Now that Asian central banks have reported their foreign reserve positions for the first quarter of 2015, when the dollar staged one of its strongest rallies, we can declare that at least half of them are "not guilty" of participating in the global currency war that many believe was escalated by the BOJ and ECB amidst the Fed's QE tapering talks.

Three of them – Malaysia, Singapore and China, in fact defended their currencies quite strongly from dollar bull attacks. In contrast, India, Indonesia, Korea and the Philippines do appear to have intervened to weaken their currencies. Can the latter group of central banks justify their actions? Apart from India, in our opinion, the others can justify their actions because of the strengthening of their real effective exchange rates (REER) and/or rise of real interest rates. To the extent that these countries have lost real competitiveness, efforts to weaken their nominal exchange rates to offset losses in competitiveness can be justified, in our opinion.

Valuation Impact of the Strong Dollar on Asia's Reserves

Since the Fed starting hinting at the normalization of interest rates a year ago, Asian central banks' foreign reserve accumulations - except for India and Hong Kong - have either incurred substantial losses or remained flat.

In absolute terms, China's reserves took the biggest hit with a loss of over USD260bn which is equivalent to a 7% drop from its peak in July 2014. In percentage terms, Malaysia lost the most with a 21% plunge in reserves. Most central banks however insist that the “bulk” of the reserve losses were due to translation losses instead of FX interventions.

Assuming that all of their reserve compositions are in line with the IMF COFER breakdown of world reserves, we stripped out the valuation effects on reserves from the weakening of the major currencies – EUR, JPY, GBP, AUD and CAD – against the USD.

We found China, Malaysia and Singapore to be “not guilty” net of valuation effects - these three central banks have still lost a significant portion of their reserves since last July, although surprisingly less so for China than for Malaysia and Singapore (see Figure 1).

For the rest, changes in reserves – net of valuation effects – were still positive, ranging from less than 5% (Taiwan and Thailand) to 5-10% (Indonesia, Korea and the Philippines) to over 10% (India and Hong Kong). Excluding Hong Kong whose currency is pegged to the USD, India, Indonesia, Korea and the Philippines certainly appeared to have done some level of “competitive currency devaluation” over the past year.

Figure 1: Movements in Foreign Exchange Reserves

Movements in Foreign Exchange Reserves

Source: HSBC

With a loss in real competitiveness through real effective exchange rate (REER) appreciation and rising real interest rates, can these central banks justify their actions? We looked at the shifts in the currencies' real effective exchange rates relative to their post-2000 means. It turns out that only MYR and INR have weakened substantially since July, while others have actually strengthened with the exception of IDR that has remained broadly unchanged - see Figure 2.

Figure 2: REER Deviations from Post-2000 Average (# of std dev)

REER Deviations from Post-2000 Average (# of std dev)

Source: Nikko AM estimates

We next looked at their real policy rates, adjusted by CPI inflation. It turns out real rates have risen sharply across the region due to falling inflation except in China and Indonesia where nominal rates have been cut in line with inflation, leaving real rates broadly unchanged except in Hong Kong which uses the Fed fund rate as its policy anchor. See Figure 3.

Figure 3: CPI-Adjusted Real Policy Rates %

CPI-Adjusted Real Policy Rates %

Source: Nikko AM estimates

Conclusion

In conclusion, the justifications for participating in the global currency war can be defended by real exchange rate appreciation and a rise in real interest rates. Figure 4 combines these two mitigation factors in a scatter plot – the majority of Asian central banks could have justified their exchange rate devaluation stance. The exceptions are Malaysia and India – between them, Bank Negara Malaysia defended the ringgit fiercely while the Reserve Bank of India did the opposite which was to weaken the rupee.

Figure 4: Change in Real Policy Rates vs. Change in REER Gaps, Jul 14 - May 15

Change in Real Policy Rates vs. Change in REER Gaps

Source: Nikko AM estimates