Ripple effects of masterfully timed yuan move all positive
Asia's regional currencies have made a strong start to the year, rising across the board as the US dollar has wobbled on the foreign exchange markets.
At any time before China revalued the yuan last July, regional central banks from Seoul to Singapore would have moved quickly to quash similar signs of currency strength, in order to keep their exports competitive. Now, following China's revaluation, they may be more willing to allow their own currencies to strengthen.
Before last July, one of the reasons Chinese officials gave for their reluctance to revalue the yuan was the risk of triggering runaway gains in other Asian markets. A poorly timed revaluation, they explained, could initiate heavy flows of hot money into neighbouring markets, potentially destabilising regional economies.
In the event, China's policy-makers picked their moment masterfully. They chose a time when US interest rates were rising and the US dollar was strengthening across the board. By keeping their move small and acting when there was relatively little interest to buy regional currencies, they barely caused a ripple in international markets.
That was six months ago and the mood in financial markets has changed in the meantime. As the realisation has set in that the US Federal Reserve is going to stop jacking up interest rates at some point over the coming months, Asian markets have started to attract fresh investor interest. Fund inflows are lifting currencies and stock markets around the region.
Now the yuan is no longer pegged to the US dollar, the region's central banks seem more willing to let their own currencies rise in response. The most striking example is Korea. Last week the won rose to its highest level against the US dollar since the currency collapsed during the Asian financial crisis of 1997. Buoyed by the inflows, Korea's benchmark Korea Composite Index closed at an all-time high of 1,416 on Friday.
The won is not only currency getting stronger. In three months, the Taiwan dollar has risen 4 per cent, the Philippine peso 6 per cent, and the Indonesian rupiah 7.5 per cent against the US dollar.
Most analysts think they are going to go on climbing. After the won hit 974 to the US dollar last week, Goldman Sachs forecast it would reach 925 in 12 months time. Morgan Stanley predicted it will end the year at 920.
Expectations of further yuan appreciation are one reason for this bullishness. Although the Chinese currency has only inched higher in the last six months, numerous analysts are forecasting the pace of the appreciation will accelerate. Some think the yuan could end 2006 almost 10 per cent higher against the US dollar.
A rising yuan will encourage China's neighbours to allow their own currencies to appreciate. Before China's revaluation, Asian central banks were anxious to prevent their own currencies from rising to ensure exports remained competitive compared with Chinese goods. Now, if the yuan strengthens, they can let their own currencies rise without fear of losing their competitive edge.
It has been so long now that regional governments have been intent on holding their currencies down, it is easy to forget that there are powerful economic advantages to appreciation. By making people richer, a stronger currency can boost demand at home. In turn, robust domestic demand means governments can rely less on exports to generate growth and so be more comfortable to let their currencies appreciate. This raises the prospect of a virtuous circle of growth.
A stronger currency will also help dampen the domestic effect of high energy prices and keep a lid on inflation. In turn that means local central banks need not be so quick to follow the Federal Reserve and raise interest rates which would threaten to slow their own growth rates.
Economists have been forecasting stronger Asian currencies for years. Finally, they may be right.