With the US 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 refusal of the European Central Bank (ECB)
to jump on the growth bandwagon. As a result,
consumer savings went up in Europe, while they
headed down in the US. While the US 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 interested foremost in social
stability through
economic growth. As a result, Asia facilitated the
growth in the US, providing what seemed liked an
unlimited amount of cheap labor. A weak or fixed
exchange rate versus the 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 the
supply of Asian goods flooded US markets, prices
of US 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 US 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 US far exceeded
what was bought. As a result, Asian countries
started building up massive US dollar reserves.
With the US 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 US 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 US dollar has increased: if Asian countries
allow their currencies to float higher, exports to
the US become even less competitive.
US cure won't work The
"cure" advocated by US policymakers to pressure
Asian countries and currencies won't do the trick,
though: the US 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 US abate. However,
this may not help the US dollar: while Asians love
many US brands, these tend to be manufactured in
Asia. And it is unlikely that the US will produce,
say, sneakers, and sell them to Vietnam. At the
same time, some of the goods produced in the US
that Asia may want, such as military and nuclear
technologies, the US is reluctant to export.
One scenario is that some Asian countries
may engage in competitive devaluation 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 US. Indeed, intra-Asian
trade has become substantial and the US 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 US
as the final destination.
But there are
more changes that influence the global economy: as
of last summer, Asia no longer is an exporter of
deflation, but of 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:
factories in the country are now moving 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 foreign currency reserves worth billions
of US dollars, in the case of China worth over a
trillion dollars, 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 US 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 initial
public offering 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 the 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 US dollar, the country has
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 US
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
US. 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 US 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
International Monetary Fund 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 large 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 is the portfolio manager of the Merk
Hard Currency Fund, a no-load mutual fund that
invests in a basket of hard currencies from
countries with strong monetary policies assembled
to protect against the depreciation of the US
dollar relative to other currencies.
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