A case for currency appreciation in Asia?

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: The 2006 World Bank/IMF meetings in Singapore are now part of history. G7 finance ministers and central bank governors issued a statement calling for exchange rate flexibility, rather than appreciation, on the part of China. China responded with a statement of intent to widen the fluctuation bands for the Yuan. But, the country left the timing and magnitude unspecified. In the meantime, US treasury secretary Henry Paulson successfully played down expectations of any outcomes during his visit to China. It seems business as usual.

So, is the Asian currency appreciation story one of ‘much ado about nothing’?

Usually, currencies appreciate when investors sense a yield advantage either now or in future. Most Asian currencies have seen their short-term interest rates peak already. Korea, Thailand and India come to mind. Malaysia is on an extended pause. China and Japan would need to increase interest rates far longer and much more, before their yield pick-up becomes a reason to own those currencies.

Currencies appreciate when they are seen as undervalued on a purchasing power parity basis—if they consistently enjoy a low inflation advantage over their trading partners, they need to increase. Such a case can be made in the case of some Asian countries (eg, China and Japan). But, other Asian countries actually had an inflation scare in 2005 and 2006 due to higher oil prices.

So, the case for Asian currency appreciation doesn’t easily arise from the standard arguments. The case rests on the excess reserves that Asian countries have accumulated. A country accumulates foreign exchange reserves only when it does not allow the demand for and supply of local currency to be balanced by market forces, but intervenes to increase the supply when demand rises. This prevents the exchange rate from appreciating. China, Japan, South Korea, Taiwan, Malaysia, India and Singapore have steadily increased their reserves in recent years. Without this, the exchange rate would have appreciated.

Another case for currency appreciation arises from current account surpluses. A country that runs a persistent and growing surplus is said to have an undervalued exch-ange rate. This makes exports cheaper and imp-orts costlier. Given healthy demand and reasonable price sensitivities, exports rise and imports decline. Trade surpluses result. When such surpluses are invested abroad, investment income also rises, leading to current account surpluses. In Asia, this has been seen in Japan, Singapore, Malaysia, Taiwan and China.