Asian currencies need to strengthen more

Emerging Asian currencies (AXJ) have gained ground against the USD. However, AXJ strength reflects a passive appreciation, since they have lost strongly versus other G10 currencies.

Asian central banks’ foreign reserve growth remains buoyant with growth rates ranging from 10% to 40%. This development is unsustainable, according to Dominic Schnider writing in the latest UBS Investor’s Guide, due to the sheer size of the foreign reserves. Foreign reserve accumulation due to strong current account surpluses and portfolio inflows has led to excess liquidity in Asian countries. If this is not mopped up, rising inflation, and inflation expectations, are inevitable. In fact, inflation in Asia is already on the rise. While food prices are the key driver behind the increase, for some Asian countries the combined weight of food and energy in the CPI amounts to 35-50%. Looking only at core prices, is therefore misleading. Taking asset price inflation in the equity and housing markets into consideration, inflation in Asia is running at an even faster pace. We believe these circumstances support an ongoing re-inflation story in Asia. Since Asian central banks act in a very mercantilist manner, soaring inflation is the only true incentive for active AXJ currency strength.

AXJ currencies should appreciate further versus the USD and ultimately gain ground against the EUR. More AXJ currency strength would allow USD weakness to find an end versus other G10 currencies – the prime valve of USD weakness. Schnider thus sees the most attractive opportunities in EURAXJ short positions.

Further opposition against Asian currency interventions is coming from G7 countries.

Their discontent towards rising foreign reserves and the use of these funds in sovereign wealth funds (SWF) will increase political pressure on Asian countries. The eye here is on China, which stands out in terms of both foreign reserve size – 1,433 billion US dollars – and rate of growth – in excess of 40% yoy. Next to inflation and political factors, the highest appreciation potential is in Asian countries that are rich in commodities and capable of moving into capital intensive industries, even the service sector. In this context, our favorite candidates are the Malaysian ringgit (MYR), the Indonesian rupiah (IDR) and the Singapore dollar (SGD).