Asian markets risk a reprise of crisis-level stress as two of the region’s most important currencies crumble under the onslaught of relentless dollar strength.
The yuan and yen are both tumbling due to the growing disparity between an uber-hawkish Federal Reserve and dovish policy makers in China and Japan. While other Asian nations are digging deep into foreign-exchange reserves to mitigate the dollar’s damage, the yuan and yen’s slump is making things worse for everyone, threatening the region’s mantle as a preferred destination for risk investors.
“The renminbi and yen are big anchors and their weakness risks destabilizing currencies to trade and investments in Asia,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore, using another name for China’s currency. “We’re already heading toward global financial crisis levels of stress in some aspects, then the next step would be the Asian financial crisis if losses deepen.”
The gravitational pull of China and Japan are evident in the sheer influence of their economies and trade relationships. China has been the largest trading partner of Southeast Asian nations for 13 straight years, according to a Chinese government statement. Japan, the world’s third-biggest economy, is a major exporter of capital and credit.
The tumble in the currencies of the region’s two largest economies may swell into a full-fledged crisis if it spooks overseas funds into pulling money out of Asia as a whole, leading to massive capital flight. Alternatively, the declines may set off a vicious cycle of competitive devaluations and a slide in demand and consumer confidence.
‘Bigger threat’
“Currency risk is a bigger threat for Asian nations than interest rates,” said Taimur Baig, chief economist at DBS Group Ltd. in Singapore. “At the end of the day, all of Asia are exporters and we could see a reprise of 1997 or 1998 without the massive collateral damage.”
Investors have already been busy pulling money from the region. Global funds have taken about $44 billion out from Taiwan’s shares this year, $20 billion from India’s equities, and $13.7 billion from Korean stocks, according to data compiled by Bloomberg. Beijing and Tokyo’s heft is even more pronounced in financial markets. The yuan makes up more than a quarter of the weighting of Asian currency indexes, according to analysis by BNY Mellon Investment Management. The yen is the third-most-traded global currency, so its weakness has had an outsized impact on its Asian counterparts.
The rising potential for spillover between the two largest regional currencies and their smaller peers can be seen in the fact they are moving in ever closer alignment as the dollar surges. The 120-day correlation between the yen and the MSCI EM Currency Index jumped to more than 0.9 last week, the highest since 2015, after the two were briefly inversely correlated as recently as April.
The threat of a spillover has become even more severe as currency declines accelerate. The yen tumbled passed 145 per dollar for the first time in more than two decades Thursday after US-Japan monetary policy divergence widened further when the Fed raised interest rates for a fifth straight meeting the day before. The yen retraced some of its losses after the authorities intervened but few see the action as doing anything other than slowing its inevitable decline.
The yuan slid past its own key level of 7 per dollar earlier this month, under pressure from the hawkish Fed and slowing growth in China caused by Covid-Zero lockdowns and a property-market crisis. The onshore currency extended losses on Friday to a level closest to the weak end of its allowed trading band since a shock currency devaluation in 2015.
Trigger point
Specific levels such as the yen at 150 may bring on turmoil on the scale of the 1997 Asian financial crisis, according to market veteran Jim O’Neill, previously chief currency economist at Goldman Sachs Group Inc. Others say the velocity of declines is more important than individual trigger points.
A rapid drop of the yen and yuan “can quickly become a ‘deadweight’ for other regional currencies,” said Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management in Singapore. “Much further yuan depreciation could be more troubling from here for the rest of the region.”
Of course, there’s no certainty further losses in the yuan and yen will bring on a financial upheaval. Nations in the region are in a far stronger position than they were in the run-up to the Asian financial crisis in the late 1990s, having greater foreign-exchange reserves and less exposure to dollar borrowing. Still, there are pockets of risk.
“The most vulnerable currencies are those with the deficit current-account positions such as the Korean won, Philippine peso, and to a lesser extent, the Thai baht,” said Trang Thuy Le, a strategist at Macquarie Capital Ltd. in Hong Kong. When the yuan and yen both fall, “the pressure can translate to dollar buying and hedging demand for those exposed to emerging-market currencies,” she said.
China’s yuan support
China made it more expensive to bet against the yuan in the derivatives market, ramping up support for the currency as it slides toward the weakest level since the 2008 financial crisis.
The People’s Bank of China on Monday said it will impose a risk reserve requirement of 20% on banks’ foreign-exchange forward sales to clients. That’s after the yuan depreciated on Friday to a level closest to the weak end of its allowed trading band since a shock currency devaluation in 2015. Pressure on the exchange rate has worsened lately due to the dollar’s surge and as the local economy suffers from Covid curbs and slowing property sector.
The yuan extended losses Monday and its depreciation past 7.1854 per dollar would send it to the weakest level since early 2008. The PBOC’s attempt to support the currency comes on top stronger-than-expected yuan fixings since August, which limits the currency’s moves by 2% on either side. It also reduced in banks’ foreign-currency reserve requirements earlier this month to boost the yuan.
“By imposing the risk reserve requirement, the PBOC aims to slow the pace of depreciation but it will unlikely turn the tide,” said Peiqian Liu, an economist at NatWest Markets. “The currency weakness is in line with most major currencies and the broad dollar strength.”
The additional risk reserve requirements would make it expensive for traders to buy foreign exchange through forwards or options, a move that may curb bearish yuan bets. The central bank had lifted the risk reserves for foreign exchange forward trading from zero to 20% in 2015, before lowering it two years later and raising it again in 2018.
The PBOC set the yuan fixing weaker than 7 per dollar on Monday for the first time since 2020. Liu sees this as a clear signal that the PBOC doesn’t intend to defend any specific yuan levels.
Liu Guoqiang, Deputy Governor of the PBOC said earlier this month that the central bank won’t allow the trend of a “reasonable, equilibrium and basically stable” exchange rate to be changed while warning traders against betting on a certain level for the yuan.
Onshore yuan fell 0.5% to 7.1633 per dollar as of 2:22 p.m. local time. It was trading about 1.9% weaker than the fixing of 7.0298 per dollar.
Currencies across the region are tumbling as the Federal Reserve leads most other central banks in shifting away from an easy monetary policy. Japan intervened to prop up the yen for the first time since 1998, while India’s efforts to protect the rupee are shrinking currency reserves at a rate that’s poised to eclipse the drawdown during turmoil a decade ago. The British pound plunged to a record low while Treasury yields surged on Monday, adding to the dollar’s strength.
The PBOC has more policy tools at hand to defend the currency, Jingyang Chen, a foreign exchange strategist at HSBC Holdings Plc said. “We haven’t seen a lot of signs of meaningful intervention,” Chen said in an interview on Bloomberg Television. “If we saw a quick fall in trade weighted yuan, then we might see more direct intervention or another cut to the foreign exchange reserve ratio,” she said.
The yuan’s weakness may push the PBOC to delay any further monetary policy easing until later this year. After a surprise cut to a key interest rate in August, the PBOC paused its easing this month as the US Federal Reserved hiked rates. Bloomberg Economics estimates the Fed will tighten through the rest of 2022 and 2023, and the PBOC will maintain an easing stance over the period, cutting its one-year rate to 2.45% by end-2023.