How to position in emerging Asia?

Constantly rising yields have left many emerging market currencies under pressure. Emerging Asian currencies are no exception, weakening nearly 3% between mid-May and end-June. As yields have further to rise, there are justified fears that emerging markets will sell-off again.

The growth outlook argues for trade balances to remain firm. The region's exports are rising at a 15% pace led by strength in the electronics sector. That follows a shaky start to the year. The better performance is reflected by the RBS Economic Surprise Index – which remains firmly in positive territory to signal that the data is matching or beating market expectations.

We are also positive on the US economy. We forecast the Fed Funds rate to peak at 5.50%. Most importantly from the US consumer perspective, petrol prices remain stable, while the adjustment in the housing sector appears orderly. We thus expect rising yields to imply a steady growth outlook, whereas the recent shake-out occurred partly on fears that growth would correct sharply.

We are similarly positive on the Chinese economy. There are risks that excessive liquidity will spark another round of investment growth, but the People's Bank of China (PBoC) has positively moved to a pre-emptive tightening stance, whereas it has previously lagged the economic cycle. Moreover, the headline investment data disguises an encouraging rotation in the composition of spending towards less-developed areas.

We expect trade surpluses to remain firm against this backdrop. However, we prefer commodity producers (MYR) that are enjoying solid demand. Also, we prefer the larger exporters (KRW, SGD, and TWD) that not only enjoy more stable trade surpluses, but are also more heavily exposed to Chinese domestic demand, in particular its steady investment spending.

The benefit of these surplus currencies is that they are better shielded in the event that risk appetite weakens relative to our positive outlooks.

The CNY underpins the broader emerging Asia revaluation trade. The region's central banks are already tiring of reserve growth – constant intervention in FX markets has resulted in excessive domestic liquidity. But the slow pace of CNY appreciation so far has left the region's central banks reluctant to unleash their currencies altogether.

However, we forecast the pace of CNY appreciation to accelerate later this quarter, or once monetary policy tightening ends. The PBoC is traditionally reluctant to tighten monetary policy aggressively. Having already tightened twice in the past two months, the central bank will now wait to assess the impact on growth. But as monetary policy tightening ends late this quarter, the pace of CNY appreciation will accelerate.

Neither can the PBoC wait too long. Domestic pressure for faster appreciation is building. The trade surplus, forecast at a large $150 billion this year, is a major driver of liquidity growth. While a stronger currency is not a quick-fix solution to this imbalance, it is better to tackle the problems today rather than delay.

Moreover, the global climate is increasingly supportive of faster appreciation. As the US Fed continues to hike and risk appetite softens modestly, the risks of speculative flows to China have fallen accordingly. USD/CNY 12M implied yields are a low 1.6% – a high bar for investors betting on speculation, especially given the disappointing returns so far.

How much? We expect USD/CNY to reach 7.7500 by year-end and 7.500 by mid-2007 – 3% faster than the 1Y NDF discounts.

We would discount the importance of yields to the region and instead focus on surplus currencies. Trade surpluses have rebounded since the start of the second quarter on stronger export growth and stable oil prices. The region's aggregate trade balance (excluding China) has stabilised at a monthly $7 billion rate after slumping early in the year.

A faster pace of CNY appreciation will spill over into the rest of emerging Asia.

But again, we emphasise the importance of differentiation. The intra-correlation between emerging Asia currencies has risen steadily in recent years, echoing the growing realisation that the region as a whole must revalue against the dollar. However, the region's central banks will respond differently to appreciation pressures in the event that the CNY strengthens significantly.

We expect North Asia to permit faster appreciation (KRW and TWD) owing to the greater integration between the region's manufacturing base. This latter stems partly from a final burst of outsourcing in 2000 that saw high-value added North Asian electronics manufacturers relocate to the mainland. This has reduced the scope for potential losses through currency strength.

But South Asia is more likely to resist appreciation pressure, as its manufacturing base remains in direct competition with the mainland.

When to put on positions? Although the chances of a summer rally suggest some opportunities in short-term tactical plays, the recent steepening of implied yield curves between six and 12 months suggests medium-term plays hold greater value.