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Lure of the familiar

27 June 2012 By John Foley

Will Hong Kong pop its peg? After three decades of hitching its currency to the U.S. dollar, many residents of the territory, including former monetary chief and peg architect Joseph Yam, believe it is time for a change. The arrival of a new chief executive, Leung Chun-ying, provides an opportunity. But Hong Kong shouldn’t rush. The dollar peg gives the city stability, and a symbolic link to the values that made it an economic success story.

There are few currency systems Hong Kong hasn’t tried. Over the last century it has been pegged to silver and sterling, freely floated and linked to the dollar twice. The latest peg, which values the Hong Kong dollar at just under 13 U.S. cents, has been in place since 1983. The philosophy is even older: Hong Kong’s “currency board” is based on the model Britain foisted on many of its colonies in the 19th century.

The latest dollar link has brought Hong Kong stability, but recently inflation and asset price bubbles too. Hong Kong has to copy U.S. interest rate policy to avoid a surge in speculative capital inflows. The U.S. bent for near-zero rates has left Hong Kong without an effective brake on inflation. Prices rose 2.6 percentage points faster than those in the United States in May, year on year, and 1.3 points faster than China’s. Property prices have doubled since 2004, according to an index by property agent Centaline.

What to do? Beyond staying put, there are three options: shift the peg to a bunch of different currencies, scrap it, or peg to China’s currency. The first is easy enough to rule out. Introducing a basket of currencies, as Singapore has, might reduce the influence of pernicious U.S. policy. But who would pick the basket? Would the yuan, only partially convertible, be in it? The possibility for accusations of political meddling would be vast, and new boss CY Leung is already unpopular with Hong Kongers.

Scrapping the peg would also be foolish. Hong Kong’s economy is tiny and open, so it would be exposed to huge swings in capital flows, and the currency’s value. Sensible fiscal policy could make it appear a “safe haven”, pushing the HK dollar up to uncomfortable levels. Besides, the territory would need an institutional overhaul. Hong Kong has no central bank ready to set monetary policy – its monetary authority just manages the currency and ensures bank liquidity.

That leaves a peg to China’s yuan. One day, that will happen anyway. Hong Kong’s growth follows China, and so does its political destiny, since from 2047 the “one country, two systems” structure will become one country with one system, and most likely one currency.

Still, now isn’t the time. China’s currency has been pretty stable thanks to its own creeping dollar peg, but isn’t yet ready to be the basis for someone else’s. Its central bank isn’t independent. Sensible monetary policy is secondary to Beijing’s desire to preserve growth and employment – which is why the money supply has roughly doubled since the financial crisis of 2008, and real deposit rates have been negative for most of the past decade.

There’s also the problem of how to support the peg. Hong Kong’s currency board has to hold foreign reserves that at least match its outstanding currency. In fact, the definition of currency is quite narrow. Take M3, a broader measure, and the Hong Kong dollar is only half-backed by the territory’s $292 billion of foreign reserves. Without free access to the yuan, the Hong Kong authorities could back a yuan peg with U.S. dollars, but a fall in the greenback, or sharp revaluation of the yuan, would create a problem.

Moreover, speculators would probably latch onto the Hong Kong dollar as a proxy for the less easily traded Chinese yuan, with volatile results.

When China’s currency is more convertible, and its policy workings more transparent, it will be the logical partner for the Hong Kong dollar – or will replace it altogether. In the meantime, it’s best to sit tight. Unemployment in Hong Kong remains low, and high property prices can be addressed through other means, like releasing more land into the market.

Besides, while the peg and currency board might be colonial throwbacks, their survival is one embodiment of the “two systems” Beijing promised in 1997, when Hong Kong became a Special Administrative Region of China. Hong Kongers who value their difference from China as highly as their linkages to it should enjoy the peg while it lasts.


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