Rigging the HK$ to the yuan can be done, but it's a bad idea

Hong Kong is likely to ditch its currency peg to the US dollar within two years in favour of a link to the yuan, according to Peter Redward, head of emerging Asia research at Barclays.

Bloomberg, October 26

Be it according to Peter or Paul, or from Barclays or Barings, we have the-peg-is-gone rumours swirling around us again. It happens regularly and in recent years has always featured the yuan as a substitute currency for the US dollar.

The stimulus this time is the growth of yuan deposits in Hong Kong and the strains of a property market pushed to overheating by low interest rates because the peg has forced us to keep our rates low in line with rates in the United States.

Can it be done? Can we abandon our currency board link to the US dollar and fix the Hong Kong dollar to the yuan instead?

There is an easy answer to this question. Of course it can be done.

We would probably need both Tsangs plus the head of the Hong Kong Monetary Authority (one Tsang and two yes-men, actually) to sign off on it, but if they did so, the HKMA would cease to guarantee HK$7.80 to US$1, and the peg as we know it would instantly be gone.

It is very easily done, and these same three people could just as easily establish a yuan exchange rate that they would pledge to target or fix for the HK dollar.

There is only one thing they cannot do. They cannot substitute our existing currency board link to the US dollar with a similar one to the yuan. It is a simple impossibility until the yuan becomes freely exchangeable against all other currencies and Beijing abolishes all controls on cross-border capital movements.

Think about it. You will readily exchange US dollars for HK dollars if Hong Kong interest rates are much higher than US rates and the exchange rate is linked with a currency board peg. In these circumstances, the HKMA is required to print up these Hong Kong dollars for you or otherwise generate them out of thin air, holding on to your US dollars all the while.

But our financial system quickly becomes awash with Hong Kong dollars this way. Hong Kong interest rates begin to fall and soon are much lower than US rates. You take your Hong Kong dollars to the HKMA and ask for your US dollars back.

In these circumstances, the HKMA is required give them to you at its linked exchange rate. It is also required to burn up the Hong Kong dollars it takes back from you or otherwise make these Hong Kong dollars vanish. Soon the Hong Kong dollar money supply becomes constricted, Hong Kong interest rates rise, and the system comes back into equilibrium.

This is called interest rate arbitrage, and I have described it very simply as it worked in a 19th century world. It doesn't work quite so simply any longer, but it is still the peg's basic mechanism. It still has formal rules the HKMA must observe. You will note, however, that the one thing it requires above all else is that the two currencies involved be freely exchangeable.

Interest rate arbitrage can never work without this. Currency board links can only operate in an environment of absolutely open capital accounts.

And Beijing's capital account remains closed, with no indication that it will be opened any time soon. Therefore a currency board link cannot exist between the Hong Kong dollar and the yuan. QED.

This does not say that the two currencies cannot be associated in some other way. It just says that you do best to avoid the use of words such as 'link' or 'peg' when talking of such arrangements. These words indicate formal mechanisms, and there will be none.

Better use words such as 'rigged' or 'manipulated' or 'stage-managed'. They more accurately describe what then happens, which is that the monetary authority pledges on its soul, makes a firm commitment etc, to uphold a certain exchange rate through market intervention. As soon as convenience dictates otherwise, however, another rate is adopted.

It is why the exchange rates of several Asian countries crashed in the Asian financial crisis of 1997/98 and why Hong Kong's held firm. Theirs had no backbone. Ours did.

If we, too, now want a spineless exchange rate, we can have one overnight. One signature from the HKMA followed by a press conference and it is done.

My guess is that the uncertainty this introduces would, in the short term, push the property and stock markets down. It would also increase the risk of a financial crash and sap our long-term economic strength.

In short, a bad idea. Let's not do it. If we must have the yuan, let's wait until it is exchangeable.