How Long Can Hong Kong’s US dollar peg last?

Politics continues to override economics as Hong Kong and China confront the issues of rising inflation and a US dollar which is collapsing against most of the world’s currencies, especially Asian ones. The US dollar is towing Hong Kong’s currency down along with it.

Nobody could say Hong Kong isn’t obsessed with “face.” Just because the government has said a thousand times that the HK$7.80 peg to the US dollar will remain, it must be so, regardless of the economic circumstances.

It has always been unfortunate that the Hong Kong dollar was pegged to the US dollar. This writer proposed a peg several months before one was instituted during the 1983 currency panic. It would replace the anchorless system in place since an earlier peg to the US dollar was abandoned during the global currency turmoil of the early 1970s (“A Peg – or Hang the HK dollar” – Far Eastern Economic Review August 4, 1983). But my suggestion was that that it should be to the Special Drawing Right, more familiarly known as the SDR (the International Monetary Fund’s currency basket) rather than a single currency.

That was deemed too complicated, so Hong Kong has had to ride periods of excessive US dollar strength and weakness which had little relationship to Hong Kong’s own economic situation. So whil other Asian currencies like the won, the baht, the Singapore dollar etc have grown up and learned to stand on their own feet, Hong Kong has been stuck with a peg from which it leaders are too timid to depart.

There is even less chance of a rethink now that Joseph Yam is being forced to step down as head of Hong Kong’s Monetary Authority. Yam has been in the job ever since the HKMA was born in 1993, combining the roles of the Exchange Fund, which managed the currency and reserves, and the Banking Commission which supervised the banks. He has always been a stout defender of the peg.

However, Yam, the world’s highest-paid central banker, is also known to have at least considered and maybe even advised a change. He has the independence of mind and intellectual capacity to do so. However his likely replacement is a former deputy, another bureaucrat who is known for his closeness to Chief Executive Donald Tsang, who in turn is known more for his fealty to Beijing than his economics.

Yam seems to have made himself unpopular in Beijing for pushing hard for arbitrage between Shanghai A shares and Hong Kong H shares and to promote Hong Kong listings. This would have been to Hong Kong’s advantage but it would have blown a huge hole in the mainland’s policy of continuing to restrict capital flows.

Politics aside, an appreciating Hong Kong dollar 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 Hong Kong dollar and a genuinely independent currency. It is happy with a dollar peg till the time comes to switch to a yuan peg.

Massive intervention to defend the fixed rate has driven down interest rates and given a huge boost to the Hong Kong dollar money supply, with their inevitable knock-on effect on asset prices. Hong Kong property booms have always been associated with periods of currency weakness – remember 1995, 1982, 1972 – and very rapid monetary growth.

This time around will be no exception. Indeed it may be worse because of the increased importance of the mainland. China’s currency appreciation has been far too slow for its own good and goes a long way to explain the stock bubble. But there is little doubt that even if the US dollar decline against the likes of the euro and Canadian dollars is almost at an end, appreciation of the yuan will continue. Indeed it may well speed up as China makes belated efforts to tame inflation at home and ward off protectionist sentiments abroad.

The result will indubitably be a surge in inflation in the territory which is already feeling the impact of the yuan appreciation of 5.5 percent over the past year and the steep rise of European and Asian currencies other than the yen and Taiwan dollar.

Consumer price inflation would already be approaching 3 percent but for a politically motivated and fiscally nonsensical temporary – but recently extended -- waiver of property rates (a tax on notional property income) which is keeping it under 2 percent. This is one of the most stable of Hong Kong’s taxes but a government which claims to want to reduce revenue volatility has done the opposite, effectively subsidizing property owners in order to claim a low inflation rate. So much for Hong Kong’s free market system!

But even when the Consumer Price Index can no longer be so artificially constrained, neither the government or its close allies, the property developers, will worry unduly. The senior bureaucrats are protected by inflation-proof pensions and the developers can only benefit from the negative real interest rates which are the consequence of a currency pegged at an artificially low level and subject – like the yuan – to speculative inflows. It’s a head I win tails you lose deal. If the Hong Kong dollar is not de-pegged, property prices will rise. If it is, speculators will reap a currency gain.

Meanwhile the bottom half of the population, facing rising consumer prices but with little wage bargaining power, few assets and savings being eroded by negative interest will be worse off. Worst of all will be the old, sick and unemployed whose welfare benefits lag inflation. Overall income distribution will deteriorate further, the very reverse of the “harmonious society” which Tsang – following the Hu Jintao rhetoric – proclaims to be promoting.