A number of past financial crises have had their roots in countries pegging their currency to the U.S. dollar. The Thai baht was at the epicenter of the Asian Crisis of 1997/98. Argentina's hyperinflation of 2001/2 was also caused by a disastrous currency peg. Today there is not much left of that policy, but there are two notable exceptions and they are two of the most important currencies in Southeast Asia, the Singapore dollar (NYSEARCA:FXSG) and the Hong Kong dollar.
While their pegs are different in nature, both countries' central banks tie their economies to that of the U.S.' at a fundamental level. And if there is change in the structure of U.S. interest or exchange rates then this will have large effects on these two important Asian economies.
U.S. bond yields have been steadily rising since July 2012, this includes during QE IV of this year. While 10 year bond yields (NYSEARCA:IEF) struggled to push past 2% that level is behind U.S. now, and we could be entering a new higher yield period. We've moved past the worst of the fear over Cyprus and bond traders are now calling the Fed's bluff on tapering QE. But since the situation in Cyprus has been resolved and the Bank of Japan has actually begun printing versus the verbal deprecations that occurred in December, U.S. Treasury yields have begun rising again, taking Hong Kong and, finally Singaporean rates with them (note the lag in SG 10 year yield rise on the chart above).
Singapore doesn't have an overt interest rate policy. Instead, Singapore allows interest rates to be influenced indirectly by the interest rates of the basket of currencies by which the MAS manages the SGD exchange rate. If bond yields had not started rising with U.S. Treasuries that would have been telling.
Initially, the Singdollar weakened as U.S. Treasury yields rose. We suspect that the MAS was looking to support exporters somewhat as Singapore struggles with low export growth to both the U.S. and China. With the yuan (NYSEARCA:CYB) trading at an all-time high versus both the SGD and the USD this would have been a good opportunity to reset the exchange rate a bit, before letting yields rise.
The rapid rise of the Hong Kong 10 year yield should be worrying considering the size of the property bubble that has formed there. Some rise in yield is likely desired at this point but too much too fast could be dangerous to the interbank market.
With QEIII being essentially open-ended, the Hong Kong Monetary Authority is obliged to intervene when the local currency hits the upper or lower limit of the trading band. This is important for Hong Kong as it forces local interest rates to follow the U.S.' while its economy may be completely out of sync with the American one. Mainland economic policy must manage inflation risks due to the appreciation of the yuan against the dollar. This will manifest in core CPI -- food and energy prices -- rising.
Why this is important is that Hong Kong and Singapore both are important cogs in China's drive to remove USD as the world's trade settlement and dominant reserve currency and replace it with the yuan. Almost daily there is another report of some small cut being sustained by the dollar in international trade -- the latest is the issuance of $245 miillion in yuan-denominated bonds in Singapore by Stanadard Chartered and HSBC (HBC). While the Fed uses the blunt instrument of monetary policy to thrash global money flows from stem to stern, the rest of the world quietly goes about the business of marginalizing it at a policy level.
China has signed more than 30 bilateral trade agreements with countries around the world and the latest news has them negotiating with both France and New Zealand. Iran has been accepting payments for its oil in gold, smuggled through Turkey. yuan-denominated commodities trading is taking shape around the region - iron ore copper, gold, silver and soon crude oil futures, all trade in Shanghai now.
Since the global financial crisis, countries like Singapore, Hong Kong and other Asia nations have been prepared to take steps to mitigate the risk of a U.S. dollar collapse. The Chiang Mai agreement between the ASEAN+3 nations - the 10 ASEAN countries plus China, Korea, Taiwan - was doubled last year to $240 billion dollars to buffer the region against dislocations in the currency markets.
We see the advent of a new currency order on the horizon with three distinct blocs of more or less equal size: the dollar bloc, a yuan/BRICS bloc and the euro (NYSEARCA:FXE). Because of this the current monetary regimes of Singapore and Hong Kong will have to be dismantled and realigned regionally. Whether the dominant currency becomes the yuan itself or one of these two trading and financial hubs remains to be seen. Everything seems to point to the fact that the Chinese want reserve currency status for the yuan, therefore that is the dominant bet.
That said, Hong Kong announced recently that it has no plans to change its currency peg against the U.S. dollar. If Hong Kong was to review the Hong Kong dollar peg, it could do worse than modeling Singapore's mananged float, rather than choosing either a complete free float or pegging it to another currency. There are still some who are concerned that China will not dismantle its capital account controls but that seems remote given the number of moves to open up the yuan, deepen the liquidity pool flowing through Hong Kong and easing the use of it overseas.
At some point both Hong Kong and Singapore will have to shift their monetary regimes to align more with the yuan than with the dollar. Inter-ASEAN trade in 2011 was still just 25% of total regional trade while China, Japan and South Korea accounted for 28.3%.
The U.S. and the EU combined only accounted for 18.1% and this is where the rub is. As we approach the Asian Economic Community these trade percentages will continue to skew regionally away from the U.S. and Europe and closer to home. And with that capital flows will continue to change and the need for the dollar locally will drop. We already have an emerging yuan bloc replacing the dollar in a practical sense. It only follows that monetary policy will eventually follow suit.