When the biggest economy in the world is so worried about growth that it decides not to raise rates for two years, it’s fair to say that the world’s economic outlook is looking pretty grim.
That is exactly what the US Federal Reserve did on August 9. Its message was clear: growth is going to be very hard to come by at home.
The Fed’s monetary decisions have major ramifications for Asia. The region has already been the recipient of major capital inflows this year – much of which could be considered hot money – as investors punted on Asia to grow, even if the rest of the world was struggling.
Now the region looks even more appealing, given the Fed’s own cynicism about the prospects for the US economy. That’s likely to mean yet more money flowing from the US into Asian economies, weakening the value of the US dollar while placing appreciation pressure on most Asian currencies.
As a result those currencies with open capital accounts and free floating currencies have seen the latter jump in value, at the risk of exporter competitiveness. Some countries have felt obliged to impose forms of capital controls at the risk of financial stability.
The likelihood of a further two years of loose monetary policy from the US means that Asia could be the recipient of a lot more of the same.
Sustained low interest rates are indicative of a frail economy struggling to jump back to life. With cheap lending, investors are keen to park their money where there is a greater chance of growth.
Asia offers both growth and higher interest rates. As a result it is already a prime target for inflows, a large amount of it hot money, and that is likely to continue due to the US’s rate policy.
This has an appreciation impact on Asian currencies, which puts the region’s exporters at a disadvantage. Plus it has inflationary risks for Asian countries, which the region’s financial authorities need to combat.
Japan, Hong Kong, and China look particularly susceptible to such pressure, albeit for different reasons. Each one has some very tough decisions to make over how best to respond to the US’s extreme rates makeover, as we discuss below.
The monetary authorities and each country will need to get smart with their FX policy in order not to suffer from the shocks of extreme volatility.
In the case of Japan this may mean capital controls; with regard to Hong Kong it should be a frank reassessment of the peg when set against the city’s likely economic prospects, and if necessary a reappraisal. And China would do well to appreciate its currency further and faster, instead of continuing to trying to hold it at an artificially low level.
These government need to demonstrate clear and determined policy goals to stem inflation and hot money. Such policies would not only protect their own financial health, it would be for the greater betterment of the world’s economic outlook.
Europe and the US are struggling to grow, and they will continue to do so for some time to come. Asia is where growth is but over-investment could yet drown this potential in too much liquidity. That would be in nobody’s best interest.
JAPAN: Domestic dollar trading
While the likes of China and Hong Kong consider the merits of strengthening their currencies to cope with the policies of the Fed, Japan has the opposite problem: dealing with the strength of the yen.
The country’s currency has risen steadily this year, from ¥80 in June to ¥77 on September 1, leaving its exporters less competitive.
The plight of the Japanese is a tough one. Many believe the overwhelming reason behind its continuing strength is that investors, both retail and institutional, are desperately parking their money into perceived safe haven currencies fearful of a market meltdown.
Yet it’s more likely that safe haven investing is just exacerbating Japan’s existing problems.
“There’s more safe haven money being parked in the Swiss franc than in the yen. I think the majority of the flow of yen buying and dollar selling is very natural and coming from two places: Japanese exporters and Japanese insurers who are selling their offshore assets in order to pay off onshore insurance claims,” says Adam Gilmour, head of corporate sales and structuring, Asia for Citi.
The sneaking suspicion among FX chiefs in Asia is that this fundamental reason for a stronger yen is why Japan has failed to convince other central banks to co-ordinate a large round of co-ordinated intervention to cool the yen’s appreciation.
Back in March Japan did persuade six of the world’s major central banks to embark on a round of co-ordinated intervention into the FX markets to ease pressure on its currency. The impact was immediate but not long-lasting, begging the question whether this is an appropriate and sustainable strategy.
With co-ordinated intervention both unavailable and dubious in terms of effectiveness, Tokyo has tried to be more innovative to solve its problems. Unfortunately its new plan to soften the yen’s painful rise – creating a US-dollar fund for outbound M&A activity – seems confused at best, plain missing the point at worst.
In short, on August 24 Japan’s Ministry of Finance (MoF) announced that it intends to tap the country’s foreign exchange (FX) fund – the Foreign Exchange Fund Special Account – to offer very cheap US dollar loans to corporates who wish to engage in M&A activity abroad.
Unfortunately it’s far from obvious how Tokyo’s new plan will in any way alleviate the strengthening pressure on the yen.
The nature of the package is that the FX fund will sell US dollar assets to the Japan Bank of International Cooperation (JBIC), which would then lend US dollars to corporates in return for yen at very competitive rates. The corporates would then use the US dollars to acquire companies abroad.
The trouble is that such an exchange would have no material impact on the yen’s value because there would be no buying or selling of any yen on the international market.
Encouraging acquisitive-minded Japanese corporates to borrow US dollars through the public markets to support international acquisitions rather than through the JBIC would make more sense; as such actions would serve to weaken the yen.
It therefore appears that by making this announcement the MoF is mainly trying to spur corporates into thinking about M&A activity. JBIC would therefore act as more as a lender of last resort to these companies, a provider of an extra few US dollars if the situation required it.
Junko Nishioka, an FX strategist as RBS in Japan, argues that Tokyo has been far too subtle with its policy change if encouraging outbound M&A was its real objective. She believes that any corporate considering offshore acquisitions would have a strong balance sheet and be unlikely to need JBIC’s help anyway.
“The government seems to try to facilitate M&A activity; including securing more energy, but the reality is that those large enterprises already have ample cash flow. Therefore, I’m not sure there is such a credit demand in the private sector. While yen's appreciation continues, funding conditions to raise US dollars is getting easier for them even without government support,” she tells Asiamoney.
Outbound M&A from Japan is definitely growing, as many businesses seek to expand beyond a non-growth home market.
But many Japanese corporates have more immediate concerns than buying offshore rivals: the yen is at an all-time high, raising the costs of Japanese exports at a time of profound economic uncertainty in much of the world.
Export advice
Instead of embarking on highly questionable attempts to stimulate M&A, the Japanese government would be better advised to help exporters lower their prices so they can continue bringing in the same level of business.
One, admittedly imperfect, way to help companies do this and help alleviate the pressure on the yen would be for the government to encourage the creation of a local US dollar trading market.
Because many Japanese companies are major exporters, they receive large amounts of US dollars and need to pay out hefty amounts as well for raw materials and services. What an internal market would do would be to let them trade directly in US dollars instead of bringing revenues back to Japan and swapping them into yen.
Swapping less US dollars into yen would reduce the pressure on the local currency to appreciate.
JBIC could help facilitate this process by offering cheap (possibly below international market rate) US dollars to local producers, allowing more businesses to trade in the currency.
Naturally most businesses won’t wish to use US dollars to trade internally because it is weakening but having more onshore dollars would act as a useful boon if the yen’s value does begin to subside – e.g. if the outbound M&A apparently favoured by Tokyo does increase.
The latter will naturally depend on whether Japan can successfully embolden its corporates to go out on an acquisition spree. The interest is increasingly there, but in this highly uncertain environment the government may well need to throw more than US$100 billion at the problem if it is to convince many companies to expand in the short-term.
HONG KONG: re-position the peg
Two years of low US interest rates offer a unique challenge to Hong Kong, a city that has kept a direct currency peg between the Hong Kong dollar and US dollar for 28 years.
The debate about the merits of maintaining the peg, which currently stands at a band of HK$7.75-HK$7.85 versus the US dollar, has been ongoing for many years. The Hong Kong Monetary Authority (HKMA) has always stood by the argument that the exchange rate stability the peg provides is worth maintaining the currency link.
As Morgan Stanley recently noted, this stability has played a critical role in reducing uncertainty and the costs associated with trade.
But the force of such an argument is diminishing. The peg means that Hong Kong has largely abdicated its control over monetary policy to the Federal Reserve. When the Fed cuts rates the HKMA has to as well, in order to ensure pressure does not build on its currency to appreciate.
But following a US monetary policy committed to staying a rock bottom for two years is not good news at a time when the economic prospects of the two are diverging.
“Having surrendered monetary policy autonomy to the US Fed, Hong Kong has to adopt the US policy stance, which may not be the most suitable when the two economies are at different stages of an economic cycle,” Denise Yam, economist for Morgan Stanley wrote on August 26 in a research note.
Hong Kong’s trouble is inflation. On August 22, the HKMA reported that inflation in July surged to 7.9%, the fastest pace since 1995. Food, rent and a distortion caused by a government housing subsidy was blamed for the high level.
The standard tool for dealing with inflation is rate hikes – and that’s something the US has expressly committed not to employing.
The most obvious answer would be to abandon the present peg. But what should Hong Kong replace it with?
An option is for the HKMA to re-peg its currency to the renminbi. However Hong Kong’s economy thrives in large part on it being an entirely market-driven and accessible economy, and pegging the Hong Kong dollar to a currency unlikely to be either or those things for many years yet would damage its appeal.
Another option espoused by some FX strategists would be for the HKMA to change the Hong Kong dollar’s fixing rate to the US dollar, effectively making the former a stronger currency.
This could certainly kill off some hot money inflows but it’s difficult to know where a good fixing point would be.
Buying into a basket
Other suggestions include policy makers in Hong Kong slowly phasing out the Hong Kong dollar’s peg to the US dollar and instead linking it to a basket of currencies in order to combat imported inflation. The theory would be that the US dollar weighting would gradually be reduced to better reflect the overall trade pattern. A position publicly put forward by HSBC’s chief executive, Stuart Gulliver on August 2.
The Hong Kong financial secretary John Tsang was quick to rebut this theory, claiming it would create currency volatility and a relative lack of transparency.
This is clearly a contentious debate, but it needs to be resolved. Uncertainty over the Hong Kong dollar’s future can only damage the outlook of the city. With that in mind somebody in government or the HKMA needs to demonstrate some leadership. Unfortunately that looks unlikely to happen.
“Everyone wants to pass the buck to the next term of government. If as strong and determined as Joseph Yam was not brave enough to execute this, I won't see any chance to have a change in peg system in the foreseeable future,” says Woody Chan, treasurer for Citic Bank International in Hong Kong.
“So far, government and regulators are worried…that a change [to the peg] would invite the market to think there are some more changes coming in the future. That is why I think the change got to be digital [a switch]. It is quite unthinkable to have a gradual process of transiting from 100% to lower percentage.”
But if speculation is what people are worried about, then why is Tsang happy to maintain the status quo? With no interest rate policy, open capital account and an undervalued Hong Kong dollar, speculators from far and wide will come in and attack the city’s already vastly over-valued property. It’s simply speculation of another kind.
It would be important for government to weigh out the pros and cons of both maintaining the peg or addressing the currency system in relation to the pain of high inflation and the possibility of currency speculation for exporters and importers. If politicians are so convinced maintaining the peg is still in Hong Kong’s best interests then they should publish data that justifies this position to the public.
“Price stability, a common policy objective among other economies, is instead a luxury for Hong Kong. An obvious result is that Hong Kong has to endure more volatility in asset and consumer prices as well as more volatile business cycles,” Yam wrote.
If price stability is key then Hong Kong, at least for now, needs to shift the peg level, strengthen the Hong Kong dollar overnight and fend off some of the imported inflation attacking the city but maintain that spot level until the renminbi is fully convertible. This would be an appropriate compromise.
CHINA: accelerate appreciation
In a similar manner to Hong Kong, the pressure on China to reconsider its currency valuation versus the US dollar is only going to rise if the US keeps its rates at almost zero for two years.
Normally China might be tempted to start intervening in the FX market to keep its currency at a weaker rate and ensure that its exporters stay competitive. But the catch is that the cheaper the dollar gets, the harder China must work to maintain the peg to its chosen basket of currencies.
To maintain the peg, China needs to either print more renminbi or buy more US dollars. Neither option is appealing. The former would fuel inflation at a time when Beijing is trying desperately to curb spending.
The latter would mean that that the central bank has accumulate a weakening asset of which it already holds far too much.
China’s US$3.2 trillion of foreign currency reserves is already the world’s biggest and have doubled in size since the beginning of 2008, mostly because of Beijing’s consistent efforts to keep its currency at an artificially low valuation. As a result China is the largest foreign owner of the US Treasuries, accumulating US$1.16 trillion of the debt so far.
The country’s policymakers want to diversify away from buying US bonds but that remains a distant goal as US Treasuries are still the safest and most liquid place to store them.
Beijing already appears to be feeling the heat of a weak US dollar. Between the August 9 and August 11 the renminbi strengthened 0.7 % against the dollar – a relatively small move by most currency standards but a large one for the renminbi. It narrowed tighter than Rmb6.4 per US dollar for the first time in 17 years, possibly as a result of large US dollar selling globally.
A perfect opportunity
Instead of worrying about how best to defend the renminbi against what looks set to be a consistently weak US dollar for two years, Beijing would do better to let its currency appreciate further and faster.
Getting the balance right will be tough. China doesn’t want to hurt exporters too much before domestic demand has picked up effectively. But there is clearly some room to continue to appreciate the currency without too much risk. The trade surplus widened to US$32 billion in July, suggesting exports will still be robust.
But even if Beijing does let its currency rise, it cannot maintain a tightly-managed currency forever. Alongside its anxiety to fully opening its capital account, the risk of doing so could create too much price volatility and inflation. Until domestic consumption overtakes export-led growth then it’s unlikely China will fully let go of the reins.
Joseph Yam, the former HKMA chief executive, wrote in a blog entry in April that opening up the capital account with a series of controlling restrictions to prevent rampant hot money inflows would be of great global benefit and would also negate the need for a heavily controlled currency.
He wrote, “An adjustment in its growth model in the form of a relative shift from being export-led to domestic consumption led. This has many benefits, not least enhancing the sustainability of economic growth and development of China. The prospects of China more meaningfully contributing to correcting the global imbalance would also be enhanced, which at the same time would shift attention away from the misguided and politically inspired remedy (through exchange rate appreciation) that many have been promoting.”
In short, Beijing needs to reduce its dependency on controlling the currency. At present there is room to strengthen the renminbi, reduce inflation and trade imbalance but at some point, it needs to find the appropriate policies in the form of transparent capital controls that will do this for them.
Vinicy Chan contributed to this story.