With the U.S. dollar reaching new lows versus hard currencies, many are waiting for Asian currencies to catch up. Why hasn't this happened, and will it happen? The short answer is: it might, but be patient and don't bet your farm on it.
To understand Asian dynamics, let's first look at Europe. Remember how many ridiculed European growth earlier this decade? A key factor was the European Central Bank's (ECB's) refusal to jump on the growth bandwagon. As a result, consumer savings went up in Europe, while it headed down in the U.S. While the U.S. economy became increasingly dependent on credit expansion, consumer spending and inflows of money from abroad to support its current account deficit , the euro-zone was far more balanced.
Asian governments tend to be foremost interested in social stability through economic growth. As a result, Asia facilitated the growth in the U.S., providing what seemed like an unlimited amount of cheap labor. A weak or fixed exchange rate versus the U.S. dollar was one of the means to provide competitive exports to the United States.
Foreign direct investment (FDI) in Asia skyrocketed, and Asia produced — a lot. As a supply of Asian goods flooded U.S. markets, prices of U.S. consumer goods remained low. American consumers neither had to pay more for goods, nor could they really afford to as their real incomes were under pressure: American manufacturers had to accelerate their outsourcing to Asia to remain competitive, thus keeping a lid on U.S. wage inflation.
Asian countries were in no mood to allow their currencies to float higher, as it was considered key to their competitive advantage. Almost solely focusing on production, the amount of goods and services sold to the U.S. far exceeded what was bought. As a result, Asian countries started building up massive U.S. dollar reserves.
With the U.S. and Asia fostering growth at any cost, commodities got ever more expensive; someone had to pay to produce this global oversupply. Because of the immensely competitive environment within Asia, a lot of the margin pressure was absorbed through investment in ever more efficient and scalable production facilities. China emerged as a clear winner in this race to produce; China's market share of Asian trade with the U.S. exceeds 30 percent and is growing. China now has the managerial know-how, skills amongst the workforce and infrastructure to implement large-scale production facilities. No other country even comes close.
This scalability will be crucial because the American consumer is threatening to spoil the party. As American consumers are out of cash and access to credit is increasingly difficult, they might just be buying less of those Asian imports that they don't really need in the first place. Asian countries are in a precarious spot because over-production at home has made them vulnerable to a slowdown. This vulnerability is exacerbated as downward pressure on the U.S. dollar has increased: if Asian countries allow their currencies to float higher, exports to the U.S. become even less competitive.
The "cure" advocated by U.S. policymakers to pressure Asian countries and currencies won't do the trick, though: the U.S. would like Asian countries to stimulate domestic consumption to reduce the trade imbalance and thus ease the pressure on the currencies. Some Asian countries, with South Korea taking the lead, are indeed starting to take measures to stimulate their domestic consumption as exports to the U.S. abate. However, this may not help the U.S. dollar: while Asians love many U.S. brands, they tend to be manufactured in Asia. And it is unlikely that the U.S. will produce, say, sneakers, and sell them to Vietnam. At the same time, some of the goods produced in the U.S. that Asia may want, such as military and nuclear technologies, the U.S. is reluctant to export.
One scenario is that some Asian countries may engage in competitive devaluation attempts to continue to sell to American consumers. There is no sign of this yet, but the risk cannot be ignored, especially among those with weaker competitive positions.
Another possibility is that Asian countries will count on intra-Asian trade and domestic consumption to pick up the slack from falling exports to the U.S. Indeed, intra-Asian trade has become substantial and the U.S. will over time become a less critical trading partner. At this stage, however, much of intra-Asian trade still ends up on the shelves of Wal-Mart in the U.S. as the final destination.
But there are more changes that influence the global economy: as of last summer, Asia is no longer an exporter of deflation, but inflation. As it became ever more difficult to absorb the cost of higher commodity prices, Asian manufacturers were suddenly able to pass on higher costs. Aside from high commodity prices, the "unlimited" supply of cheap Asian labor suddenly isn't so unlimited anymore: wages have been going up in many areas.
While the migration to cities continues, factories are moving up the value chain to secure a viable business model, and wage demands for more sophisticated jobs are steadily increasing. China, again, is the best positioned: China is now moving factories to the regions where migrant workers used to come from. This bodes well for infrastructure investments within China, but it will also help develop the regions that were previously left out. We're not suggesting China is without challenges: amongst others, transportation costs will increase as more remote areas are developed.
Within Asia, holding billions, in the case of China over a trillion, in foreign currency reserves, has also become a politically sensitive issue. While traditionally foreign currency reserves were considered a welcome cost to help build up the domestic infrastructure, ever more American educated policymakers influence Asian monetary policy.
At first, the calls were to invest these reserves more strategically: investments to secure access to raw materials in North America, Latin America, Africa and Australia, in short — everywhere — have soared in recent years. But with the U.S. dollar under pressure, pressure to invest these reserves more profitably have increased.
Sovereign wealth fund investments from Asia have made numerous headlines over the past year, some of them embarrassing to the managers: investing in Blackstone's IPO only to see the investment plummet is bad publicity not welcome to senior policy makers at a sensitive time. While sovereign wealth funds will play a role in global capital market, we expect that they will devote a lot of attention to domestic issues, such as investing in domestic banks where returns may be more stable and losses easier to keep from public scrutiny.
As inflationary pressures have risen in much of Asia, allowing currencies to rise would be an obvious solution. But what may be obvious to readers used to free floating exchange rates is a radical step to governments that cherish control.
Ask any businessperson in Asia, and you will likely hear that they like fixed exchange rates. It's far easier to conduct business not worrying about what your currency may be worth tomorrow. However, as pressures may become too great at some point to ignore, some Asian governments have taken steps to prepare for greater exchange rate flexibility.
While China gets most scrutiny for not moving fast enough to allow the yuan to appreciate versus the U.S. dollar, they have taken a very responsible approach by developing local expertise and markets to deal with great exchange rate flexibility.
Many have argued that China will allow its currency to float higher to combat inflation; others argue that China will only allow greater appreciation as a gesture of goodwill to the incoming U.S. administration in early 2009. The wheels of politics grind slowly, but they do grind. Note that China is extremely wary of inflation as political unrest in the past was usually linked to inflation.
Japan warrants special attention. Japan is part of Asia, but unlike other countries in the region, it has a highly developed economy. Rather than inflation, deflation is Japan's major concern.
In the past, our view has been that the Bank of Japan (BOJ) will intervene should the yen appreciate too much. Currently, we have a special situation because there is a leadership vacuum at the BOJ. The outgoing governor retired, but parliament has not agreed on a successor. The deputy governor recently assumed the role of acting governor. Just like at all central banks, officials are busy trying to contain the fallout from the credit crisis in the U.S.
On this backdrop, the Japanese yen has been able to strengthen beyond what we would have deemed permissible to the BOJ in a more normal environment. However, we believe the Japanese economy can stomach a stronger yen. It remains to be seen whether and how the BOJ will act.
In the long run, Asian governments would be well served if they opened their markets further. Only if exchange rates are allowed to float freely will domestic bond markets have a chance to more fully develop.
While the U.S. may show the signs of a good thing taken too far, domestic bond markets are crucial in providing more stability to the local economies in the long run. The World Bank in conjunction with the IMF is spearheading an effort to develop domestic bond markets in Asia; we applaud their efforts, but we note that solid markets will take many years to build and require governments to cooperate. Because Asian markets are not as developed, their markets remain vulnerable to fast money moving in and out of the region. Local stock markets make international headlines as thinly traded markets see large institutions leave during times of turmoil.
Currencies also react, but typically with less volatility than the stock markets; currencies in Asia may also be influenced by activity of major corporations active in the country: the Indian rupee makes it to the currency headlines from time to time as major funds are shifted. Major currencies are also affected by the flow of funds, but the markets are huge and select players are unlikely to have a noticeable impact.
Asian currencies are subject to different dynamics from those affecting hard currencies. Hard currencies may be suitable for investors looking to diversify out of the dollar. Asian currencies are driven not only by fundamentals, but to a much greater extent also politics; this increases the risk in them, but also provides for opportunities. A basket of Asian currencies may be able to mitigate the risks associated with any one Asian currency.
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