Why China's economic slowdown could spell bad news for Asian currencies

China's strong economic recovery is expected to fade in the months ahead, putting downward pressure on the yuan exchange rate and consequently creating headwinds for other Asian currencies, analysts said.

China is a net importer of goods from many Southeast Asian countries such as Malaysia, Thailand, Vietnam, Singapore and Indonesia, so a slowdown in demand would have knock-on effects for their currencies.

Generally the Chinese yuan acts as an important anchor in the regional foreign exchange market, as economies in East Asia such as Taiwan and South Korea have tight China trade links via complex supply chains, analysts said.

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Weaker currencies would make exports from Southeast Asian nations more competitive in international markets. But it would also increase the cost of key raw materials and components for them, already high because of rising global demand and supply chain disruptions.

Historically, Asian currencies tend to move in tandem with the yuan (RMB) when there is weak risk appetite and peaking growth momentum, said Paul Mackel, head of emerging markets currency research at HSBC.

"This is a development to watch given how it could turn into a headwind for those currencies that are typically more sensitive to RMB movements," Mackel said. "Low confidence in the prospects of [some Asean] economies could be pushing local investors to invest in overseas assets." 

China has led the global recovery from the Covid-19 pandemic, but there are signs underlying growth momentum is softening.

The official manufacturing purchasing managers' index (PMI) - a gauge of industry sentiment - slumped to 50.4 in July, its lowest level in 17 months, indicating a moderation in business activity. The non-manufacturing PMI dropped to a five-month low of 53.3. The 50-mark separates growth from contraction on a monthly basis.

"A slowing Chinese economy would increase business uncertainty and a deter ioration in confidence in the region," sa id Be rnard Aw, Asia-Pacific economist a t Coface. "The most affected Asian economies would be those deeply integrated in the Asian production chains."

China runs a trade deficit with many countries in the region, underscoring its importance as a source of final demand. These Asian nations relied on exports to support growth throughout the pandemic while domestic activity remained sluggish, said Sue Trinh, senior macro strategist at Manulife Investment Management.

"That is a major vulnerability since it leaves an economy hostage to foreign demand," Trinh said. "As China slows, so too will demand for regional exports. In this regard, Asean stands out as relatively exposed, which has increased its dependence on Chinese demand to record highs over the past few years."

Asean jumped to be the number one trading bloc with China for the first time in 2020, with trade volumes hitting 4.74 trillion yuan (US$733.6 billion), 7 per cent growth year on year, and making China Southeast Asia's largest trading partner for 12 years in a row.

In addition, China imports cars, capital equipment and high-end machinery from the United States and Europe Union (EU), so slowing demand would affect these industries, said Aidan Yao, senior emerging Asia economist at AXA Investment Managers.

But overall, the US and EU run trade deficits with China, meaning they are a source of net export demand for China, not the other way round.

"The interaction between China and the rest of the region across many industries, via complex supply chains, is tighter than China's trade links with the US and EU," Yao said. "[China's] growth slowdown, if abrupt, could be negative for RMB assets, depressing the yuan vis-a-vis the dollar and euro."

Analysts said it was clear that the US Federal Reserve and the People's Bank of China (PBOC) are on diverging monetary policy paths.

HSBC's Mackel forecasts the yuan's exchange rate to decline about 2 per cent from its current level of 6.47 against the dollar to 6.60 by year end. A higher US dollar-yuan exchange rate figure means it takes more yuan to purchase one US dollar, indicating a weaker Chinese currency.

Few Asian currencies will be unscathed by the double whammy of more hawkish Federal Reserve policy and a resurgence of the coronavirus. But South Korea's won and Taiwan's dollar are likely to be affected the most because of their tight trade links in China and East Asia, said Gao Qi, currency strategist at Scotiabank.

Recent regional data has already indicated the impact of China's expected economic slowdown.

South Korean manufacturing confidence fell to 92 in August from 99 in July, while confidence among non-manufacturers dropped to 78 from 82. Korea's trade surplus also narrowed to US$1.76 billion in July from US$4.45 billion a month ago.

The Taiwanese economy grew 7.47 per cent from a year earlier in the second quarter slowing from growth of 8.92 per cent in the previous period.

Indonesia's current account deficit has deteriorated considerably due to the pandemic, and its currency has been one of the worst hit in Asia, falling 18 per cent against the US dollar in the last six months after worries emerged over US policy tapering plans.

Indonesian healthcare workers receive the third dose of a coronavirus vaccine in Palangkaraya on Friday. Photo: Antara Foto/Makna Zaezar/via Reuters alt=Indonesian healthcare workers receive the third dose of a coronavirus vaccine in Palangkaraya on Friday. Photo: Antara Foto/Makna Zaezar/via Reuters

Malaysia's growth outlook is also set to dim over the rest of the year after the nation reported a record number of daily Covid-19 cases in July, resulting in new restrictions on businesses and consumers.

The Malaysian ringgit fell 2 per cent last month, the largest drop in four months. It is expected to drop another 2.4 per cent to 4.32 per dollar by year end, although depreciation pressure may be most acute in the third quarter, Heng said.

HSBC's Mackel predicted the Singapore dollar would drop a modest 0.7 per cent to 1.36 per dollar by the end of the year after last month's underperformance due to its sensitivity to global growth concerns.

The city state's small economy is heavily reliant on trade with Asean countries, more than with mainland China. Anxiety around the latest virus wave should ease as it may soon open its economy and borders, given its vaccination rate is expected to increase to 80 per cent of the population by September.

"One potential exception could be India's rupee," Mackel said. "The ability to withstand portfolio outflows of up to US$3 billion per month given steady inflows from external borrowing and non-resident deposits and improved foreign reserve adequacy metrics could help defend the rupee against external headwinds."

This article originally appeared on the South China Morning Post (SCMP).

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