Hong Kong still needs its dollar peg
Hong Kong has had a charmed ringside seat as speculation about a revaluation of the Chinese yuan waxed and waned. Now that Beijing has made its historic decision to revalue and the fallout is set to work its way through our economy, there will be winners and losers.
Over the past year the expectation of a revaluation of the yuan has added momentum to Hong Kong's economic recovery. It drove huge flows of foreign money into our stock and property markets as international investors looking to benefit from a possible revaluation saw Hong Kong dollar assets as a readily tradable proxy for the yuan.
Our economy has benefited significantly. The flood of money helped sustain very low interest rates and stock and property markets boomed. However, the idea that Hong Kong would match a revaluation by Beijing was always fanciful and was quickly ruled out by monetary authority chief Joseph Yam Chi-kwong. As he said, the 21-year-old peg of the local currency to the US dollar has served us well and there is no need to change it.
The peg has delivered 'hard' money and imposed a more rigorous economic discipline. The discipline of a fixed-currency regime demands that domestic prices adjust freely without intervention by government agencies. During Hong Kong's great five-year deflation that ended this year, this is precisely what happened. It was driven by an unwinding of the mid 1990s property-market bubble, but also by the strong US dollar. The Hong Kong dollar became very expensive internationally for a time.
China's decision to revalue the yuan upwards has changed the ball game and reshuffled the winners and losers. The opposite situation now applies. This is because while other regional currencies seem certain to follow the yuan higher, the Hong Kong dollar must remain fixed.
As a result, our services economy - an increasingly important sector as our close economic relationship with the mainland evolves - can expect a welcome boost to its competitiveness. Everything from hotel bills to legal services should become relatively cheaper when ranked against the likes of Singapore or Shanghai.
The other side of the coin is that inflationary pressures loom larger. China is not only Hong Kong's biggest trading partner but the source of most of the staple goods and food that form the core of household budgets.
Higher costs seem likely to be passed on directly to the poorest members of our society. Pressure for higher wages, already gathering pace, will intensify. Such pressures may be mitigated by the fact that many mainland goods sold in Hong Kong continue to be bought at a big discount across the border, leaving room to cut the profit margins of the middleman, which may ameliorate the rises.
Nonetheless, the economy is undoubtedly taking on an inflationary bias. This process inevitably creates winners and losers. Exporters in southern China, many controlled by Hong Kong investors, face smaller profit margins. In the short term, industry seems set to face an earnings squeeze that will have a direct impact on the profits that flow back into the property and consumption markets in Hong Kong.
On the other hand, inflation usually implies economic expansion, which should be good for employment prospects. While the absolute level of the revaluation may be small, it makes Hong Kong a more attractive destination for mainland tourists. Property prices can also be expected to maintain an upward bias as the cycle of higher prices forces wage rises and hence higher rents.
Hong Kong has coped with much worse in the past, but it is nevertheless fortunate that Beijing has resisted pressure for a larger revaluation and opted for a measured first step towards making the yuan a completely free-floating currency. Meanwhile, the dollar peg continues to be the anchor of the stability of our economy and trust in our financial system.
