What's Up With Asian Currencies?
Axel Merk
Mar 25, 2008
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 liked 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% 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 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 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 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 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.
Axel Merk
Manager of the Merk Hard Currency Fund, www.merkfund.com
The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard Currency Fund. Foreside Fund Services,
LLC, distributor.
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