16 January 2019
The yen dropped the most in more than a year after BoJ chief Haruhiko Kuroda unexpectedly adopted negative interest rates, a move that may trigger a fresh round of competitive devaluations. Photo: Japan Times
The yen dropped the most in more than a year after BoJ chief Haruhiko Kuroda unexpectedly adopted negative interest rates, a move that may trigger a fresh round of competitive devaluations. Photo: Japan Times

HK could be hurt as Japan reignites currency war

The Bank of Japan’s move last Friday to implement a negative interest rate policy was taken by the markets as a positive step. Stock markets around the world jumped higher, and bond yields fell.

However, it remains to be seen how long this positive sentiment will last, as the BoJ’s desperate move also seemed to reflect the fading effectiveness of quantitative easing. There is also a wall of worries about world growth, corporate earnings, oil prices and monetary policy divergence that investors have to climb.

The BoJ’s latest move is reviving the currency war, which may increase in intensity this time around. This is because China’s renminbi has entered into the dynamics via a foreign exchange policy shift by the People’s Bank China (PBoC) from targeting the US dollar (USD) to targeting the trade-weighted exchange rate of the renminbi.

My view on no renminbi (CNY) devaluation still stands, despite the recent market volatility. This is because devaluation cannot effectively resolve China’s structural economic woes today, while the cost of such a move would significantly outweigh the marginal benefits.

However, the PBoC’s policy to target a stable renminbi’s trade-weighted exchange rate has negative implications on the CNY-USD cross rate when the USD continues to strengthen against other currencies.

China has been holding the CNY-USD cross rate relatively steady since the beginning of this year as the renminbi’s trade-weighted exchange rate (based on China’s CFETS basket) has remained stable. However, the BoJ’s latest move could upset the renminbi’s stability.

In the short term, the risk of a weakening yen (JPY) will prompt stronger response from the European Central Bank (ECB), which is also battling deflationary pressures in Europe. If the ECB’s response results in weakening of the euro, it will further strengthen the USD against the other currencies in the renminbi basket.

Thus, a rising USD will push up the renminbi’s trade-weighted exchange rate, disrupting the current stable CNY-USD cross rate conditions. If the PBoC is really targeting a stable trade-weighted exchange rate, as I believe it is, then it may allow more CNY depreciation against the USD as an adjustment to keep the trade-weighted exchange rate stable.

However, the truth is that the market still has no clue about the PBoC’s foreign exchange policy goal: Does it want to target a stable RMB trade-weighted exchange rate, or does it want to keep the trade-weighted exchange rate in a range — and what is the bandwidth of the targeted range? This uncertainty is bad enough to create more market volatility on the back of a weakening JPY for both China and the world markets.

If the renminbi does weaken against the USD further, Asian currencies will be also be dragged down. Evidence shows that market development had led to the formation of a renminbi currency bloc in Asia, with the regional currencies tracking the renminbi’s movement more closely than they track the USD and the euro in recent years.

There is also a direct impact of a weakening JPY on the renminbi and the Asian currencies through trade. According to the United Nations Comtrade database, Korea has the biggest export similarity (59.9 percent) with Japan, making the Korean won the most vulnerable to depreciation pressure in this round of the currency war.

Taiwan, Singapore and Thailand all have more than 40 percent of exports competing with Japan’s in the third markets. So their currencies are also vulnerable to further JPY weakness. Even China has about 39 percent of exports similar to those of Japan, so the renminbi is not totally immune from the yen’s depreciation pressure.

Although Hong Kong has a lower (30 percent) degree of export similarity with Japan, the Hong Kong dollar (HKD) is also a proxy used by some investors to “hedge” against the China risk. And this may not bode well for the SAR’s asset market. Why?

Hong Kong was not hurt much by the last few rounds of the currency war. Indeed, Hong Kong stocks benefited from the G3’s quantitative easing. The situation is different this time due to the uncertainty of the RMB policy.

While the PBoC was quite clear about its strong RMB policy before, its foreign exchange policy has become uncertain recently, creating market fears about an economic crisis in China dragging on the global economy.

Hence, market sentiment has turned negative on China, with the effect spilling over to Hong Kong dollar which has seen significant selling pressure lately. Unless market sentiment turns positive on Hong Kong or China, the HKD will likely come under more selling pressure in this round of the currency war.

As long as the HKD-USD peg remains in place, Hong Kong’s asset prices would suffer when local interest rates rise to protect the peg when it is under selling pressure. This is the natural cost of keeping the peg. So hold tight for more volatility with downside risk during the storm.

The only factor that can reverse the currency war dynamics is for the US Federal Reserve to reverse its interest rate normalisation course.

Opinions here are of the author and do not necessarily reflect those of his employer.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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