Guan Tao is a director of the China Chief Economist Forum and the global chief economist of Bank of China Securities
synopsis
The sharp depreciation of Asian currencies is mainly due to the external shock of the market's repricing of the Fed's tightening expectations and the renewed strengthening of the US dollar index, which is very different from the Asian financial crisis triggered by internal vulnerabilities such as current account imbalances, heavy external debt burdens, and rigid exchange rate mechanisms more than 20 years ago.
In recent days, Asian currencies such as the Japanese yen, South Korean won, and Indian rupee have hit new lows against the US dollar in recent years and even decades. For a time, the talk of the "Asian financial crisis" or "Asian currency defense war" was very loud. However, the sharp depreciation of Asian currencies is mainly due to the repricing of the Fed's tightening expectations and the external shock of the renewed strengthening of the US dollar index, which is very different from the Asian financial crisis triggered by internal vulnerabilities such as current-account imbalances, heavy external debt burdens, and rigid exchange rate mechanisms more than two decades ago. Against the backdrop of continued divergence from the Fed's monetary policy, there is a high probability that the Asian region will only be under monetary pressure, and in the case of a general increase in exchange rate flexibility, it will not even be a currency crisis, let alone a resulting debt and banking crisis.
PCE inflation rebounded in the first quarter, triggering a pullback in market interest rate cut expectations
On April 25, the United States released economic data for the first quarter. In the current quarter, US real GDP grew at an annualized rate of 1.6% quarter-on-quarter, well below market expectations of 2.4% and lower than the previous quarter's 3.4%, the lowest since the third quarter of 2022, indicating a slowdown in US economic growth. However, the first quarter is usually the trough of the U.S. economy growth throughout the year, and it is too early to conclude that the U.S. economy is stagnant from the single-quarter data. In fact, US real GDP grew at an annualized rate of 2.97% year-on-year in the quarter, 1.25 percentage points higher than the same period last year and down only 0.17 percentage points month-on-month (see Figure 1).
What surprised the market even more on the day was the US personal consumption expenditures (PCE) inflation data. In the quarter, PCE rose 3.4% q/oQ at an annualized rate compared to 1.8% previously, the biggest increase in a year, while core PCE, which excludes food and energy, rose 3.7% versus 2.0% in the previous quarter (see Figure 2). This has raised concerns about persistent inflation, which, along with the release of the March Consumer Price Index (CPI) inflation data on 10 April, confirmed the bumpy road to the fight against inflation.
After the release of the data, US Treasury yields moved higher and the stock market shook dramatically. During the session, the 2-year and 10-year U.S. Treasury yields rose above 5% and 4.7% to close at 4.96% and 4.70%, respectively, 7 and 5 basis points higher than the previous day. Market expectations for a Fed rate cut have cooled again. According to the Chicago Board of Trade (CME) Fed Watch Tool, there is a 45% chance that the Fed will start cutting interest rates in September, a 40% chance of cutting rates only once this year, and a 29% chance of two rate cuts. On the day, the U.S. dollar index recovered some of the losses during the Asian trading session and still settled below 106 at 105.56, down 0.23% from the previous day.
On 26 April, the US released PCE inflation data for March. In the same month, PCE increased by 2.7% year-on-year, with an expected value of 2.6% and a previous value of 2.5%, a month-on-month increase of 0.3%, in line with expectations and the same as the previous value, while core PCE increased by 2.8% year-on-year, with an expected value of 2.7% and a previous value of 2.8%, a month-on-month increase of 0.3%, in line with expectations and unchanged from the previous value. After the release of the data, U.S. stocks jumped and all three major indexes closed higher, with the S&P 500 and Nasdaq Composite both recovering their losses last day, the 2-year Treasury yield closing flat from the previous day, and the 10-year Treasury yield falling 3 basis points to 4.67%. At the same time, traders have ramped up bets that the Fed will cut rates for the first time in September, with a 65% probability, slightly higher than the 60% before the data release. However, the market generally believes that US inflation may have bottomed out, and it is easy to rise and difficult to fall in the future. On the same day, the U.S. dollar index returned to 106 and closed at 106.09, up 0.49% from the previous day.
Asian currencies continued to come under pressure as the Fed's tightening stance revolved
Last year, market expectations of a U.S. recession were falsified. Throughout the year, inflation in the United States continued to fall, the unemployment rate rebounded moderately, but the economic growth rate jumped from 1.9% to 2.5%, which is completely a "non-landing" state. The market did not wait for the Fed to cut interest rates, and although the Fed only raised interest rates four times by 100 basis points last year and paused rate hikes since September 2023, it still maintained a restrictive monetary policy stance.
At the end of last year, the market widely expected a "soft landing" for the U.S. economy in 2024. The Federal Reserve also said at the last interest rate meeting that it does not see the possibility of a recession in the United States, suggesting that interest rate hikes are nearing the end, and that the U.S. economic growth will slow down in 2024, and will consider cutting interest rates three times a year. However, this year, the market consensus has been "slapped in the face" again. At the beginning of the new year, the market repriced the Fed's tightening stance due to the impact of the inflation data that continued to exceed expectations in the previous three months. In April (as of April 26, the same below), the yield on 2-year and 10-year Treasury bonds rose by 37 and 47 basis points respectively from the end of last month, and the dollar index rose by 1.5%, and the yield on 2-year and 10-year Treasury bonds has risen by 73 and 79 basis points respectively since the beginning of this year, and the dollar index has risen by 4.6%. Against this backdrop, the Mexican peso, which has been strong since the start of the Fed's tightening cycle, fell 3.6% against the dollar in April (see Figure 3).
Last year, Japan's economy grew by 1.9 percent, 0.9 percentage points faster than the previous year. However, as the Bank of Japan (BOJ) insisted on yield curve (YCC) control, the negative interest rate differential between Japan and the United States widened further, causing the yen to become the only one of the six baskets of currencies in the Intercontinental Exchange's (ICE) dollar index to fall against the dollar for three consecutive years. In 2021 and 2022, the average annual negative 10-year daily Treasury yield spread rose by 50 and 153 basis points month-on-month, respectively, while the yen fell 10.3% and 12.2% against the dollar, respectively. Last year, the average annual negative 10-year U.S. Treasury yield spread rose 68 basis points month-on-month, while the yen fell 7.0% (see Figure 4). As a result, Japan's economic growth last year and Germany's recession led to a decline in Japan's world economic rankings, with Germany ranking ahead of Japan.
After CPI inflation exceeded the 2% target for 24 consecutive months, at the interest rate meeting on March 19 this year, the Bank of Japan finally withdrew from the eight-year-old era of negative interest rates and abandoned YCC control, but said that the next tightening will be cautious and generally maintain a monetary easing stance. Negative interest rate differentials between Japan and the U.S. continue to be high amid high Treasury yields and further upside driven by Fed tightening expectations. On the same day, the yen fell below 150 again, and since then it has continued to update its lowest record since 1990 (see Figure 4).
Despite recent warnings from the Ministry of Finance and central bank officials about the depreciation of the yen, even the finance ministers of the United States, Japan and South Korea issued a joint statement on April 17 during the annual spring meetings of the International Monetary Fund (IMF) and the World Bank, saying that they were concerned about the recent depreciation of the won and the yen, and agreed to cooperate closely on the development of the foreign exchange market. However, the market did not see the Japanese official enter the market, and the yen exchange rate continued to decline.
At the April 26 interest rate meeting, the Bank of Japan kept interest rates unchanged and expected that price risks will be skewed to the upside and growth risks to the downside in FY2024, and accommodative financial conditions will continue. After the decision was announced, the market no longer waited and watched, and the yen exchange rate fell below the 156, 157 and 158 marks in a single day, closing at 158.33, a new 34-year low. In April, the average daily 10-year daily U.S. Treasury yield spread was negative by 369 basis points, up 24 basis points from the previous month (see Figure 4).
At the same time, other Asian currencies fell and fell victim to the Fed's most aggressive tightening cycle in four decades. As of April 26, the exchange rates of the Malaysian ringgit, Vietnamese dong and Indian rupee against the US dollar have all refreshed new lows since data are available, the new Taiwan dollar and Indonesian rupiah of Taiwan have hit new lows since May 2016 and April 2020 respectively, and the South Korean won, Thai baht and Philippine peso have all hit new lows since November 2022. So far this year, the Japanese yen, Thai baht, South Korean won, Taiwanese New Taiwan dollar, Indonesian rupiah, Philippine peso and Malaysian ringgit have fallen 10.9%, 7.6%, 6.3%, 5.8%, 4.8%, 4.0% and 3.9% against the US dollar respectively (see Figure 5), while the Singapore dollar and Chinese yuan have fallen 3.1% and 2.1% respectively, both hitting new lows since November 2023.
Asian currencies are at risk of continued weakness, but there are no financial crisis concerns
At the November 2022 interest rate meeting, Fed Chairman Jerome Powell divided Fed tightening into three phases: the first stage, how fast the rate is raised, the second stage, how high the terminal rate is, and the third stage, how long the restrictive policy stance is. It now appears that even though the Fed has passed the second phase of tightening, it is not yet out of the third phase.
At the interest rate meeting on March 20 this year, the Federal Reserve sharply revised the US economic growth forecast for 2024 from 1.4% to 2.1%, and on April 16, the IMF updated the world economic outlook and revised the US economic growth forecast for 2024 from 2.1% to 2.7%. Both forecasts are well above the Fed's estimate of 1.8% for potential U.S. economic growth.
Given the rising probability of a "no-landing" of the US economy, the market has gradually shifted to expecting the Fed to cut interest rates later and less. At present, the market has postponed the time for the Fed to cut interest rates for the first time this year from the beginning of the year to the end of the year, and the number of interest rate cuts has also been reduced from five or six to one or two throughout the year. On 16 April, Powell said that given the lack of progress on the fall in inflation, it might be appropriate to let high interest rates work for longer. On 18 April, New York Fed President Williams was hawkish and would consider raising interest rates if needed, although this is not the baseline scenario.
With inflation becoming an obstacle to US President Joe Biden's re-election, the US Treasury has no willingness to cooperate with other countries to intervene in a strong dollar, and the Fed will not sacrifice the independence of monetary policy for the sake of international economic policy coordination. At present, in the US pain index of inflation and unemployment, the unemployment rate contributes slightly more than 50% to the pain index, which is much lower than the level of about 80% in the mid-80s of the 20th century. At that time, the strong dollar was considered the main cause of unemployment in the United States, which led to the Plaza Accord's call for a revaluation of the yen and the Deutsche mark, and now the strong dollar is not strongly questioned by all walks of life in the United States. Of course, it cannot be ruled out that the mercantilist Trump may return to the topic of competitive devaluation. The Fed itself is not responsible for exchange rate policy, but a strong dollar helps to reduce the cost of imports. In order to fight inflation, the Fed may be happy to see the appreciation of the dollar when there is no room to cut interest rates (see Figure 6).
The Japanese side is not so nervous about the depreciation of the yen, and at the same time, it is also weak. The depreciation of the yen has indeed increased the cost of raw material imports and overseas consumption by Japanese residents, but it has had a limited impact on Japan's overall inflation. At present, Japan's CPI and core CPI inflation, although above 2%, have risen to around 4% at the highest, and are currently less than 3%. Conversely, given Japan's position as the world's largest net overseas creditor, a weaker yen would increase the profits of Japan's overseas investments (see Figure 7). This is an important underlying logic for the yen to fall and Japanese stocks to rise. In addition, the experience of large-scale intervention at the end of 2022 that failed to prevent the continued weakening of the yen shows that the effect of Japan's unilateral intervention is limited against the backdrop of the divergence of monetary policies between Japan and the United States. Other Asian countries and regions face a similar situation of not being able to be independent of the Fed, and can only passively bear the negative spillover effects of their policies.
Asian currencies are expected to remain under adjustment pressure until the Fed's monetary policy pivot. However, after the Asian financial crisis, the flexibility of exchange rate policies in most Asian economies has increased, and exchange rate fluctuations have become a "shock absorber" to absorb internal and external shocks, rather than passively depleting foreign exchange reserves to stabilize the exchange rate. Even under the floating exchange rate arrangement, the yen exchange rate has fallen year after year, and the cumulative decline has exceeded 20%, but no one says that there is a currency crisis in Japan.
On the other hand, the last Asian financial crisis was mainly caused by internal vulnerabilities such as the imbalance of the current account balance, the heavy external debt burden, and the rigidity of the exchange rate system. For example, Thailand, the country that started the crisis, had a large current account deficit for a long time before the crisis, which was covered by short-term external debt (see Figure 8). As a result, the ability of foreign exchange reserves to repay short-term foreign debts due for the year fell sharply, and eventually the Thai baht had to be abandoned after the currency continued to be attacked and foreign exchange reserves were depleted. This triggered a domino effect of international investors' revaluation of Asian market risks, which in turn triggered the Southeast Asian currency crisis, which gradually evolved into the Asian financial crisis that swept the world's emerging markets.
Asian economies are now generally in basic balance of payments under the current account, with increased exchange rate flexibility, moderate external debt, increased adaptability and tolerance to exchange rate fluctuations, and are less likely to trigger balance-of-payments (including currency and debt crises) and banking crises (see Figure 8) due to exchange rate depreciation. Of course, it cannot be ruled out that a few low-income, heavily indebted emerging Asian economies may "burst" under the pressure of a strong dollar or even default on sovereign debt, but this will only be an individual crisis, and it is unlikely to trigger a crisis of confidence in the Asian region.
Currency depreciation is often referred to as a "financial crisis" and a "currency defense war", reflecting the mindset that appreciation is a good thing and depreciation is a bad thing, which was formed during the period of foreign exchange shortage in the past. In fact, exchange rate changes are a "double-edged sword", and there are pros and cons to both ups and downs. Moreover, during the 2022 Autumn Annual Meeting, the IMF recommended that countries should maintain the flexibility of exchange rate policies to accommodate differences in monetary policy. However, foreign exchange intervention is necessary if changes in the exchange rate hinder the transmission of central bank monetary policy (i.e., affect price stability) or create broader financial stability risks.
(This article was published in China Business News on April 29, 2024, and the author is the global chief economist of Bank of China Securities)