Measuring the response -- With negative debt dynamics and a possible threat of a ratings downgrade now looming for Japan, questions of how a falling yen could affect Asia are likely to resurface in the coming months. In this regard, we have run some sensitivity analyses of Asian currencies under various $/yen exchange rate levels. The results bear some degree of promise that a second currency crisis in Asia could be avoided in the months ahead.

The extreme scenario -- We begin by estimating the historical response of Asian currencies to movements in the yen. Our previous work shows that the yen matters for Asian currencies when it is falling, much more than it does when it is rising. Indeed, our econometric estimates show that there were two peak periods when the yen?s effects on the KRW, TWD and SGD were at their strongest. Both episodes occurred when the yen was falling:
A.) In the depths of the crisis in mid-98, when "yen-funded carry trades" put pressure on the yen, which fell to a low of JPY147/$ in September. B.) In March last year as Asia's slowdown was just beginning, when worries over Japan's banking system and macro outlook, coupled with the BOJ's expressed policy intentions to ease monetary policy until CPI inflation stopped falling. We view these episodes as representing the outer limits that circumscribe how far Asian currencies can fall in response to a weakening yen. At such points of maximum duress, our estimates show that a 1% fall in the yen has resulted in an equivalent move of 1% in the $/KRW rate, 0.4% in the $/SGD rate and 0.3% in the $/TWD rate. In extremis, if Asia?s exports fail to recover and if risk aversion were to affect Asian asset markets adversely, such a high response rate could theoretically materialize.

The baseline scenario -- It remains our belief, though, that Asia's vulnerability to currency contagion has decreased markedly since the crisis. Exports are already recovering, economies are not in immediate need of devaluation relief, nominal exchange rates are not significantly overvalued and current account balances remain in surplus. Thus, going forward, we expect the response of Asian currencies to a falling yen to be much more muted in nature:

-In Singapore, a 1% change in the $/JPY rate has on average led to a move of about 0.1% in the $/SGD rate, which we think corresponds roughly to the weight of the yen in the currency index that the MAS explicitly targets as a policy variable.

-We believe that a weaker yen is not a significant threat to Korea's growth story. For some time, we have argued that Korea?s aggressive macro policies - in particular, fiscal policy - would support the economy and we think that a 1% fall in the yen should not lead to more than a 0.4% move in $/KRW, roughly the magnitude of the response seen in H2 2001.

-Although the central bank appears to be acquiescing to a weaker exchange rate in Taiwan, deliberately pursuing a substantially weaker currency runs against the ethos of the CBC, and we believe remains an unlikely outcome. The response of the $/TWD exchange rate has been typically weak - at around 0.1% to a 1% change in the yen - in the past.

The ready reckoner -- We have used these coefficients to compute likely exchange rates at different $/yen levels under a "baseline" scenario. We define this high probability scenario as one of continued export recovery in line with a gradual resumption to trend growth in the US. Under this scenario, at JPY150/$, we expect exchange rates to be no weaker than SGD1.88/$, KRW1386/$ and TWD35.5/$. However, under a low probability "extreme scenario" of no US growth and a fall in investor confidence in Asia, we expect a much more severe reaction of Asian currencies to a falling yen - probably approaching the limits seen in mid-1998.

Leaning against the wind -- Yen considerations aside, central banks in the stronger economies of Asia, far from propping up their currencies at over-valued levels, have actually been intervening to prevent their currencies from rising too fast. Faced with burgeoning trade surpluses and capital inflows in the last few months, central banks have been buying dollars to limit FX appreciation. These show up in a rise in official foreign reserves, by $16bn in Taiwan and by $7bn in Korea last year. Central banks, in turn, have sterilized their FX intervention by mopping up the excess liquidity, either by inter-bank borrowings or via bond issuance. After pausing briefly in 2000, sterilization operations resumed in earnest last year with the CBC absorbing excess liquidity amounting to $22bn in Taiwan and the BOK some $10bn in Korea. Both economies face neither a BOP crisis nor a liquidity squeeze, again signifying that a currency meltdown looks unlikely. Indeed, with the yen likely to strengthen near term as year-end repatriation of funds continues, the modus operandi of sterilized FX intervention will likely continue in the next few weeks.
In any case, while the Merrill Lynch view allows for further dollar reversal near term, the yen is forecast to weaken to 135/$ by mid-year once the financial year effects of yen repatriation for year-end book closing comes to an end. Asian currencies will likely weaken when the yen falls anew, but we stress that the move will likely be orderly and not of the magnitude seen at the depths of the Asian financial crisis. Thus our baseline scenario remains one where Asia's response to a falling yen would be muted, and would be conducive to recovery and constructive to asset markets going forward.