The Other Side of USD Weakness

The weakness in the US dollar has already sprung some surprises in 2005. Kuwait announced a revaluation in the value of its currency against the US dollar, whilst the Egyptian pound is amongst the best performing currencies so far this year.

Local currencies are appreciating or revaluing and not just in Asia. Year to date, the top performers against the USD have been the Egyptian pound (up +2.38%), Uruguay peso (+1.34%), Sri Lankan rupee (+1.14%), Romanian leu (+0.88%) and Colombian peso (+0.72%).

Just looking at two of these, while the COP has continued its 2004 rally (in which is was LATAM's best performing currency), the move in the EGP may have surprised many. The EGP effectively spent 2004 pegged at USD-EGP 6.20. The trigger for local currency appreciation seems to have been the creation of an exchange that allows domestic banks to trade FX amongst themselves. However, the broader economic picture has also been improving. Exports are higher, tourist numbers are recovering and Suez Canal traffic income hit a record high in 2004. Crucially, a new government has embarked on a serious reform programme for the first time since the 1990s. The local stock market's performance underlines the improved situation with a 140% USD return in the last 12 months. The growing government fiscal deficit is a worry and on current trends may weigh on the EGP over the medium term, but near-term fundamentals suggest more room for appreciation, particularly if the USD continues to weaken.

Elsewhere, Kuwait revalued its currency peg against the USD at the weekend by 0.92% to 0.292. Although the new peg remains well within the central bank's +/- 3.5% official band, the move took local markets by surprise as the dinar had been fixed ay 0.29476 since November 2003. The revaluation is likely to be an attempt to cool the local economy and dampen inflationary pressures. Unlike its neighbours, Kuwait's central bank has a dual FX policy of not just maintaining currency stability against the USD, but also shielding the economy from the effects of imported inflation. Given USD weakness and the strength of the economy, further moves are possible. Could Kuwait's move prompt changes in other Gulf currency pegs? There should be no direct impact. Kuwait has traditionally maintained a much more pro-active FX policy than its neighbours. However, as we have discussed before, the causes of Kuwait's move - USD weakness and surging domestic inflation - could potentially lead the other countries to revalue. This risk is currently a small one, but as the USD continues to decline it is growing.

Staying on the subject of currency revaluation, the likelihood of the Chinese yuan (CNY) being revalued in 2005 remains a key focus for global markets. The PBoC's annual conference starts today and will be watched carefully for policy hints. The conference is likely to cover broad topics such as economic management and liberalisation of interest rates, but FX policy could also be on the agenda although it is unlikely to feature in the post-meeting statement. Nonetheless, speculation could return as a result of this meeting. Other dates that CNY speculators will focus on are the February G7 meeting and the March National People's Congress meeting.