The “Bernanke put” may have made Asian markets dizzy with excitement, yet very few central bankers in the region will be joining the celebrations.
To most Asian policy makers, the larger-than-expected cut this week in the US Federal Reserve’s target for overnight interest rates is just the return of an all-too-familiar headache: unwanted liquidity. Following the Fed’s move, currency strategists are already advising clients to buy Asian currencies, though it’s highly unlikely that the Bank of Korea or the Reserve Bank of India will allow their currencies to surge against a weakening dollar. When the Fed stopped raising interest rates in June 2006, the three-month interbank interest rate in South Korea was one percentage point lower than the comparable US rate. Since then, Korea has had to progressively raise the cost of domestic money to deal with a liquidity-driven asset bubble.
On Wednesday, Korean rates topped US inter-bank borrowing costs for the first time in more than two years.
If Korea raises borrowing costs again—which it just might because money supply growth is still very rapid—the interest rate differential will become even more supportive of fresh dollar funds coming into Korea.
The Korean won will appreciate. “Stronger capital inflows would increase pressure on the won to appreciate, which, together with weakening global demand, could squeeze Korean exporters’ profit margins,” says economist Kwon Young Sun at Lehman Brothers Holdings Inc. in Hong Kong.
And what happens if the Bank of Korea (BoK) follows the Fed and pares domestic interest rates?
“If the BoK cuts in an effort to resist currency appreciation, it could compound liquidity growth and risks fuelling inflation or asset-price bubbles,” Kwon says.
The Reserve Bank of India (RBI) faces a similar dilemma.
It, too, wouldn’t want to allow further appreciation in the local currency, which has already risen 10% against the dollar this year, reaching its strongest level since May 1998. If it weren’t for the central bank’s $38 billion (Rs1.5 trillion) of US currency purchases in the first seven months of 2007, the rupee would have climbed even higher.
Preserving export competitiveness may not be the only reason why the central bank is reluctant to let the rupee appreciate too quickly. Prime Minister Manmohan Singh is facing a tough challenge from his communist backers, who don’t want his government to implement the civilian nuclear energy agreement it recently concluded with the US administration.
If the Marxists pull the plug and Singh’s government falls, there might be a stampede among international investors to sell Indian equities. The stronger the rupee is now, the greater its decline will be. The central bank wouldn’t want to raise rates to defend a falling currency if the economy needs the cost of capital to be lower.
So in all likelihood, the central bank will step up purchases of US dollars. “We flag heavy RBI intervention,” Yen Ping Ho, a currency strategist at JPMorgan Chase & Co. in Singapore, wrote in a note to clients on Wednesday.
RBI has managed to steer the economy to a soft landing: Mortgage demand is falling, vehicle sales have slowed, and bank credit is now growing at a sober 23%, almost a 10 percentage-point decline from a year earlier. At some point, the central bank will want to take its foot off the brakes and let the economy reaccelerate, though with local energy costs depressed by government fiat and waiting to be repriced, premature monetary easing may be inflationary.
For investors, it might be more profitable to buy Southeast Asian currencies, which policy makers may allow to rise. Foremost among them is the Indonesian rupiah. Bank Indonesia wants to lower interest rates, but it doesn’t want the local currency to weaken because that might reignite inflation. The Fed rate cut this week will, thus, allow the Indonesian central bank to pare domestic borrowing costs—for the 14th time since May 2006—while continuing to give bond investors a high yield premium over US securities.
The Philippines, too, will want to pare the cost of capital further, having lowered the benchmark rate by 1.5 percentage points in July, to the lowest level in 15 years. And since the country has a high level of foreign currency debt, it can’t afford to weaken the home currency too much.
Yet, the peso has already gained almost 8% in 2007. One can’t be very sure if Bangko Sentral ng Pilipinas will tolerate further appreciation in the home currency this year.
China is facing its worst inflation scare in a decade. That makes it almost certain that the authorities won’t want the yuan to follow the dollar’s decline, though how far the Chinese currency rises is anybody’s guess.
It’s unlikely that China will use the exchange rate as the main tool for cutting its trade surplus and easing the country’s liquidity glut.
The strategy for dealing with the latter is to export more domestic capital into the Hong Kong stock market. Investors looking for significant appreciation in Asian currencies this year may be disappointed.
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