Time of Trial for Hong Kong’s US Dollar Peg

The time is coming before too long when the world’s highest paid central banker, Hong Kong’s Joseph Yam, may have to do rather more to justify his salary.

Being the head of the HK Monetary Authority, or de facto central bank, has been relatively cushy position for most of the 15 years that Yam has held the job – heading the Exchange Fund from 1991 and the HKMA since it was established in 1993. Apart from some scary moments during the 1997-8 Asian crisis, operating a US dollar currency peg backed up by huge foreign exchange reserves (now US$130 billion) and by the implied support of the sovereign power has not been a very demanding one.

Most of Yam’s time can be devoted to overseeing management of the HKMA’s assets and the operations of its banking supervisors, again not a very onerous task when banks are highly liquid. He is also a prolific writer of lectures delivered via the HKMA website, at times suggesting that his undoubted talents are not fully utilized.

But the time is looming when Hong Kong will have to decide where it wants to take its currency: to stick with the US dollar peg, to move to a yuan peg or to let its currency float, whether freely or within some broad parameters linked to a basket of major trading currencies.

Of course, for public consumption there will not be any thought change. Nor, from a current point of view does there necessarily need to be in the short term. But Yam is a realist and probably more flexible than his boss, the bureaucrat’s bureaucrat and timid politician Donald Tsang.

The issue has come to the fore as yuan appreciation has brought it close to parity with the Hong Kong currency, now 7.84 to the US dollar compared with the official peg of 7.80 and an actual rate of 7.78 – a fluctuation band up to 5 HK cents is permitted.

The assumption that there is a possibility that Hong Kong will abandon its dollar peg for a yuan one has been partly responsible for keeping local interest rates slightly below US counterparts.

In practice the excess of HK dollars probably has as much to do with technical factors such as the liquidity of local companies, the local booking of mainland profits and the spate of big IPOs in the Hong Kong market as with currency speculation.

Nonetheless it has served to touch off a lively debate on appropriate currency policies for the first time since the Asian crisis. Then, the strains on the dollar peg following the sharp falls in most Asian currency values not only put huge short-term strains on interest rates and asset prices. It contributed to the medium-term problems of the economy, the era of deflation necessary to restore Hong Kong’s competitiveness.

It is fair to say now that competitiveness has been restored by the combination of deflation and the revival of most Asian currencies, the strengthening of the euro and the appreciation of the yuan against the US-pegged local unit.

Investors in Hong Kong property have particular reason to welcome the relative decline in the HK dollar because history suggests that price booms tend to follow and more than compensate for currency declines. Although he does not like to admit it, currency declines also make it easier for Yam to boast big HKMA profits, part of which then flow directly to the government budget, even if they are unrealized book profits.

There are really two issues now, though they have become confused. The first is whether Hong Kong is now so integrated into China economically and politically that it should shift to a yuan peg. The second, what to do should the US currency decline of recent times develop into a rout of the sort that Asian currencies experienced in 1997/98.

There are some apparent attractions in a yuan peg. Yes, China trade accounts not just for a huge part of Hong Kong’s economy. Mainland supplies are a major contributor to Hong Kong’s consumer prices, hence a peg to the yuan would ensure the stability that existed when both HK dollar and yuan were in practice tied to the dollar. (The informal yuan peg lasted 11 years till 2005). Also, although not fully convertible, the yuan level also has growing influence on the values of other Asian currencies. So a yuan peg would keep the HK dollar closer to that of the emerging block of Asian currencies.

However, there are three fundamental flaws to this proposition.

First, most of China’s trade remains denominated in US dollars. Smaller portions are in euros and yen and almost none in the yuan itself. That seems likely to remain the case for years to come. After all, even the yen, despite more than 30 years of full convertibility and Japan’s massive trading presence, is still used to only a modest degree in global trade.

Second, the yuan itself is not fully convertible and is unlikely to be until China’s financial system is in much better, more market-oriented shape. Currently the yuan is the subject opaque currency and interest-rate regimes. Any Hong Kong currency peg to it would make the HK currency the focus of constant speculation as to where the yuan itself was going. This would be extraordinarily disruptive. The role of the HK dollar as a convertible version of the yuan sounds a nice idea. In practice it would be a nightmare – for local business as well as Yam.

Third is the loss of Hong Kong’s economic and commercial autonomy implied by a peg to the mainland currency. There is a huge difference between a peg to the main global currency and one to a national currency with a short track record and an economy still in an immature phase.

But then what then should be done to the HK/US peg should the US currency fall drastically – let us say, to 6.00 yuan, 80 yen, equivalent falls against NT dollars, won etc. and a 145 level against to the euro?

Don’t say “impossible”. The euro has already risen to 131 against the dollar from 85 a few years ago. The yen was at 85 back in 1995, since when the inflation differential vis-à-vis the US has been more than 30%.

Would it really be in Hong Kong’s interest to remain the odd man out in an appreciating Asia, importing inflation and asset valuation turmoil as the price of the stability of the dollar peg?

The peg has been much praised for the stability it has provided since introduced in 1983 to stem a currency crisis. It has survived the handover and the Asian crisis. However, it never was the best solution. It was second best at the time and remains so.

Shortly before the peg was instituted in 1983 this writer wrote an article in the Far Eastern Economic Review entitled “A peg – or hang the Hong Kong dollar”. It recommended a peg in place of the then lack of any currency anchor, but suggested it should be tied to a known basket of currencies, then including the German mark and yen as well as US dollar, or to the SDR, the IMF’s unit of account which itself is a basket.

That would provide stability against international fluctuations as well as for the HK currency itself. In the event Hong Kong opted for the simpler (or simplistic) solution of a US peg alone.

Even back then the peg was a success more because of a change in the political climate – a climb-down by Britain in negotiations with Beijing over the territory’s future – than because of its innate virtues. It held again during the Asian crisis – but more because of direct intervention in the currency and stock markets than because the government was willing to stomach the prolonged high interest rates and monetary contraction that would likely have happened if the peg’s automatic defense mechanism had been allowed to work in the way the theory says.

Thinking ahead, the government should be seriously considering again a shift to a basket. This could either be a formal one based on the SDR of some more Asia/China centered one. Or something akin to the managed float operated by Singapore, which steers a course between fluctuations of the major currencies and local conditions but seldom strays very far from a path where it is never as strong as the strongest major currency but never as weak as the weakest. Perhaps Hong Kong lacks the instruments that Singapore still posses to limit currency flows, and perhaps its administration lacks the self-confidence to move beyond a simple single currency peg.

Or it could try an almost free float such as seen in Korea and Thailand where intervention takes place only to smooth change and in conjunction with perceived local interest rate

needs.

But that implies a policy, and hence public criticism. Does the Hong Kong government have the stomach for it? Probably not.

Yet one way or another trend almost everywhere is towards a much greater degree of flexibility than provided by a formal dollar peg. Hong Kong has almost the last one left in Asia and it will stick out more and more as Asian currencies rise. Hong Kong would also be an odd man out as Asian central banks continue with their efforts to have some kind of informal mutual understanding that they all benefit from not allowing their currencies to fluctuate too much against each other, whatever happens to the dollar and euro.

Could a new currency regime be Yam’s contribution to Hong Kong’s development as an autonomous economy and financial centre? He is only 58 so not due for retirement for two years at least. Or will Hong Kong have to await a new incumbent as chief executive and HKMA boss before it can respond to the changes in the international financial landscape. Or will those be forced upon it by global events?