It is hardly surprising that the debate on the future direction of the US dollar and emerging market currencies continues to heat up in the news. The dollar’s strength in recent months has grabbed the attention of many, particularly investors, exporters and economists. Greater optimism about the greenback’s prospects has evidently induced portfolio investors to re-assess their portfolio allocations, especially in emerging market economies.
Asian currencies have been on the downtrend in recent months. The Indonesian rupiah has slumped by 6% in the year to date, despite its central bank’s move to raise the benchmark interest rate three times in May and June. After a brief respite following the rate hikes, the rupiah weakened by another 1.5% against the greenback. Similarly, the Indian rupee weakened by almost 7% as at end-June as foreign institutional investors sold off their holdings of equities and debt. Only the Malaysian ringgit remained sturdy, at least for now. Even then, the ringgit is slowly slipping in value against the greenback.
Much of the blame – at least from the rhetoric of emerging market policymakers – goes to Uncle Sam, whose policies are now strengthening the greenback. Putting aside factors like a continuing hike in the Fed funds rate (a standard move by the central bank to be ahead of the curve and to prevent the economy from heating up further), current US policies that precipitated a trade spat with China are some of the main factors for the weaker currencies in emerging market economies. The underlying logic for this makes clear sense: China’s economy is critical to global economic growth, accounting for about a third in terms of contribution in recent years. China’s market is also the main destination for Asian exporters. Case in point: China has been Malaysia’s primary export destination for the past few years, accounting for roughly 14% of the latter’s total exports. This is in contrast with a decade ago, when China only imported about 9% of Malaysia’s total shipments. A weak Chinese economy means equivalently lacklustre Asian export-dependent economies.
With the increasing intensity of the trade spat between the US and China, economic prospects for the latter are getting more uncertain. Although GDP growth cooled down by only 0.1 percentage point in the recent quarter, China’s weakening macro prospects are beginning to give investors sleepless nights. Those who heavily invest in emerging markets are now more concerned about the possibility of a further depreciation of the renminbi, which could translate into a further drop in the value of emerging market currencies. Such a fear is not baseless, as some Asian currencies tend to follow the path of the renminbi very closely (although one should not imply any causality in their relationships). An example of this would be the ringgit: the ringgit-USD exchange rate tends to track the renminbi-USD movement very closely, with a stunning correlation of 87% in the past five years. This is, of course, much too close for comfort. A further drop in the value of the renminbi will likely be followed by a further depreciation of the ringgit, if history is any guide.
But why would anyone think that the renminbi could be weaker in the near term? Some insist that the notion that China is using its currency to protect its export sector is misleading. In fact, according to this argument, the weakness in the renminbi in recent times is mostly due to the strength of the US dollar, and not because of any intentional policy to weaken the currency.
Whatever the truth may be, one should note that as far as portfolio investors are concerned, the real reason for the weakness of the renminbi is probably irrelevant. Instead, a more critical question is whether it would continue to depreciate in the near term. And there are reasons to believe so. First, even if one were to believe that the strength of the greenback explains the weakness of the renminbi, statistics reveal that the US dollar index has strengthened by more than 8%, while the renminbi depreciated by only 6%. Hence, the Chinese currency could depreciate further to reach the level implied by the basket of currencies it uses in determining the value of the renminbi.
Second, although the Chinese authorities keep pledging not to use the currency to support its export sector, one has to be extra careful in interpreting such a statement. Under normal circumstances, yes – the authorities would probably refrain from using the renminbi as a weapon to enhance its trade competitiveness. But these are hardly “normal circumstances” – the trade spat with the US had never gone this far in recent decades, certainly not during the Reagan or Bush administrations. And China under President Xi Jinping has tremendous pride. As such, the trade jabs between the two countries may not stop in the near term. Under such circumstances, if China comes under tremendous pressure to support its export sector in the face of the tariffs imposed by the US, one cannot rule out the possibility that it could let the renminbi soften further to provide some temporary relief to its exporters.
Of course, contrarian investors will argue otherwise in their assessment of the future prospects of emerging market currencies. One argument cites how the US dollar historically weakened during periods of rising US protectionist policies, i.e. prior to the Plaza Accord in 1985 and after the imposition of steel tariffs by President Bush in 2002. Again, these experiences should not induce us to think that such a trend will keep repeating.
For one thing, the dollar’s current appreciation coincides with an increasingly strong US economy. The solidifying US job market, as evidenced by rising capacity utilisation and the jobless rate being at its lowest in 18 years, imply that the US Fed would continue to try being ahead of the curve by hiking interest rates to avert future macro imbalances (e.g. surging asset prices and inflation). On top of that, Trump’s fiscal stimulus would hit the economy at a time when it is not needed at all. This will compound the pressure on the Fed to control future inflation.
Therefore, if emerging market currencies remain under pressure in the near term, it is not something that is totally unexpected. In fact, a confluence of factors are indeed working against emerging market currencies at this juncture. The good thing is that, such a scenario may not last for too long for the ringgit. Its medium-term prospects remain encouraging, judging by the real-effective exchange rate remaining below one-standard deviation from its long-term mean. More favourable macro prospects that are underpinned by fewer economic imbalances (i.e. lower debt and contingent liabilities) in the medium term will also induce investors to flock back into the country, pushing up the ringgit to its long-term mean.
This article was first published in The Edge Malaysia Weekly on 06 Aug 2018 – 12 Aug 2018.