History suggests it will. The last time this happened was during the Asian financial crisis of 1997/98. In the years prior to the crash, the economy was roaring ahead. To tame the exuberance, the government should have raised interest rates, but because of the peg, this was not an option. On the contrary, local interest rates were coming down in tandem with US rate cuts û even though both economies were at quite different stages in the economic cycle.
Naturally, the rate cuts added fuel to the asset price inferno in Hong Kong. As a result, the Hang Seng index went from around 7,000 points in 1995 to over 17,000 in mid-1997. By mid-1998, it had crashed back to under 6,000 points. A similar devastating story occurred in the property market. Even today, many properties have not overtaken their bubble peaks. (This is in contrast to the stockmarket which has blown away the record set during the bubble - a warning sign in itself.)
But despite the obvious high-performance of the Hong Kong economy on the back of the China boom (the economy grew at over 6% in the first half of this year), the Hong Kong Monetary Authority (HKMA) has cut rates by 75 basis points in the past few weeks - because the peg means it has to follow US monetary policy. The result will almost certainly be more asset inflation, which won't be driven by similar improvements in economic fundamentals.
ôYou canÆt control everything,ö is the way James McCormack, sovereign bond specialist for Fitch Ratings, explains Hong Kong's currency dilemma. Indeed, the existence of the peg precludes the HKMA from exercising control of money supply and of interest rates. On the face of it, thatÆs an extraordinary state of affairs and raises the question of what the peg does provide. (Some economists argue itÆs not a strict peg, as the HK dollar moves in a narrow band against the US dollar, but the term is widely used).
At least for Sean Yokota, north Asia economist at UBS in Hong Kong, the merits of the peg are clear. ôHong Kong is a small, open economy. If the currency were to float, it could fluctuate wildly,ö he says. Some observers suggest pegging the HK dollar to the currency of its giant neighbour China. But Yokota sees that as inappropriate to Hong KongÆs development cycle. ôChina is going through a high-growth cycle, which will eventually feed through to a stronger currency. But a strengthening currency is not appropriate for Hong Kong, since itÆs a mature, developed economy.ö
It is certainly true that the Hong Kong economy is small and open. But the peg doesnÆt solve that problem. All it does is shift the problem to another part of the economy. The peg creates a tidy, buttoned-down impression and it stops the currency from gyrating wildly, but in practice, it allows assets to fluctuate madly. ThatÆs a huge danger for Hong KongÆs large retail investor base. A crash could trigger a new rise in poverty levels û just as the last crash did.
ItÆs not clear why rampant asset volatility should be preferable to a fluctuating exchange rate. The inconvenience caused by a lack of clarity in currency direction can be mitigated by hedging, just as companies do in the US and Europe. Or they are just borne as part of the cost of doing business.
Hong Kong faces some gigantic economic forces which are a product of the territoryÆs success in attracting the biggest and best initial public offerings from China. Singapore (which also has a variant of the currency peg arrangement) attracts a lot of Chinese stocks as well, but they tend to be smaller and from the private sector. Hong Kong has incontestably attracted the cream of the Chinese state sector in oil, banking, coal and large-scale manufacturing.
These Hong Kong IPOs attract tens of billions of offshore dollars into the territory. In an economy with a floating exchange rate, that would cause the HK dollar to appreciate. But the HKMA doesnÆt allow this to happen. It keeps the HK dollar at the same level by issuing an identical amount of freshly minted Hong Kong dollars to soak up the supply of US dollars. This results in a huge increase in the money supply. And as economist Milton Friedman always emphasised, an increase in the money supply means an increase in inflation. Recently, for example, dollar inflows strengthened the HK dollar to a rate of 7.75 to the US dollar - at which point the HKMA started to create, and sell, HK dollars.
ôThe big difference between Hong and Singapore is the size of the capital inflows. Singapore doesnÆt have these û and as a result, the currency system in Singapore leads to less volatility,ö points out FitchÆs McCormack.
WhatÆs for sure is that investors in Hong Kong should be braced for a rollercoaster ride.
¬ Haymarket Media Limited. All rights reserved.
