ANALYSIS - Asia to loosen grip on FX as inflation returns

Fri, 23 Oct 2009 14:45:24 GMT

 By Kevin Yao

SINGAPORE - The dollar's plunge has prompted Asian central banks to intervene to curb strength in their currencies and support exports, but they may change tack in 2010 to rely on currency appreciation to contain inflation.

Asian currencies are rallying strongly as investors pile cash into emerging markets, believing they will not only recover from the global downturn before developed economies but will start to raise interest rates first as well.

But the risk for Asian central banks is that raising interest rates as growth and inflation revives could spur yet more capital inflows, especially if it means a growing rate premium over G7 economies.

Another option would be to reduce the level of intervention and allow currency appreciation to take up the policy slack.

"At this juncture, we think central banks are seeking to prevent excessive speculative pressure while trying to accommodate endemic dollar weakness," said Emmanuel Ng, currency strategist at OCBC Bank in Singapore.

"Probably in the first to second quarter, the global outlook would have better clarity and the central bankers would be able to sleep better when they loosen up slightly to allow their respective exchange rates to reflect better economic conditions."

For now, currency intervention is serving the purpose of helping Asian exporters in their time of need as they try to recover from the global downturn and compete with China, which has kept the yuan flat against the dollar since mid 2008.

But China is likely to unshackle the yuan early next year when export markets are expected to pick up, which will help calm fears among its smaller neighbours about losing out to Chinese exporters, analysts say.

Investors are already pricing in the prospect of stronger economic growth and higher interest rates. The South Korean won and Indian rupee have each gained 6 percent since September. The Philippine peso is up 5 percent.

The Indonesian rupiah is soaring. It's up 16 percent this year as the dollar sits at 14-month lows against major currencies.

"Obviously we see currency-strengthening despite the fact that they are intervening, and I would expect that to continue to be the case as long as there are appreciating pressures," said Magnus Prim, chief Asia currency strategist at SEB in Singapore.

A Reuters poll shows analysts expect the won and rupee to gain about 6 percent from now to the end of 2010, leading Asian currencies higher.

Foreign currency reserves held by Asian central banks surged by nearly $112 billion in September to a record $4.96 trillion, reflecting dollars accumulated in intervention.

"PRE-CONDITION"

Earlier this month, Australia became the first G20 country to raise interest rates and markets are pricing in the risk of tighter policy elsewhere in Asia, including in South Korea, India and China.

Analysts believe some Asian central banks, particularly those in Indonesia, India and the Philippines, may see inflation rising closer or beyond their comfort levels in the first half of 2010.

But raising interest rates aggressively when borrowing costs stay low in the United States would only fuel capital inflows and eventually negate the tightening effect of rate rises, analysts at HSBC said in a note.

"In other words, monetary policy decoupling in Asia virtually requires as a pre-condition that exchange rates appreciate. This is especially so the longer low interest rates are expected to persist in the West," they said.

A Reuters poll suggests Philippines inflation could hit 4.1 percent in the second quarter of 2010, inside the government's annual target of 3.5-5.5 percent. It's just 0.7 percent now.

The poll shows Indonesia's inflation will more than double to hit 5.9 percent in the second quarter of next year, against a central bank forecast of 4-6 percent.

In India, analysts expect inflation to surpass the central bank's comfort level of 5 percent before March 31 from 1.2 percent now.

Another incentive to cut back on intervention is that it can fuel inflation because of the domestic liquidity that is generated.

"That's when one of the side effects of fighting currency appreciation becomes a pressing domestic issue," said Sean Callow, currency strategist at Westpac in Sydney.

While reduced intervention may suit a policy purpose, China may hold the key to easing central bank nerves about rising currencies.

"I think in general terms, this kind of intervention is likely to step down rather than step up when China starts to let its currency strengthen again, which I expect to happen during the first quarter of next year," SEB's Prim said.

(Editing by Neil Fullick)



(Reuters)

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