It’s time to end the HK$ peg

The peg is doing more harm than good and many believe it’s time for it to go.

Imagine two Siamese twins sharing the same blood system – only one has diabetes and is being treated with shots of insulin, while the other is healthy. The insulin in this allegory are excessively printed greenbacks, and the diabetic twin is the US.

Conversely, the healthy twin is Hong Kong, which with its thriving economy, does not need to be treated with monetary expansion – which has expanded four-fold in the past decade – because it is suffering from ‘sugar highs’ in the form of uncontrollable property prices. Yet that’s what the Hong Kong dollar peg to the US dollar has caused; the SAR’s monetary policy is forced to mirror America’s so long as it remains tethered to it.

The Hong Kong Monetary Authority (HKMA) announced earlier this year the city’s 26-year-old currency peg to the US dollar would stay. HKMA chief executive Norman Chan said much the same late last year.

Franklin Lavin, former US undersecretary of commerce for international trade, thinks the peg is here for the near term because it instills confidence in Hong Kong’s role as a financial centre, and that dismantling the current regime would mean giving up a lot of prestige and stability. “It’s an enormously valuable signal.”

The local currency has been pegged to the US dollar since October 1983. In May 2005, the SAR instituted a trading band to buy or sell should it rise above HK$7.85 or fall below HK$7.75.

Rudi Prenzlin, CFO of the Hong Kong Islamic Index and a former HSBC Swiss private banker, believes the peg now imposes too dear a cost on the city. “The money supply expansion is obvious these days … we’re under-pricing ourselves given our healthy economy,” he says.

Veteran investment analyst Marc Faber believes that the peg has been important in the city’s skyrocketing real estate prices, given that with loose monetary “spectacular asset bubbles” have occurred. “Obviously this can most easily be seen in inflated property prices,“ says Schroders’ Clive Dennis.

Prenzlin thinks Hong Kong needs tighter monetary policy: “Hong Kong is suffering because it’s subject to US monetary and also fiscal policy because when private investors and savers keep dumping the greenback, we suffer too.

Through the peg, Hong Kong “is hostage to US monetary policies” and cannot implement an independent monetary policy. “Excessive incoming liquidity is all absorbed by soaring asset prices, and not partially by an appreciating currency [as with Singapore, Malaysia, Thailand, China and Japan],” says Faber.

Connie Bolland, managing director of Economic Research Analysis, agrees: “We’ve surrendered our monetary freedom; the Federal Reserve Bank is our de facto central bank and the US needs to deflate its way out of recession following the bursting of the US bubble and the CDO meltdown.” While looser monetary flows are what’s needed in America, she believes they are destructive locally.

However, she notes that while the peg attracts funds – especially those from stronger currencies – it’s not the only factor. For example, since July 2005 to now, the Hong Kong dollar has depreciated 25% against the yuan. “It’s cheaper for mainlanders to enter the Hong Kong property market.”

Similarly, local investors, “combined with international investors, are likely to continue to put upward pressure on Asian asset prices,” says Faber.

Looking ahead, she asserts that high-net-worth individuals worldwide “have completely given up on the US administration and its foreign and economic policies,” and they increasingly invest their surplus funds in Asia, for its better returns. Last year, commentators predicted the city would cut the peg with mounting inflation and surplus foreign funds flowing into the SAR, and the HKMA’s sale of over HK$480 billion (US$61.5 billion) halt currency gains.

Without the peg, Bolland argues, interest rates would not have been as artificially low. “Many countries without the peg can let interest rates or their currencies rise, but we can’t, and this has pushed property prices up,” she says.
Yet, the greenback appreciated this year and the Hong Kong dollar has also risen against other regional currencies. Singapore has tried to tie its currency to a basket of other currencies, and some suggest China Beijing may permit the yuan to appreciate.

“Maybe a peg based on a basket of US dollars, Yen, euros and a few other Asian currencies [like Singapore’s] is best,” says Prenzlin. Faber agrees, suggesting a link to a currency basket of currencies “or no link at all” is “more desirable”.

While Prenzlin believes the peg was once beneficial to Hong Kong because of US-China trade, he cautions that since Europe is now the mainland’s largest trading partner, “the value-added from Hong Kong [because of the peg] is gone”.

Prenzlin stresses that though the rate has not changed in 27 years, the world has. “We’re much more dependant on China than the US, so a yuan peg is inevitable”. Faber is more pointed, noting Hong Kong today has “little to do with the US,” but everything to do with China and the Asian region.

However, the US dollar has lost 40 per cent of its value since 2000 and because Hong Kong, which imports most of what it consumes is tied to a sinking currency’s monetary policy and interest rates, it is essentially importing inflation. “The cost to the local population is felt daily,” says Bolland.

Some suggest that if Hong Kong’s currency floated, five of its dollars would equal a greenback – much like the Singapore-US dollar exchange rate. Yet Lavin, former US ambassador to Singapore, is not so sanguine about such comparisons.

“Going down that path could cause Hong Kong to lose its ‘halo’ as a pristine financial hub. The value of the currency might go up like Singapore’s, but to say it is cheap to do business here because of a free floating currency would not attract companies and investors,” he says.

Yet, the yuan may effectuate Hong Kong’s salvation. The Chinese currency has been pegged to the US dollar at 6.83 since July 2008.

Though improbable until 2011, should the yuan appreciate, the Hong Kong dollar would likely rise to HK$7.75 to the greenback – compelling the HKMA to widen its band.

Prevailing wisdom is that as Hong Kong economically integrates with China, as the mainland economy keeps growing, and as the yuan becomes freely tradable, the yuan will inevitably become Hong Kong’s medium of exchange for daily transactions before mid-century. If that happened, the HKMA may peg to the yuan instead.
However, Lavin argues “Any challenge to the [current] arrangement will come from movements with the yuan, and any showdowns it might have with the greenback”. He thinks the peg remains strong for now, but that “adjustment [in its band] and recalculation” may be necessary.

“If there were economic pressure between Hong Kong and China, then perhaps de-linking makes sense,” says Lavin. The upshot would be grey areas and arbitrage as people head to mainland China for better deal at any given time because of exchange rates,” he warns.

There’s no “intrinsic appetite for change” amongst the local business community, “nor is Beijing looking to end it,” says Lavin. “The peg maintains Hong Kong’s leadership role as a regional financial hub.”

He believes that finance isn’t just about investment banks but also merchants, traders and exporters. “They have the ability to finance their trade with predictable exchange rates ... the city’s business as a shipping and export hub is also undergirded by the peg which, while it sometimes puts pressure on the local economy, is on balance good.”
The great unknown is whether China will float the yuan. “Ultimately, it’s a political consideration when China will make the yuan convertible,” says Prenzlin. “It’s in the cards, but not anytime soon.”

Nevertheless, Faber advises swift action on the Hong Kong dollar, because “slowly [ending the peg] … drives speculation” in Hong Kong dollars.

By Ajay Shamdasani