Asian emerging market (EM) currencies are cheap. They have depreciated in real, inflation-adjusted terms against the U.S. dollar to an extent that is likely to result in (real) appreciation in the coming decade.
This is according to a report S&P Global Ratings (S&P) published today (Feb 27), entitled, “Asian Emerging Market Currencies Will Chart A Comeback,” as the ratings house expects EM economies to significantly outgrow the U.S. during this time. While exchange rates can deviate from price-based benchmarks for long periods, their long-term trajectory typically adheres to these gauges.
The low valuations and prospects for continued economic catch-up should help the currencies strengthen in real terms against the U.S. dollar, with nominal appreciation probably playing a crucial role.
S&P Global Ratings’ benchmarks suggest much larger room for appreciation for some Asian EM currencies than for others; currency prospects also differ for most developed economies.
Asian EM Exchange Rates Have Waned Against The U.S. Dollar
S&P’s price-based benchmark gauges long-run currency movements and can anchor the long-term evolution of Asian EMs against the U.S. dollar after their prolonged depreciation. It doesn’t say much about short- or even medium-term shifts. They have generally excluded the exchange rates of Asia’s developed markets but include those of Japan and South Korea for context.
Asian EM currencies have lost much ground against the U.S. dollar since early 2021. They generally depreciated by 10%-15% during this period, alongside other major currencies. The Japanese yen weakened by a whopping 28.5% amid stark monetary policy divergence. The exception among EM currencies was the Vietnamese dong, which dropped only 3.5% against the greenback.
In general, inflation in Asian EMs has either lagged U.S. inflation or broadly equalled it; consequently, real exchange rates (RERs) have typically depreciated at least as much against the U.S. dollar in recent years as nominal exchange rates.
The recent EM Asia currency weakness followed earlier RER depreciation against the U.S. dollar since they peaked in the early 2010s. The RER weakening since these peaks is in part because of a relatively strong U.S. dollar generally, which has put depreciation pressure on all other currencies. Some regional currencies may also have been overvalued in the early 2010s.
In Asian EMs such as China, Malaysia, Thailand, and recently, Indonesia, relatively low inflation has added to the real deprecation.
A Benchmark For Long-Term Currency Valuation
Relative price levels can serve as a long-term benchmark for exchange rates. A high or low price level relative to comparable economies may suggest the currency is too expensive or cheap and needs to depreciate or appreciate to restore balance. That’s even the case if divergence from price anchors lasts for many years.
The most comprehensive prices come from the International Comparison of Prices (ICP) project coordinated by the World Bank. The prices from the ICP are used by the World Bank to calculate its purchasing power parity exchange rates. The idea is the same as that behind the Economist magazine’s Big Mac index, but the ICP data compares prices of hundreds of items.
Economic catch-up tends to lead to rising relative prices, i.e., RER appreciation. When Ems grow fast and catch up with richer economies, we expect price levels to rise relative to those in high-income countries, most obviously via the Balassa Samuelson effect. This effect occurs if prices of non-tradables rise because of rapid productivity growth in the tradable sector. Consider the relative price level vis-à-vis the U.S. in 2022 for 177 economies, as well as the fitted line from a simple linear regression.
Asian EM Currencies Broadly Adhere To Our Framework
For solidly growing EM economies, the currency weakness against the U.S. dollar in the past decade is unusual. Indeed, it followed an average 50% strengthening of Asia EM real exchange rates against the U.S. in the 20 years before the peaks of the early 2010s.
Almost all Asian EMs have seen significant RER appreciation against the U.S. since the early 1990s as they caught up with the U.S. economically (see chart 3). Also, richer Asian economies tend to have higher price levels and thus stronger real exchange rates.
In China, this was in no small part due to nominal currency strengthening, whereas in most others–especially Indonesia and India–it stemmed more from relatively high domestic inflation.
Malaysia is an exception, with substantial catch-up but no real exchange rate appreciation. The relationship also holds in the other direction. Japan, where per capita GDP growth lagged that of the U.S., saw its currency depreciating in real terms.
Asian EM Currencies Will Strengthen Against The U.S. Dollar
The significant real depreciation of Asian currencies in the past 10 years, even amid solid economic growth, has resulted in relatively cheap valuations from a price perspective. In January 2024, all of them were undervalued on this price basis, on average 16%, and ranging between 1.7% (China) and 31% (Malaysia).
S&P’s baseline forecast sees Asian EM economies growing on average by 5% in 2024-2026, helping them to continue to catch up with the U.S., which we project will grow 1.8% over the same period.
India, the Philippines, and Vietnam lead, with 6%-7% annual expansion.
There is significant scope for Asian EM currencies to climb in real terms against the U.S. dollar. Exchange rates can deviate many years from price-based anchors. In addition to short-term changes, external imbalances affect currencies over the medium term. In Asian EMs, there is still strong demand for U.S. dollar funding and foreign portfolio assets, and capital flows can be volatile.
Relatedly, the accumulation of foreign reserves by central banks has often kept Asian currencies weaker than their fundamentals suggest. Still, as the experience of the yen and the renminbi show, currencies tend to eventually gravitate toward the price-based benchmarks.
Real appreciation can occur through either nominal strengthening or relatively high domestic inflation. Yet, several Asian EMs have already become low-inflation economies. That suggests that nominal appreciation against the U.S. dollar is likely to play a key role.
Regardless of the exact channel, in the long run real exchange rates–i.e., relative price levels—are likely to strengthen for Asia EMs.
