It is finally happening. After a few false starts in recent years, the greenback is embarking on a relentless climb. This is bound to rattle markets.
Major swings in exchange rates force investors to reassess their positions, not just tactically but strategically. Global finance is thus in for a turbulent time. Even the U.S. Federal Reserve has expressed worries. But not everyone is equally vulnerable: Emerging Asia should withstand the shift better than most. While the region has its share of challenges, a stronger dollar is not the main one.
It is easy to see why investors are a little jittery. Along with other regions, Asia has splurged on debt in recent years. Credit as a share of gross domestic product has grown rapidly not only in China but in all major economies. This is why the region has delivered robust growth, notwithstanding tired shoppers in the West and consequently sluggish growth in world trade. Strong fundamentals and attractive interest rates, at least compared to developed markets, have drawn capital, much of it in the form of bonds, from funds desperate to bolster their returns. Along the way, strengthening local currencies have added to the allure.
The big question
As the dollar now strengthens, the inevitable question is whether this will knock out credit and, more broadly, hit economic growth. That seems unlikely. First: Despite the strengthening greenback, interest rates in the U.S. remain low. In fact, long-term yields have remained remarkably steady. It is also difficult to see a sharp rise in the coming quarters even if the Fed takes the plunge and pushes up short-term rates. Deflationary pressures persist in the U.S. as elsewhere, and debt remains too high to accommodate a swift increase in funding costs.
This, therefore, is no ordinary cycle. The dollar is on the move, but yields are not. At the very least, that should ease pressure on Asian markets.
Second: The flip side of a stronger dollar is a weaker yen and euro. The former matters especially for Asia -- not because Japan might exert competitive pressures on the region, which for most countries it does not, but because the country is a growing source of capital. With the Bank of Japan keeping its foot firmly on the accelerator, bank lending and foreign direct investment into neighboring countries have hit record highs. Portfolio money has started to pour in as well. What is more: The weaker yen is not doing much to propel growth at home, with rising import costs not offset by improving exports. Local banks, with cash reserves now topping 12% of their assets, are thus increasingly venturing abroad.
Third: To the extent that a stronger dollar reflects stabilizing growth prospects in the U.S., this should support shipments across the Pacific. In fact, the country has regained its status as Asia's largest market, overtaking the European Union, which had been the biggest importer of the region's products for the last seven years. This, of course, is not enough to lift Asia out of its growth malaise, but it provides a degree of support, not least for export profits.
Fourth: Falling commodity prices, which in part reflect the stronger dollar, are helping to keep a lid on inflation. This is an important point. Unlike in past cycles, central banks in Asia can afford to keep interest rates largely on hold. South Korea even cut interest rates further, with the weakening won being an unlikely trigger for tightening anytime soon. Elsewhere, too, officials are likely to keep funding costs near historical lows. In a region where most economies still enjoy excess savings, a stronger dollar in itself, therefore, is unlikely to push interest rates higher as it did in the past.
Reassuring stuff. Still, there is potential currency trouble lurking in the background. So far, the yuan has held steady, relieving China's neighbors of a potential headache. But as the currency floats up with the dollar against others, Chinese exports are feeling the squeeze. Furthermore, a strengthening redback exacerbates deflationary pressures at home. Should recent easing measures fail to gain traction, officials may well decide to weaken the exchange rate. The effects on the region could be severe.
Fortunately, in periods of turmoil, China usually opts for exchange rate stability, offering its currency as a financial anchor to locals and neighbors alike. In any event, a sliding currency would hardly solve the country's real challenge: to press ahead with domestic reforms. Still, the risk for Asia of a weaker yuan, while small, is material.
At the same time, even if Asia can ride out dollar strength, other challenges remain. Credit-driven growth is no recipe for sustained development. For this, productivity needs to rise. Structural reforms, therefore, remain imperative.
Things are gradually moving in the right direction. In China, President Xi Jinping has clearly stated his intention to remold the economy. In India, the election of Prime Minister Narendra Modi has radically improved prospects for far-reaching changes. Around the Association of Southeast Asian Nations, too, subsidies are being cut, infrastructure spending is rising and leaders have proposed ambitious policy agendas.
This, then, highlights the real risk the region faces -- that despite recent efforts, reforms ultimately fall short of what is needed to restore economic vitality. Pitfalls abound. Vested interests push back. Populations grow tired of sacrifices. It is politics, in short, that will determine Asia's fate. A stronger dollar might create headwinds, but it will not, in itself, prompt the region to stumble.
Frederic Neumann is co-head of Asian economic research at HSBC.