Hong Kong’s peg to US dollar still ‘appropriate’

We asked our readers last week when they thought Hong Kong would give up its currency peg to the US dollar, and most said that the special administrative region will wait for the renminbi to become freely convertible.

Hong Kong Monetary Authority chief Norman Chan yesterday weighed in on the debate, supporting the peg to the US dollar and rejecting calls for a switch to the renminbi or a basket of currencies. A day earlier, financial secretary John Tsang wrote a blog entry in which he said the US dollar link was still the most appropriate mechanism for managing Hong Kong’s exchange rate.

The two officials were responding to critics of the peg, who turned up the volume after Standard & Poor’s downgraded America’s credit rating on August 5, arguing that substantial depreciation of the US dollar could drive further inflation in Hong Kong and create price bubbles.

“I do not agree with this proposition,” said Chan. “The US dollar remains the most important international reserve currency as well as the main currency in which financial and trade transactions are denominated and settled. These roles can hardly be replaced overnight.”

The US economy might be weak at the moment, he went on to say, but so too are economies in Europe and Japan. Indeed, their problems might even be more severe and protracted than America’s.

“While the exchange rate of the US dollar will inevitably fluctuate in the short term, there is not enough evidence to support the view of a medium- to long-term depreciation of the US dollar against the euro and the Japanese yen,” he said.

Another problem created by the peg, according to critics, is that the lack of flexibility in monetary policy forces Hong Kong to adopt low interest rates, which drives up property prices. And higher rates are not on the horizon. Officials at the US Federal Reserve voted last week to keep interest rates at ultra-low levels until at least mid-2013.

But the HKMA chief argued that interest rates would not be much higher even if Hong Kong pegged to a basket of currencies. Three-month interbank rates in the eurozone are the highest among the world’s main currencies at just 1.5%. In Japan, they are 0.3%. At the same time, the city’s officials would have no more flexibility to adjust interest rates than they have today.

“Moreover, overseas experiences show that raising interest rates does not necessarily have an impact on property prices, because once the expectation of a one-way bet takes hold, the momentum and dynamics formed are difficult to be reversed unless interest rates rise very substantially,” said Chan. “But a very sharp interest rate hike could hurt the general economy too.”

More important, said Chan, Hong Kong’s role as an international financial centre means that its economy is closely aligned to the global financial environment, which in turn is heavily dependent on the health of the US economy and its financial markets. China is a rising power, to be sure, but it is not as important to Hong Kong as many assume. Most of Hong Kong’s exports to China are raw materials or semi-finished products that are eventually re-exported to the US.

“Put simply, Hong Kong’s exports are still mainly driven by demand from overseas markets, especially the US,” said Chan, adding that mainland tourists mainly buy foreign goods that contribute little to the domestic economy. “As regards the suggestion of a link to the renminbi, I have repeatedly pointed out that the conditions for contemplating this option are not there because the renminbi is not yet freely convertible.”

That leaves only one other option: floating the Hong Kong dollar in its own right — a plan that Chan does not find convincing. “A floating exchange rate regime is not a panacea for economic problems. On the contrary, it can also create new problems,” he said. “The Hong Kong dollar may appreciate in the good times, attracting volatile hot money into the Hong Kong dollar and at the same time weakening Hong Kong’s competitiveness, while not necessarily helping to contain inflation.”

All in all, Chan’s lengthy and emphatic rebuttal suggests that our readers were exactly right to say that the peg will stay in place until the renminbi is freely convertible.