Why Asian economies are shrugging off weaker Chinese currency

There are other bigger headwinds to tackle.

Asian economies face several big challenges on the horizon, but a weaker Chinese currency isn't even in the top three.

According to a research note from UBS, it's been six weeks since China allowed the CNY to depreciate slightly and announced that going forward the daily fixing will consider the previous day's closing spot price.

All of this has lead UBS' China economist, Tao Wang, to reiterate her view that the currency will most likely depreciate modestly over the next year.

The market is drowning in reports on who loses competitiveness in a scenario where the CNY might depreciate more. As it stands, the empirical answer for non-China Asia is apparently nobody.

Asian currencies have simply weakened along with the Chinese currency and if the CNY depreciates more in the future it will likely have lots of company from her Asian neighbours. The big headwinds for Asia going forward are 1) a poor outlook for trade, 2) resolving the paradox of leverage internally, and 3) rising US rates without a meaningful improvement in top line Asian growth.

Here's more from UBS:

Asia should struggle to sustain top line growth as we move into 2016 independent of China's currency policy. Weakness in global trade is mainly a function of debt overhang. It's true there is a structural component to weak global trade, but that is a trend that began unfolding well over a decade ago for those of you in that camp.

In our opinion, debt overhang is dragging global trade far below even what a structural view would imply. Our earlier report, In Search of Top Line Growth, demonstrated that the debt cycle is without a doubt the primary cyclical driver of global trade.

Hence, global deleveraging is a necessary adjustment to set the stage to re-leverage the global economy and generate a meaningful cyclical recovery in trade. There simply hasn't been enough deleveraging in major economies to make us optimistic on trade.

The other challenge for much of Asian top line growth is what we've called the paradox of leverage in our "Debtopia" notes. Many highly leveraged countries in the region are implicitly relying on credit growing faster than their economies in an effort to put a floor under economic growth, not least of which is China.

Such policies suffer from diminishing marginal returns as debt rises or other imbalances emerge, which logically imply growth is more likely to slip on the horizon rather than accelerate. This has been the background for a while and largely explains why top line growth has been weak and should remain so.

Into that mix you need to think about rising US rates. If you expect top line growth for Asia or trade to pick up then rising US rates shouldn't be a problem. However, if you're like us and you believe that Asia's top line growth is going to remain weak in the face of rising US rates, then the average Asian central bank will probably lean against the Fed's policy and as we've said before that implies weaker Asian currencies around the region.

Furthermore, slower growth in China would also amplify this general tendency, since it should restrain exports to China and thus non-China Asian central banks would feel the need to counter that additional downward pressure on their economies.

Unfortunately, you are likely to see even more reports arguing that China's new currency policy is the principal culprit behind Asia's woes. The truth is that it's the outlook for the Chinese economy that matters the most and her dance with the paradox of leverage, not the CNY.