TOKYO -- Asian currencies are mostly undervalued against the U.S. dollar, and although the yuan does not fall into this category it is trending weaker and could become a point of contention in the U.S.-China trade war, according to an in-depth analysis by Nikkei and the Japan Center for Economic Research.
While the yen had been undervalued since 2015, this week it strengthened to the lower 107 range against the dollar, right where its equilibrium exchange rate -- as calculated by Nikkei and the JCER based on the most recent macroeconomic data -- says it should be. Five other Asian currencies remain undervalued compared to the equilibrium exchange rate calculated from January-March data.
Among all currencies analyzed, only the baht and euro were stronger than what our equilibrium model suggests. In Thailand, this is partly due to the stability offered by the tens of millions of tourists who every year bring foreign currency into the country.
The results of the analysis come days ahead of the Group of 20 summit in Osaka, which already has market players edgy as they consider how the leaders and senior policymakers of squabbling industrial and emerging-market nations might deal with one another.
U.S. President Donald Trump is commanding especially keen attention from investors and currency traders. Last week, he took to Twitter to vent against Mario Draghi, the Italian economist and president of the European Central Bank.
"Mario Draghi just announced more stimulus could come, which immediately dropped the Euro against the Dollar, making it unfairly easier for them to compete against the USA," Trump tweeted. "They have been getting away with this for years, along with China and others."
In fact, Trump has been criticizing the monetary policies of America's trading partners since he began his bid for the presidency four summers ago. His recent tweets came in reaction to a speech in which Draghi said "additional stimulus will be required" to help the EU weather economic turbulence. Now Trump is repeating his refrain in the lead-up to an important gathering of global leaders already besieged by controversies ranging from the recent Hong Kong protests to the Strait of Hormuz attacks to the escalating U.S.-China trade war.
Exchange rates constantly fluctuate, affected by a broad confluence of factors, ranging from economic conditions to political events. Nikkei and the JCER have tried to pin down the appropriate dollar exchange rates of eight Asian currencies as well as the euro and pound by analyzing an array of economic data.
As for the yuan, its dollar equilibrium rate for the first quarter of 2019 was 6.74, mostly in line with the actual average exchange of 6.75. Currently, the yuan is trading in the higher 6.8 range, which suggests Chinese authorities are willing to allow a weaker yuan.
Looking ahead, the International Monetary Fund has predicted that China will start running a current-account deficit as early as 2022. Taking this into account, the equilibrium exchange rate would be around 6.8 yuan per dollar. From this point of view, the yuan is currently undervalued. This raises the possibility that exchange rates could emerge as a key issue in the U.S.-China battle over trade and other matters.
Our estimates show that five Asian currencies -- the South Korean won, the Indonesian rupiah, the Malaysian ringgit, the Singapore dollar and the Taiwan dollar -- are undervalued against the dollar.
The weakness of these currencies can probably be attributable to last year's U.S. rate hikes, which invited capital to flee many of Asia's emerging markets.
The Indonesian rupiah last year plunged to the 15,000 range against the dollar, sinking below the all-time low that it logged back in 1998, when the Asian currency crisis wreaked havoc across the region.
The rupiah's equilibrium exchange rate in 2018 was in the 13,000 range.
Given Indonesia's persistent current account deficits and other shaky economic fundamentals, the rupiah often finds itself the target of speculative selling.
The Malaysian ringgit is also undervalued against the U.S. currency, remaining weaker than the equilibrium rate of 4 per dollar, due partly to low oil prices.
Besides having the outlier currency, Thailand finds itself in a pickle. Its tourism-led economy and the stable baht are attracting investment from overseas. As this dynamic further strengthens the currency, it makes Thai exports more expensive and thus acts as a drag on the country's manufacturing sector.
As for Japan, our equilibrium model shows that the yen should be in the lower 107 range vis-a-vis the greenback under current conditions. But if the U.S. Federal Reserve starts cutting interest rates, the yen's appropriate dollar value would rise to the 105 range.
We have estimated the most reasonable exchange rate, or the Nikkei equilibrium rate, between the Japanese and U.S. currencies by using a range of relevant domestic and international macroeconomic indicators.
The Nikkei equilibrium exchange rate between the two currencies for the first quarter of 2019 was 107.2 yen per dollar, some 3% higher than the average yen-dollar exchange rate during the three-month period, which was 110 yen per dollar.
The yen had remained undervalued since 2015 but this week its actual dollar rate has been close to the appropriate level, in the lower 107 range. On Tuesday, it was threatening to push into the 106 range.
The dynamic is playing out as major central banks scramble to ease their monetary policies in response to the increasingly murky global economic outlook.
On June 19, the Fed cited economic uncertainties and indicated it is ready to lower interest rates for the first time since 2008. The Federal Open Market Committee said in a statement it "will act as appropriate to sustain the expansion."
Bank of Japan Gov. Haruhiko Kuroda has also signaled a readiness to provide additional stimulus, saying Thursday that the BOJ "will consider extra easing measures without hesitation" if Japan's stubbornly steady prices don't get a move on.
But Kuroda has little room to maneuver. He began hemming himself in with extremely low interest rates in 2013. Three years later, the BOJ introduced a negative rate that charges commercial banks 0.1% interest on some deposits they park at the central bank. If the Fed starts moving U.S. rates in the BOJ's direction, it would close the interest gap with Japan and provide an incentive for investors to sell dollars for yen.
Trump is leaning on the Fed to do just that, and economists warn his administration could start attacking Japan's policy at any time. The U.S. Treasury Department has named Japan, China and other countries as major trading partners whose currency policies should be monitored.
Furthermore, Washington officials have suggested attaching currency provisions to any trade agreement with Tokyo.
According to our formula for calculating appropriate exchange rates, two Fed actions to lower interest rates by a total of 0.5 of a percentage point would push up the yen's rate against the dollar to 105.9.
The pull on the yen, though, would likely be much stronger, given the ripple effect the Fed would have on interest rates in other countries.
"As the Fed is now changing the direction of its monetary policy, the yen could rise past the 100 mark by the end of the year," said Mizuho Bank's Daisuke Karakama.
Nikkei and the JCER based their equilibrium exchange rate formula on the assumption that exchange rates are determined by long-term economic fundamentals. We are considering whether to report equilibrium exchange rates on a regular basis.
In creating our regression-analysis-based formula, we selected a range of domestic and international macroeconomic indicators, including government debt, net overseas assets, gaps in interest rates, the terms of trade and price ratios between tradable and nontradable goods.
After testing various mixes of variables, we selected the most convincing, then used it to estimate quarterly equilibrium exchange rates.
First, we calculated the effective exchange rates of the 11 currencies. Then we used these rates and the trade weights for each country/region to calculate the bilateral exchange rate of each currency against the dollar. This allowed us to factor in the movements of currencies other than the dollar.
JCER President Kazumasa Iwata says the method yields results less susceptible to arbitrariness and more useful for objective assessments on whether a currency is undervalued or overvalued.