be reversed.

Figure 4: Flows into emerging Asia.
Source: Bank Negara Malaysia, based on IMF World Economic Outlook data, April 2011.

As is shown in Figure 4, the composition of capital flows to Asia has changed markedly during the recent inflow episode starting in late 2009. Previous flows were mainly made up of foreign direct investment (FDI) – in red bars – which is usually committed to a country for the long-term. The other component, cross-border banking flows (shown in green) and portfolio investment in debt and equity (shown in blue) are far more volatile. A country and its authorities cannot relax when these are prevalent. They have to prepare policy actions for both cases, when these arrive as well as when these leave. The Asian crisis of the late 1990s demonstrated the damage that could occur from a reversal in banking flows.

Policy measures
Asian central banks that face this “financial tsunami” have prepared appropriate measures well in time and are ready to face the challenges, inflows as well as reversals.

When capital flows in, central banks have a choice of doing nothing or intervening. Doing nothing means accepting the outcome of a market determined exchange rate. Australia and New Zealand have wildly fluctuating exchange rates. So far, Asian central banks are not prepared to do so, fearing the fallout of the real economy, in particular the importance of the export sector. Therefore they have opted for intervention in the foreign exchange market in order to cushion the impact. They can do this by intervening in the foreign exchange market to avoid spikes in the exchange rate.

More protracted intervention is called sterilisation, when central banks actually buy foreign exchange in the market, by selling government securities or issuing securities of their own. Both interventions have their limits, the first one being the increase in the amount of local currency liquidity in the economy. This risks a rapid credit expansion, a rise in inflationary pressure and possible asset price bubbles. The second is limited by the costs of sterilisation and effect on the balance sheet of the central bank. In actual fact the central bank buys low yielding foreign exchange and issues higher yielding securities denominated in domestic currencies. This erodes the profitability of the central bank and possibly causes losses, which have to be replenished by the government.

If both measures are exhausted, the country can resort to capital controls, either by taxing away the higher yield on capital inflows or forbidding them outright.

When capital flows are reversed, the measures work in the opposite direction. The central banks can refrain from intervening, letting the currency slide with a highly inflationary potential. If they choose to intervene, they can sell off foreign exchange reserves, as long as foreign exchange reserves last. Their level limits this option. Ultimately they can impose controls on capital outflows which are not very effective and not sustainable.

Policy coordination and cooperation
The consequence of the unilateral approach is that capital flows successfully prevented in one country will be diverted to neighbouring countries and cause havoc there. Therefore Asian countries have called for a strengthening of surveillance of exchange rates and short-term capital flows in order to gauge rising pressures. This policy dialogue is already taking place within Asean and the South-East Asian Central banks (Seacen), but there is reluctance by various governments and central banks to lay all their cards on the table.

Further progress could be achieved by institutionalising the surveillance and policy dialogue within Asean. These are the strengthening of the Chiang Mai Initiative (CMIM) and a dialogue within the Asian Macroeconomic Research Office (AMRO).

Conclusion
What does all this mean for businesses in Penang? Given the present global scenario which is unlikely to change in the coming future, current account surpluses will continue to characterise Asian economies. This will lead to further appreciation of regional currencies such as the MYR, driven by fundamentals. In addition, capital inflows will continue, causing exchange rates to overshoot the basic rates. Authorities will strive to smooth the appreciation path. If looking at derivatives, such as forwards, futures or options to share the appreciation risk, this will be costly, given that market expectations are all moving in the same direction.