Asian insurers and other businesses have been helping strengthen Asian currencies in recent months by buying more protection against US dollar weakness.
These investors, who have large holdings of US bonds and other securities, had little urgency to hedge when the dollar was strong. But they are now increasing their hedge ratios to protect against a fall in the greenback. This typically involves selling the dollar for local currencies, which appreciates the latter’s value.
“The Taiwanese dollar’s surprise rally in early May serves as a reminder to those hoarding US dollars to manage their exposure,” said Christopher Wong, a forex strategist at OCBC in Singapore.
“We believe Asian currencies can continue to appreciate so long as US dollar softness persists, owing to US-centric risks, and global growth outside the US still holds up,” Wong said.
East Asian currencies have notched noticeable gains. Those of Taiwan, Japan, and South Korea have appreciated between 8% and 11% this year.
In May, a Taiwanese media report that the US would demand a stronger Taiwan dollar in a trade deal prompted the island’s cash-rich corporations to convert their dollar holdings and life insurance companies to increase hedge ratios. Taiwanese authorities denied such a trade deal.
The Taiwan dollar surged a near record 10% in two business days in early May, underscoring a broader diversification away from the US and highlighting Asia’s large dollar assets.
Taiwan’s holdings of US stocks and US bonds are equivalent to more than 90% of its gross domestic product, followed by Japan at around 60% and Australia and South Korea, both with holdings exceeding 30%, according to Bank of America Global Research.
The “diversification away from US dollar assets” will be a key theme that will continue to drive most Asian currency markets over the coming months, Gek Teng Khoo, a strategist at Morgan Stanley, said in a report. He said that he expects Asian currencies, excluding the Japanese yen, to appreciate by up to another 3% over the next 12 months.
Currency hedging aims to protect assets from fluctuations in exchange rates. Hedging costs are influenced by short-term interest rate differentials between currencies. The US federal funds rate target range remains 4.25–4.50%. This is higher than South Korea’s 2.5% interest rate, Taiwan’s 2% and Japan’s 0.5%. Rate differentials between the US and Asia mean hedging costs remain high.
“While [Taiwanese] life insurers have some flexibility to maneuver their hedging ratios within their mandates, broader changes don’t happen over a week or so,” said Chidu Narayanan, head of macro strategy for Asia Pacific at Wells Fargo in Singapore. But “it is another factor that will be very important to watch going forward, especially in Northeast Asia foreign exchange.”
While no other country “comes close” to Taiwan’s scale of US assets, Japan, Australia, and South Korea also have “meaningful” holdings, said Bank of America Securities strategists in a report. “Portfolio hedge ratio dynamics will be key for these countries, although they are unlikely to lead to the kind of disorderly forex adjustment observed in the Taiwanese dollar.”
Japan is the largest overseas holder of US Treasuries, with USD 1.1 trillion as of March. Japanese life insurance companies are major holders of US debt. Currency hedge ratios at large Japanese insurers are at a “historically low level” of around 30%, said Kenta Tadaide, chief FX strategist at Daiwa Securities, in a note.
The yen’s appreciation to 140 to the dollar could prompt exporters to hedge their exposure, while causing life insurance companies to buy US assets, the BofA Securities strategists said. The yen traded in the mid-145 level as of June 13.
Hedging costs using currency forwards, which lock in future exchange rates, remain “stubbornly high” for Japanese investors, said an official from an international bank in Japan. This has led investors to prefer currency option-based hedging, which gives investors the alternative to use a set exchange rate in the future, the official said.
Exporters’ conversion of their dollar-based export proceeds into local currency would help strengthen Asian currencies, Morgan Stanley’s Khoo said.
Onshore foreign currency deposits in Asia’s emerging market economies have increased across the board over the past three years, Khoo said. He added that Thailand’s foreign currency deposits have doubled over the past three years, followed by Malaysia (34%) and the Philippines (31%).
Most emerging market Asian investors are expected to reallocate their dollar investments into “other large, liquid markets like Japan” rather than repatriate to local markets, Khoo said.
While structural diversification away from the US is already in motion, the pace of change is expected to be gradual.
“It’s very hard to find an immediate alternative for the entirety of their dollar exposure, so we don’t see dramatic reductions happening,” Wells Fargo’s Narayanan said. “That said, we expect a slow reduction of overweight US dollar investment positions.”
This article first appeared on Nikkei Asia. It has been republished here as part of 36Kr’s ongoing partnership with Nikkei.