The recent spasm of U.S. dollar (USD) strength is more likely a symptom, less likely a cause, of several political and economic dislocations in today’s markets. But what does the dollar rally mean to investors of Asian equities and fixed income?
The Asian Financial Crisis of 1997–98 looms like a ghost over any consideration of Asian currency risk. Given the robust performance of Asian currencies since 1999, however, it may be time to reconsider Asian currencies in a modern context that takes into account the diverse monetary systems, business cycles and development stages of Asia’s economies.
Over the third quarter, the worst-performing Asian currency was the Korean won, which depreciated 4.1% against the U.S. dollar. Interestingly, this was better than the best-performing G-10 currency—the Norwegian krone, which lost 4.6% vs. the USD. Performance in other Asian currencies ranged from a 1% gain in the Chinese renminbi to a 2.9% loss in the Philippine peso.
With the trade-weighted basket of Asian currencies losing 1% vs. the dollar in the third quarter, it’s fair to say that Asian currencies were relatively stable over the quarter compared to other currencies. Latin American currencies lost 6% over the same period. Even traditional safe haven currencies—the Euro, Swiss franc and Japan’s yen—lost ground against the USD, losing in the neighborhood of 7% to 8% each.
This is not the first time that Asian currencies have shown resilience in the face of stress emanating from more developed markets. They performed better than expected during the Great Financial Crisis of 2008, losing 9% vs. the USD from the end of July 2008 until the end of the following March. This compared favorably to the 27% loss in Latin American currencies and 14% loss in all trade-weighted currencies over that period.
Equity investors usually pay little heed to currency risk due to its small contribution, over the long run, to total returns. Foreign exchange (FX) volatility is also not a meaningful contributor to overall returns volatility.
For investors in Asian bonds, currencies matter more. Over the long run, currency returns have contributed about one-fifth toward total return and about two-thirds toward volatility. When you buy a bond denominated in a foreign currency, you receive the following basket of returns: local currency coupon income, local currency price return (primarily due to yield changes that can arise from either interest rate or credit spread changes), and FX return on the coupon income you have received as well as on the bond principal. Currency movements can either add to or detract from bond coupon and price returns.
The tension between FX return and coupon plus price return is starkest when markets become risk averse. For investors whose home currency is a “safety currency” (the USD preeminent among them), negative returns from local currency depreciation can negate positive returns from coupon cash flows.
Since the Asian Financial Crisis, have Asian currencies been net positive or negative contributors to Asian bond returns? On a trade-weighted basis, they have appreciated about 1% each year on average. A valid objection is that 1999 is an unfair starting point because that marked the end of the Asian Financial Crisis. Use any point after that, and Asian currencies still look relatively stable compared to currencies of other developing markets. Compared to Latin American currencies, to which they are often compared, Asian currencies have performed decently, with less than half the volatility and less severe drawdowns.
Gerald Hwang, CFA