'Grexit' and yuan devaluation could put significant pressure on Asian currency pegs

One measure of the fragility of the international financial system is that a Greek exit from the euro or a devaluation of the Chinese yuan could trigger off a financial storm powerful enough to destabilise several Asian currencies.  Will Hickey explains how this could happen.

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ALREADY driving a housing bubble in all major Asian cities from Seoul to Jakarta, significant hot money inflows are what Hong Kong, China and Singapore seek to avoid. However, a Greek exit from the eurozone coupled with subsequent quantitative easing by the People's Republic of China (PRC) to jumpstart flagging growth could quickly exacerbate this Asian dynamic.

'Grexit' and the knock-on effect

Though the markets are betting against it, if Greece pulls out of the European Union (EU), expect the euro to immediately freefall as investors and speculators rush for the exits to find a safe-haven currency. The tide could be large indeed, and the usual actors, the US dollar and pound sterling, will no doubt soar. As the US dollar and pound sterling become more expensive with the scrum, savvy investors will look to the currencies of alternative safe-haven economies with strong balance sheets (but smaller liquidity), such as the Hong Kong dollar, Singapore dollar and Danish krone. Unlike the Australian dollar or New Zealand dollar (currently with weak balance sheets due to declines in commodity prices), the other three are pegged or in trading 'bands' that are undisclosed by central banks, and thus their true market-derived values, most probably undervalued, are hidden.

Already, the Hong Kong Monetary Authority (HKMA) has had to defend the Hong Kong dollar peg on a few occasions in recent years when speculative inflows tested the HK$7.75 = $1 rate floor. The Singapore dollar has traded in a 'monitoring band', which is no doubt heavily skewed towards the US dollar, administered by the Monetary Authority of Singapore (MAS) loosely between S$1.20 = $1 and S$1.40 = $1 in the past several years. A monitoring band is generally backed by a secret currency board, or basket of foreign currencies, say 70% in US dollars, 25% in euros and 5% Australian dollars (the exact compositions are closely held and never publicised), whereby a trading band is linked to just one currency.

PRC-style quantitative easing

A bigger uncertainty surrounds the PRC, where President Xi Jinping and the People's Bank of China are now considering unleashing quantitative easing and widening the renminbi (RMB) or yuan trading band on a more grandiose scale than the EU (and according to the Economist on 22 November 2014, perhaps by $200 billion or more, in anticipation of a currency war with the Republic of Korea and Japan and to slow rising housing prices).

Predictably, then, a tidal wave of hot cash from the PRC with a devaluing RMB would swamp Hong Kong, China next door and Singapore down the road, with Asian investors seeking to preserve their capital. Neither of these scenarios should be taken lightly by the HKMA or MAS, which have historically intervened to create the most stable and liquid currencies in Asia. Like Switzerland and Denmark, both may have to consider negative interest rates to discourage this cash inflow, but this would also crimp investment and thus growth in the region.

It is doubtful the HKMA could seriously hold the dollar peg with the double whammy of both events simultaneously. A revaluation to HK$7 = $1 might not be out of the question. It might even be possible to bring the Hong Kong dollar to parity or beyond, as it traditionally was until February 2007, as a depreciating RMB converges in value to the Hong Kong dollar. This happened in Switzerland in January, when the Swiss National Bank (SNB) lifted its euro cap (essentially a SwF1.20 = _1 'ceiling peg') due to an increasingly weak euro.

The Swiss franc undefended

Under Mario Draghi, the European Central Bank was preparing for quantitative easing (printing money) to jumpstart the languishing EU economy. The Swiss had to act before it did, otherwise the cost of maintaining the peg with an ever-cheapening euro could have become prohibitive. Nonetheless, the SNB and in particular SNB Chairman Thomas Jordan proclaimed late in 2014 that the Swiss franc cap was here to stay and that 'the franc is still highly valued. Enforcing the minimum exchange rate of 1.20 per euro is absolutely central to ensure adequate monetary conditions in Switzerland and the SNB stands ready to enforce it by buying unlimited foreign currency' (Bloomberg, 2014, 'SNB Jordan pledges to defend cap as global risks rise', 16 September). Obviously, this was not the Swiss economic reality.

The Swiss franc peg had served to keep Switzerland in line with the eurozone economy and thus shield its exporters from non-competitive currency appreciation. Removing the peg put immediate upward pressure on the Swiss franc, causing it to surge as much as 38% against the euro in one day and causing havoc with forward currency markets, especially those 'shorting' the Swiss franc in any way with approaching EU quantitative easing. Indeed, the sudden whiplash that followed led to the insolvency of at least one brokerage and severe multi-million-dollar hits to Chase, Deutsche Bank and Barclays. The latter two banks are still recovering from the financial crisis.

The Swiss episode serves as a strong reminder that while the Hong Kong dollar and Singapore dollar are both strongly linked to the US dollar, they are becoming more influenced by the RMB. For Hong Kong, China, this is due to its proximity to the PRC. For Singapore, the RMB serves as a proxy currency for the Association of Southeast Asian Nations member countries due to significant PRC investment in commodities trade.

Events in Europe and the PRC are moving more quickly now. As seen with the SNB, currency pegs can become quite difficult to maintain if economies diverge, and can also be broken in the crossfire of a currency war with much collateral damage.

Will Hickey is an associate professor and technical adviser, School of Government and Public Policy (SGPP), Jakarta, Indonesia, and two-time US Fulbright Professor of Management and Energy for Central Asia (2003) and South Asia (2009). This article was first published in Asia Pathways, the blog of the Asian Development Bank Institute (www.asiapathways-adbi.org).

*Third World Resurgence No. 293/294, January/February 2015, pp 26-27