Following the one-off devaluation of the Chinese yuan (CNY) last August, Asian currencies’ correlation to the USD has noticeably declined while the hitherto non-existent correlation to the CNY has increased. We believe this can slowly lead to Asian currencies forming a CNY-centric currency bloc and is occurring due to China’s FX policy regime shift away from a pseudo dollar-peg that paves the way to make the CNY an independent, floating currency. Considering the strong ties between their economies and China, it makes sense for Asian currencies to realign themselves from the dollar to the yuan – a move long delayed due to the rigidity of the CNY in the past.

There is widespread evidence that after the 2008 Lehman crisis, Asian economies’ links to the Chinese economy have become very strong. This warrants a much closer link between Asian FX and the CNY, but this had not been the case until recently. Figure 1 gives the correlation matrix among the eight major Asian currencies versus DXY, EUR, JPY and CNY over the post-Lehman crisis period from January 2009.

Figure 1

Figure 1

Source: Bloomberg, Nikko Asset Management estimates.

It shows that Asian currencies, as a bloc, are highly correlated to each other (green highlights) but they are weakly correlated to EUR, JPY and least of all, to CNY (red highlights). The Asian bloc’s highest correlation, albeit not a very strong one, to the outside world was to the DXY (a weighted index of the USD exchange rates to six other developed market currencies, EUR, JPY, GBP, CAD, SEK and CHF). The reason for the weak correlation to CNY, despite the strong economic ties to China, was because of the latter’s rigid and opaque FX policy. This is now starting to change as the CNY is clearly delinking from the USD after its one-off adjustment last August (Figure 2).

Figure 2: CNY weekly correlation with DXY

Figure 2: CNY weekly correlation with DXY

Sources: Bloomberg, Nikko Asset Management estimates.

At the same time, Asian currencies are also delinking from the USD, especially those that historically had a higher correlation to the dollar than the others – SGD, TWD, MYR and KRW (Figure 3).

Figure 3: Asian currencies’ weekly correlation with DXY

Figure 3: Asian currencies’ weekly correlation with DXY

Sources: Bloomberg, Nikko Asset Management estimates.

How sustainable is this trend of Asian currencies delinking from the dollar to link up with the renminbi? We believe the trend is sustainable as long as the CNY moves into a true float, or even a managed float. Since last August, the official RMB Index (a weighted average of the CNY exchange rates to 13 foreign currencies, announced by the PBOC last December) has been on a gradual depreciation path. From its peak in August, the index has depreciated by nearly 8% (Figure 4).

Figure 4: PBOC RMB Index vs DXY and MAS SGD NEER Index

Figure 4: PBOC RMB Index vs DXY and MAS SGD NEER Index

Sources: Bloomberg, Nikko Asset Management estimates.

The move was necessary to counteract the massive capital outflows that resulted in a 20% drop in the country’s foreign reserves from the high of mid-2014. But the commitment to a currency float is tied to the CNY inclusion in the IMF’s Special Drawing Rights (SDR) basket in October this year. Prior to the entry, there is a final chance to restore equilibrium as well as confidence in the CNY. On entry into the SDR basket, the CNY will be driven by market forces, in turn dictated by the Chinese economic performance and the PBOC’s monetary policy direction. The crux of the matter is therefore whether the CNY continues to weaken or not, as long as it is no longer a controlled currency, it can serve as an anchor for the rest of Asian currencies.

In this regard, one central bank to watch closely would be the Monetary Authority of Singapore (MAS) as it is the only central bank which runs an exchange rate policy rather than an interest rate policy. Its 14 April move to a zero appreciation caught the market by surprise as a zero appreciation policy in the past was deemed as a “weak” policy, implemented only when the economy was in recession. The Singapore economy is not in a recession; in fact, it dodged recession for most of 2015. Although the recovery is currently tenuous, the risk of recession is no longer as high as last year. Therefore, while not its main intention, we see MAS’ latest policy move as symbolic of the gradual alignment of Asia FX (policy-directed or market-driven) towards the CNY.

Conclusion and Ramifications

The rise in a CNY-centric Asian FX bloc – if it eventually emerges – has an interesting reference to the region's Asian financial crisis in 1998 triggered by the Thai baht's devaluation. Regional central banks at that time considered creating an Asian monetary union. That idea was quickly abandoned because there was no single strong currency anchor within the region – the Japanese yen was the only potential candidate but it wasn't a true international reserve currency. The countries were also at different stages of development. Furthermore, the region's growth was still heavily bound to the US which meant any currency union would become a facto dollar bloc and that would have been “anti-thesis” after a massive devaluation crisis.

In the end, the region progressed to launch the Asian bond fund (ABF), pooling funds from the regional central banks with those from Japan, Australia and New Zealand to invest into the region's domestic bond market. The larger ambition to deepen the debt capital markets and jointly promote the markets as a bloc to global investors and issuers, however, never quite developed. Today, global investors' presence in the region remains very uneven due to variations in market access, with the ABF ambition all but forgotten. A CNY-centered Asian currency bloc, however, could be seen as a loose form of a currency union driven by market forces that could actually be more ideal than a formal monetary union. This in turn could help the regional central banks revive the ABF ambition of promoting the regional bond markets as a bloc to global investors.