A case for currency appreciation in Asia?

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.

Thus, it is clear that northeast Asian currencies (Japanese yen, Chinese yuan, Singapore dollar and the Taiwan dollar) have a stronger case for appreciation. In south Asia, only the Malaysian ringgit qualifies. The Singapore dollar is seen more as a northeast currency due to the high per capita income of the city-state.

However, over the long-term, all these countries face the same problem that the West faces: they become societies of the old. This includes China.

Asian societies are somewhat insular. Unlike the US, they won?t easily allow immigration. Hence, such societies would see their incomes and savings rate drop and would also witness erosion of accumulated savings. So, in the long-run, their exchange rates would have to depreciate. However, this will not happen immediately. It might manifest in the consciousness of investors some time around 2010.

As southeast and south Asia enjoy better demographics, their potential growth rates are higher. For their actual growth to match the potential, they would need higher investment. Their interest rates would thus have to be higher than other countries, and/or rise over time.

Further, if higher economic growth results in higher return on invested capital, investors would mark up the value of the currency due to its higher yield. Thus, the attractiveness of the southeast and south Asian currencies arises from their long-term growth potential. India, Indonesia, Thailand and Malaysia belong to this category.

However, the story is not straightforward. There are risks. India faces many internal and external problems. Indonesia, Thailand and Malaysia face a dearth of skilled manpower with higher education.

Malaysia consequently faces competition from China in light and medium manufacturing and would be unable to go up the value chain. The ringgit might seem undervalued based on its current account surpluses, excess savings and reserves accumulation, but it is not clear if its appreciation would be justified based on its long-run growth potential. While Indonesia has tremendous potential, without more investment, its potential would remain unfulfilled and its vast Muslim population might turn restive without job opportunities.

Therefore, the case for Asian currency appreciation is not an easy one, it is a mistake to treat all of Asia as a homogeneous bloc in dealing with this subject. North Asian currencies have more scope to appreciate in the next few years, while south and southeast Asian currencies have better scope in the long run. Further, their logic for appreciation is different.

In spite of the different dynamics and varying speeds of potential currency appreciation, Asian nations?the cradles of civilisation?were the world?s dominant powers in the past. Unlike other emerging regions, countries of this region aspire to recapture such greatness. That is why Asian thrift and hard work are evident and recognised too. It would be appropriate to place one?s chips on Asia assuming a dominant position in the global economy.

?The writer is head of research, Asia Pacific & Middle East, Bank Julius Baer, Singapore. The views are personal