HK dollar - float or repeg?

(as published in The Star 8 March 2008) Naturally when your currency is pegged exclusively to the USD, there will be good and bad problems. I had examined in Part I (in my column last week) and concluded that the Hong Kong dollar would have been better off if the government had floated the currency or re-pegged it from HK$7.8 to HK$10 to the dollar back in 2000.
To peg to the USD might have been a sound idea back in the 70s or even the 80s as the USD had a special position in global trade and was the “reserve currency”. However, the economic paradigm has shifted substantially over the last 5 years and while US still retains economic leadership, their economic dominan ce has diminished substantially.

While it can still be said to have the “reserve currency” status, even that appears to have diminished somewhat. The euros, the pound and even the yen have emerged as viable alternatives in global trade.

No longer tied to US

While HK's trade had been significantly with the US in the past, that is clearly not the case over the last few years. HK's economic fortunes are more closely tied to China now. In fact, if it wasn't due to the rise and rise of China as an economic force in recent years, HK would have not recovered so fast and so spectacularly over the last 5 years. Hong Kong has sustained a protracted period of stagnation and deflation following the Asian Financial Crisis in 1997; it did so to preserve the HK dollar peg.

Now they are faced with a good set of problems, which still need to be addressed. If the weakness of the USD is only temporary, then there is strong case to maintain the peg. But what if it's not? It looks increasingly likely that the global economy paradigm has shifted, and HK's peg has to shift with the changes or else face the dire consequences.

Hong Kong Monetary Authority has matched Federal Reserve cuts over the last 2 years – required of currency board – despite rising inflation, thus giving rise to possible asset bubbles in Hong Kong. How long can HKMA play along with this charade? HK now basically has to accept inflation as the cost of maintaining peg.

As explained in the first part, it is certainly too early for HKD to be pegged to Chinese Yuan. China's financial and monetary systems have to be more mature and credible before that can happen – a convertibility issue. Even so, HK should see more trade and services being priced in CNY, which might crowd out the dollar's significance.

Seeking alternatives

Are there no credible alternatives? Free floating is one. A safer option would be to peg to a basket of currencies: e.g. ¼ yuan, ¼ USD, ¼ Euro and ¼ yen. Certainly that would be an easier way to manage the capital flows and trade competitiveness given HK's reputation as a financial centre.

The current situation actually yields more economic benefits for HK's economy in terms of competitiveness. The downside being asset bubbles will form in stocks and property. Another factor to keep in mind is that the longer the HKMA holds onto the peg, given the persistent weakness of USD, the better for stocks and property in HK which will witness upside momentum. On that note, the signs are evident already of the beginnings of future asset bubbles in HK.

As things stand now, with rising income in China, and a strong yuan – there is a rising trend of China mainland buyers of HK property. The perception of HKD being undervalued will increasingly attract more hot money as well. We can expect these strong inflows to exert a lot more pressure on the HKMA to act in the future.

Greenback – then & now

If you carry out a survey of HK citizens and international investors, it would appear that most of the non-Chinese prefer the idea of the HKD peg being dismantled, while most HK citizens beg to differ.

There needs to be a better appreciation of the global economic changes and trends, and the fact that USD now is not the USD of old.

What we will see is the HK economy accepting the yuan as part of the dual currency system. Soon, we will be able to use both currencies for all goods and services in HK. That's because the yuan will not reach full reserve status for sometime yet (not for at least another 5 years and even that is optimistic).

For the Chinese yuan to fully displace the HKD, the yuan will need to be seen as the superior money in all three aspects: store of value, medium of exchange and unit of account.

That is not going to happen anytime soon, but the dominance of trade flow and investments with China will cause the yuan's usage to be widespread in HK in the not too distant future.

Another 100-150 basis point cut by the Federal Reserve over the next 12 months, which is likely, will exert enormous pressure on the HKD.

The near term path of USD is dragging the HK's economy down with it, littering HK with a whole load of monetary, economic and financial problems.

Initially though, the results will be higher stock prices and property prices, which will be seen in a positive light by most HK people. That's the devil in disguise.

However, even if Joseph Yam and Donald Tsang were open to revaluing the HKD, the move is unlikely to move ahead without the political approval from Beijing.

In my opinion, Beijing may be more open to a revaluation of the HKD than most people would think.

Beijing is already pressured to keep the yuan gaining from strength to strength – they would be in a better position to appreciate the difficulties faced by HKMA.

Pegged to the past

An appreciating HKD would also help Beijing as it strives to cool markets with mini measures. But Beijing supports the dollar peg partly because it fears change of any sort and partly because it does not really want to see the HKD being an independent currency. If they could, Beijing would want full convertibility for the HKD to the yuan.

HKMA has a huge arsenal to intervene to maintain the peg. Still, no arsenal is unlimited and eventually it will become critical. In theory, if Hong Kong is prepared to accept runaway inflation, there is no limit to the ability of the HKMA to defend the HK dollar peg on the upside.

As foreigners pile into the HK dollar the HKMA buys the foreign currency and sells HK dollars. The HKMA is the legal entity that can create money by the stroke of a pen.

However, it is better to revalue on HK's accord rather than be forced by capital flows and market forces. To do so in the latter scenario would bring about more negative repercussions and leave HKMA with less room to be flexible. To revalue with the former scenario will bring forth better conditions and planning to execute the move well.

For an economy which has the reputation of being the freest in the world, the currency issue is making HKMA more manipulative and dictatorial in their monetary policies.

HKMA is making a big bet that the USD's weakness is only temporary. In my opinion, a collapse of the USD is more likely than a stable USD in the next 12-24 months.

That is what Hong Kong should prepare itself to face.