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As fears of a global currency war grow, all eyes in Asia are on whether China will devalue its currency to avert a sharper economic slowdown.
The urgency with which Asian central banks are cutting interest rates is an indication of not just the deflationary forces they are seeing but also recognition that if China weakens the yuan, their policy options will be severely limited.
Indonesia was the latest to surprise investors on Tuesday with a rate cut, joining Singapore, India and China, all of whom have unexpectedly eased policy this year to spur growth.
Bank Indonesia's rate cut was in some ways a reminder of how critical China's yuan is to the region's policy making.
Indonesia has a weakening currency and inflation that is falling but still elevated. Yet Tuesday's move hinted at an urgency to act before two major risks play out: a spike in U.S. bond yields or a sharp weakening of the yuan.
Both scenarios could cause steep falls in the Asian currencies and a flight of foreign capital.
While the jury is out on when and how fast the U.S. Federal Reserve will raise rates, the odds of China weakening the yuan are growing, albeit from very low levels.
"It's no longer inconceivable that China will go for a weaker currency," said Frederic Neumann, HSBC's co-head of Asian economics research based in Hong Kong.
Deflationary pressures in China are stoking expectations that it could follow Japan and other European nations by easing policy to put a floor under domestic prices, he said. Such moves have triggered major weakening in the yen, euro and other currencies.
"China could throw a spanner in the works for central banks looking to ease policy. They may have to stem currency weakness by keeping rates higher than otherwise would be, and that should be a major dampener on growth because these economies are highly dependent on credit to drive consumption," Neumann said.
Yuan as anchor
China justifiably can weaken the , which has appreciated considerably in trade-weighted terms in the past year.
Consumer inflation in the world's second-largest economy is at a 5-year low, while factory deflation is deepening. Because Beijing is trying to restrain local debt, it has been loath to cut rates aggressively or increase government spending.
A weaker yuan would help prop up export earnings, boosting growth and creating jobs in an economy that grew at its slowest pace in 24 years in 2014.
Yet, there are equally compelling reasons for China to keep the yuan stable. Capital outflows can be destabilising, cause property prices to collapse further and trigger a vicious cycle of bad debts and defaults in its vast shadow banking sector.
While China's central bank has allowed the yuan to gradually decline and even shifted its daily mid-point guidance for the currency to that effect, the yuan's losses have been modest.
It has fallen 2.3 percent against the dollar since November, less than most other Asian currencies. The Indonesian rupiah has dropped nearly 6 percent in that period.
Analysts at BofA Merrill Lynch said a yuan devaluation is still just a tail-risk, meaning it has very low odds. But they estimated market pricing showed a 30 percent probability of a 10 percent devaluation of the yuan in 2015.
The sizable depreciation premium in onshore yuan and offshore yuan forwards suggested the yuan "is viewed as facing clear and present risk of competitive devaluation," their strategist Claudio Piron wrote in a note to clients.
With most Asian countries either selling their exports to China or competing with the Chinese for a share of declining global demand, the race to have competitive currencies could become intense.
Piron estimates the , the Thai baht, the Singapore dollar and the rupiah are most at risk because of their being overvalued in trade-weighted terms relative to history, while the and Indian rupee are less so.
Still, analysts reckon things would get ugly only if China makes some kind of dramatic move, such as shifting its mid-point sharply weaker or moving away from shadowing the dollar to tracking a more broad basket of currencies.
That could spark currency volatility and weakness, massive capital outflows and force them to raise rates.
"China's currency has become an anchor for the region and we just hope the Chinese will not throw the anchor overboard and cut everyone loose," said Neumann.
"We'd be exposed in the currency storm that follows and that could be quite a bumpy ride."