RGE: On 14 April, the Monetary Authority of Singapore (MAS) made an aggressive policy tightening move. The MAS re-centered the SGD target band at the prevailing level of SGD’s nominal effective exchange rate and changed the band’s slope from a zero percent appreciation to one of “modest and gradual appreciation.” Judging from past experience, we believe the slope of the new target band is likely to be around 2% a year.
Source: RGE, Bloomberg
The MAS’s move reflected the growing confidence about the strength of the recovery as well as concerns about inflation risks associated with domestic demand later this year. The MAS has just revised its GDP growth forecast for 2010 from 4.5-6.5% to 7-9% and its CPI projection from 2-3% to 2.5-3.5%. RGE fully shares this view. Singapore’s growth and inflation have surprised significantly on the upside and the recovery is broad-based led by the rebound in manufacturing and services. RGE expects Singapore to grow 8.0% in 2010—the strongest performer in Southeast Asia—and inflation to average 3.0%.
A rebound in economic activity, high food and commodity prices, closing output gaps, rising private demand and wage pressures will increase headline and core inflation in the coming months (see Figure 3). Upside surprises to growth and record low policy rates are leading Malaysia, Singapore and India to frontload monetary tightening into H1 2010 in order to contain inflation expectations. Capital inflows, potential CNY appreciation in Q2 2010 and slower growth at home and in U.S. and China in H2 2010 will lead EM Asia to maintain caution over the pace of rate hikes in H2 2010, but rely more on currency appreciation to curb inflation.
Source: RGE, Bloomberg
We started to track a “Long Asia” currency basket in December 2009 and formally introduced it in January 2010. “Long Asia” is an equal-weight long basket of four Asian currencies—CNY, INR, IDR and KRW—against JPY (see Figure 4). The basket appreciated by 9.1% (spot) since its inception.
Source: RGE, Bloomberg
As we noted above, our outlook on Asian FX is generally bullish, but we believe this is the right time to rebalance the ‘Long Asia” basket by replacing IDR with MYR. First, Malaysian GDP growth has surprised significantly on the upside. RGE forecasts Malaysia to grow 5.4% in 2010 as supportive private demand, commodity prices and exports to China, reviving global electronics cycle and Asian inventory cycle drive exports and industrial activity in the near term. The rate hike in March—which came earlier than its neighbors—will support capital inflows and the currency. Malaysia will hike rates by 25 basis points (bps) in May and by another 25 bps in H2 2010—more than what RGE initially forecasted—to contain speculative investment and lending to households. By contrast, there was little upside surprise to growth in Indonesia, while inflation is rising slower-than-expected and core inflation continues to ease. RGE also believes that Indonesia will delay rate hikes at least to Q3 2010—later than RGE’s initial forecast—amid political uncertainty.
Second, Bank Indonesia’s decision to phase out a 1-month certificate facility (SBI) by June can lead to a near-term IDR weakness. 1-month SBIs account for about 50% of all open-market operations. In addition, 1-month tenor attracts the bulk of foreign capital (besides SBIs, non-residents can also invest in government bonds). In the past, changes in foreign holdings of SBI had a noticeable impact on IDR. BI hopes that non-residents will switch into longer-term instruments, but this remains an open question at the moment.
As such, we choose to close our current “Long Asia” recommendation (long CNY, KRW, IDR, INR against JPY) and open a new “Long Asia” basket which tracks long CNY, KRW, MYR and INR positions (equal weights) against JPY.
An important caveat here is that unlike Singapore, the larger Asian economies will be more prone to use a sequence of policy measures—including credit curbs, raising reserve requirements and interest rates hikes—in addition to the exchange rates, as recovery and inflation risks gather momentum. Another key consideration is that growth and interest rate differentials will drive capital inflows, prompting further tightening (or at least no further liberalization) of real estate regulation, credit controls (such as margin requirements) and soft capital controls. The difference is of course that a very small, very open economy can do much less with these alternative routes to tightening than a larger, more closed one. Even though this will not be enough to reverse the general currency appreciation trend, it can increase volatility and limit or reduce risk-adjusted returns.