Watching Southeast Asia's Correction Play Out

JAKARTA -- The correction would seem about half-done in the Asia ex-Japan region. Greed & Fear is monitoring its progress via the MSCI Far East Free ex-Japan Index, which peaked out at 314, just below the resistance level we recently identified. The view we expressed was that the correction would see a maximum downside of 25%, which would take us to the 235 level. There seems strong resistance, though, at 253, which would seem an appropriate re-entry point, assuming markets decline that far. The low on the index this week was 274.

To repeat, this is a correction in a bull market. Meanwhile Greed & Fear will use the renewed low-quality bounce in Korea to take another 2 percentage points out of this market to add to the cash position.

The past few weeks have seen renewed focus on the devaluation risk in China. This has in part been encouraged by statements from Beijing that seem to be preparing a move for some sort of adjustment of the currency. Greed & Fear would be of the view that a shift to a crawling-peg regime, via an adjustment of the band, is now likely in the first quarter of next year. A more hasty move seems less probable given the 50th anniversary of the Communist revolution due to be celebrated Oct. 1 and the many statements made by senior leaders that there would be no devaluation this year.

An adjustment of the renminbi, suitably handled, need not be bearish and should not set off regional currency contagion providing, of course, it is not on the scale of 1994's 33% devaluation. Indeed, most Asian central banks are currently in the business of holding down their exchange rates via dirty floats. This marks a deliberate reflationary attempt to keep monetary conditions easy to help ensure sustained economic recovery.

A controlled, say 15%, depreciation of the renminbi could even be positive for market sentiment given that a weaker currency provides another way of addressing China's deflationary problem. It is in this respect that the latest noises out of Beijing are significant. At the peak of the Asian crisis, the question for China on whether to devalue focused full square on the issue of export competitiveness. That point is now less pressing given the bounce in regional currencies, as is clear from moves in real effective exchange rates over the past year.

The deflationary problem, however, has become ever more pressing. China is now engaged in a full-scale battle against deflation. This focus has seen the leadership adopt a variety of aggressive reflation policies, including fiscal stimuli, interest-rate cuts and the implementation of measures to boost the stock market. As a partial consequence the A-share market is now capitalized at $342 billion, which makes it the third-largest market in Asia after Japan and Hong Kong.

It is not surprising in this context that the authorities should also be looking again at the exchange-rate option. A depreciation of the renminbi is not the only answer to combating deflation, but it will help by easing the pressure from cheap imports. An adjustment of the renminbi, however, will do little immediately to ease deflationary pressures within Hong Kong, since the territory will retain the currency board system.

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