Won Crushes Yen as Dollar Substitute in Asian Rally

By Matthew Brown and Patricia Lui

Oct. 19 (Bloomberg) -- Asian central banks are running out of ammunition to fight their currencies’ biggest rally since 1998, paving the way for South Korea, Taiwan, Indonesia, Thailand and India to help lead foreign-exchange performance next year.

JPMorgan Chase & Co.’s index of Asian currencies has risen 5.6 percent since its strongest two quarters in 11 years began March 31. Of 34 currencies ranked by Bloomberg forecast surveys, the won, Taiwan dollar, rupiah, baht and rupee will be among next year’s dozen strongest, median estimates show. The won has the best prospects and is the second-most undervalued of 16 major currencies as measured by purchasing power.

The currencies are rising even as policy makers sell them, amassing record reserves on concern that too much appreciation will slow export-driven recoveries. Investors are fueling the rallies by seeking greater returns outside the U.S., where near- zero interest rates have made the dollar a favorite to sell in so-called carry trades. With Asia leading the way out of the worst global recession since World War II, 15 of its 18 country stock indexes are beating the Standard & Poor’s 500 Index.

“The money’s going to keep on flowing into Asian currencies, and central banks can’t continue to accumulate reserves indefinitely without some major side effects,” said Simon Derrick, the London-based chief currency strategist at Bank of New York Mellon Corp., the world’s biggest custodian of assets. “They have to let their currencies rise.”

Longest Stretch

Asia isn’t alone in facing unwanted foreign-exchange strength as investment capital inundates emerging economies from Eastern Europe to Latin America. Brazil’s real just posted its seventh straight weekly advance, the longest stretch since 2004.

“I hear a lot of noise reflecting the government’s discomfort with the exchange rate, but it is hard to fight this,” said Rodrigo Azevedo, the monetary policy director of Brazil’s central bank from 2004 to 2007. “There is very little Brazil can do,” said Azevedo, who runs $1.8 billion at JGP SA in Rio de Janeiro, in an Oct. 16 interview.

In the past month, five of Asia’s currencies were among the top 10 emerging-market performers against the dollar, with the rupee, won, rupiah, Malaysian ringgit and Philippine peso up between 2 percent and 4 percent.

The rise has been propelled by an unprecedented net $47 billion that flowed into equities in India, Indonesia, the Philippines, South Korea, Taiwan and Thailand in the last three quarters. That eclipses the previous full-year high of $33 billion in 2005, nine years of data compiled by Bloomberg show.

Top Performers

Median forecasts see the won gaining 7.4 percent against the U.S. dollar by Sept. 30, 2010. Taiwan’s dollar and the rupiah, baht and rupee may strengthen 4.6 percent, 2.2 percent, 1.9 percent and 1.7 percent against the world’s reserve currency, putting them in second, seventh, 10th and 11th place globally. They rank similarly against the other two top currencies, the euro and the yen. Japan’s cash is predicted to lose 6.7 percent against the U.S. dollar and 13.1 percent versus the won.

Speculation that Asian countries will raise interest rates as their economies outpace the West is also boosting their currencies. China will expand 8.3 percent this year and 9.5 percent next as the U.S. contracts 2.5 percent and then grows 2.4 percent, median economist predictions show. Forecasts show Hong Kong, Indonesia, Thailand, South Korea and the Philippines increasing rates sooner or more than the U.S., Europe and Japan by the end of next year.

New Highs

As South Korea fought the won’s rise by selling it, reserves grew 26 percent in the first three quarters, the fastest since 2000. Taiwan’s coffers rose 14 percent in the same period, the most since 2004, to a record $332 billion. Reserves in Thailand and Hong Kong also hit new highs as of Sept. 30.

The central banks now find themselves in a conundrum. They can let inflation accelerate as they flood their economies with local currencies sold for foreign cash. Or they can raise interest rates to keep prices in check and become even more attractive as carry-trade investors use money from countries with lower borrowing costs to buy Asian financial assets.

Taking funds from the U.S. and Japan, with benchmark rates of 0.25 percent or less, to buy won, rupees and rupiah, with rates between 2 percent and 6.5 percent, has produced an annualized carry trade return of 36 percent since Feb. 20 -- the most ever for that length of time, Bloomberg data show.

Some governments are trying to soak up the local cash they’re printing by selling short-term local-currency debt, a process known as sterilization, but there aren’t enough buyers for the bills to finish the job.

Mopping Up

“The depth of financial markets in these currencies is not large enough to issue the bills to mop up the excess liquidity,” said Bilal Hafeez, the global head of foreign- exchange strategy in London at Deutsche Bank AG, the world’s largest currency trader. “That’s going to cause inflation unless they raise interest rates and let their currencies appreciate further.”

South Korea’s reserves soared $22.5 billion to $254 billion in the third quarter as the country sold won and the amount of its so-called monetary-stabilization bonds outstanding fell 3.5 percent to $132 billion. The currency rose 8.1 percent against the dollar in those three months. Taiwan added $14.7 billion to its reserves in that period and issued about $1 billion in local debt as its dollar rose 2.1 percent.

Even after the won rallied 33 percent from an 11-year low on March 6, it remains undervalued by 56 percent against the dollar, second only to Mexico’s peso among 16 currencies in the Organization for Economic Development’s purchasing power parity gauge. It’s even more undervalued against the euro and yen, also second to the peso.

‘Price Bubbles’

“Korea is paying the most” for its currency’s strength, said Mirza Baig, a Singapore-based foreign-exchange analyst at Deutsche Bank. “The pace of intervention, based on reserves accumulation, is very high, so that shows the currency is massively undervalued. Inflation is creeping up while money supply also looks high, and this leads to concerns about asset price bubbles.”

Consumer prices in South Korea increased 1.62 percent in July, 2.17 percent in August and 2.2 percent in September from the year before, the first time the figure jumped two consecutive months since July 2008. Median forecasts show inflation rising in three of the next four quarters.

Bets on continued foreign-exchange strength in Asia may lose money if governments impose restrictions on their currencies’ use. Malaysia limited the ringgit’s convertibility in the Asian financial crisis for a year starting in September 1998. Indonesia and Thailand employed capital controls in 2001. Thailand tried to curb the baht’s rise again from December 2006 to March 2008 by requiring investors to put 30 percent of their funds into bank accounts that penalized withdrawals after less than a year. The baht strengthened 13.9 percent in that period.

Controls ‘Not Harmful’

Taiwan’s central bank sent a document to local media touting capital controls on Oct. 9, two days after the government reported a 13th drop in monthly exports. It quoted a United Nations report saying such limits are neither “ineffective nor harmful” to emerging-market economies.

South Korea plans to restrict state-controlled companies from taking out dollar loans because foreign currency borrowed from local banks is helping drive up the won, a Ministry of Strategy and Finance official said last week, declining to be identified because the move hasn’t been announced. The won declined 0.6 percent to 1,171.2 per dollar today.

China, which amassed a record $178 billion in new reserves in the second quarter, has effectively pegged the yuan to the dollar since July 2008 and probably will keep it there until mid-2010, according to the median of 26 forecasts in a Bloomberg survey. The currency is seen strengthening 2.5 percent to 6.66 per dollar in 2010 and 6.20 in 2011, from 6.83 as of Oct. 16.

Yuan in Check

After letting the yuan appreciate almost 18 percent in the three years to July 2008, China has kept it in check to help exporters weather the global recession. Shipments abroad fell a less-than-forecast 15 percent in September.

“The Chinese will first apply administrative controls on the banks, then look at reserve ratios of banks, then raise deposit rates before allowing the currency to appreciate,” Hafeez said.

Asia is more dependent than the West on exports, which become relatively pricier as the currencies of overseas competitors or customers weaken.

Sales abroad were the equivalent of more than a third of 2008’s gross domestic product in 14 countries in the region, including China, Taiwan, Malaysia, Thailand, South Korea and Cambodia, Asian Development Bank data show. In the U.S., exports were 11 percent of GDP in 2009’s second quarter. About 41 percent of developing Asian countries’ exports were shipped directly to the U.S., the euro region and Japan in 2007, the International Monetary Fund’s most recent data show.

Hurting Profits

Asian governments may find they can live with stronger exchange rates, said Peter Redward, head of emerging markets research for the region at Barclays Plc in Singapore.

“It takes a relatively large change in Asian exchange rates to have an impact on export volumes,” he said. “As for exporter profitability, it clearly has an effect, but appreciation typically happens when global demand is accelerating and prices of exports are rising, such as now.”

David Bloom, head of foreign-exchange strategy at HSBC Holdings Plc in London, said emerging-market central banks risk a crisis if they don’t let their currencies rise.

“The model of exporting goods to the U.S. and building up foreign-exchange reserves has failed,” Bloom said. “It leads to excess buying of U.S. fixed-income paper, lowering the cost of capital in the U.S., which makes people more anxious for returns elsewhere. They can either change their ways now or they change them under duress.”

To contact the reporter on this story: Matthew Brown in London at mbrown42@bloomberg.net; Patricia Lui at plui4@bloomberg.net