This is not too dissimilar with 2005 when a July 17 Financial Times story reported that the Bush administration was privately informing Senators that China would revalue in August. In reality, the CNY move followed four days later. Indeed, the exact timing of Beijing’s policy action will remain a guessing game.
Thus far, the market has reacted by buying Asian currencies in local markets that are still open namely INR and SGD. USD/INR has dropped from 44.65 prior to the news and fallen to around 44.40, after being met with suspected RBI action. USD/SGD fell from its intra-day high of 1.3995 to a low of 1.3942 and currently stands 110bps on the strong-side of the NEER band.
History has also demonstrated that the market can be very quick to take profit in the aftermath of a PBOC revaluation, as was also demonstrated on July 21, 2005. Indeed, it is not outside the realm of possibility that China could also widen its existing trading band of +/-0.5% to +/-1.0% to prompt some self-doubt to the speculative assertion of CNY being a one-way bet.
The 2005 case study also showed that KRW, SGD and TWD were the biggest gainers over the 4-week horizon that followed the initial 2.1% CNY revaluation – see table below. However, these gains failed to be sustained during the remainder of 2005 as concerns over rising energy prices and “over-tightening” action by the Fed worked against Asian revaluation trades and portfolio inflows.
This time around Asian policy makers are faced by a different dilemma. How to deal with potential asset inflation arising from “lower, for longer” interest rate policies among the G3. At the same time, energy prices are starting to break higher again. The most obvious answer appears to be regional policy normalization. Something that India and Malaysia has already engaged. Indeed, we believe China will engage in normalization this month with a 27bps hike to its 1yr working capital lending rate (currently at 5.31%) and then later follow with CNY appreciation in May, though this action could be brought forward as suggested by the latest media reports.
Given this clear difference between 2005 and 2010, the next question is which Asian currencies will benefit and correlate with this move over the year. There are two standard approaches to assessing this. The first is to look at the trade links as identified in chart 7 as the percentage of total trade with China. This shows Taiwan and Korea roughly neck-and-neck in terms at 20.34% and 19.6% respectively in terms of trade shares with China. Hong Kong, not shown in the chart is the highest at 47.5%. Thereafter, the trade exposures follow as India at 13.7%, Malaysia at 10.9% and Thailand at 10.10%. This would suggest a schematic ordering of Asian currencies that would appreciate in sympathy with CNY appreciation by descending rank of KRW, TWD, INR, MYR and THB.
The difficulty, however, is that differences in FX regimes and policies may obscure the transmission from CNY appreciation to Asian currency appreciation with the HKD currency board being an extreme example. This leads us to the second approach of looking at the empirical behavior with correlation analysis. The chart right shows the correlation of CNY spot and CNY 12M expectations with other Asian currency returns in the post July 21 2005 CNY revaluation period.
Generally, the orderings are the same between using spot and NDF CNY, though the NDF registers higher correlations as it is not constrained by the PBOC FX band of +/-0.5% around a daily reference fixing. The key point is that TWD, MYR and SGD appear to offer the best and most consistent proxy hedges for CNY appreciation. By contrast, KRW has been plagued by too much idiosyncratic risk, most notably in 2008 when its currency depreciated 28% in spot terms against USD.
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