Revaluing HK$ would probably lead to disaster

A reader writes in with a question about the Hong Kong dollar peg. Hong Kong's currency link to the declining US dollar is both fuelling consumer price rises in the city and inflating property prices. So, he asks, why not just revalue the Hong Kong dollar upward, and re-peg it at a stronger exchange rate against the US currency? It sounds a seductive solution to Hong Kong's economic problems. The city imports pretty much all of its food, fuel and consumer goods. Raising the value of the Hong Kong dollar would cut the local currency price of those imports. And given that those three categories together contributed almost half of June's 5.6 per cent rise in consumer prices, it would significantly reduce the city's rate of inflation. Not only that, argues our reader, but lifting the value of the Hong Kong dollar would raise the prices of Hong Kong properties from the perspective of foreign currency-based buyers. That would make Hong Kong apartments less attractive to buyers from outside the city, deterring the inflows of foreign funds that are driving home prices beyond the reach of local families. So, raising the value of the Hong Kong dollar would kill two birds with one stone: it would reduce inflation and take the steam out of property price rises, possibly even making the city's homes more affordable for its inhabitants. Our reader acknowledges that increasing the value of the Hong Kong dollar would result in a paper loss on the government's holdings of foreign currency reserves. But given that the government has a vast excess in reserves, that would be a small price to pay for boosting the purchasing power of Hong Kong's people. In effect, it would be a neat way of transferring some of the government's excess wealth to the city's population. 'Surely a one-off revaluation and a re-peg to, say, HK$7 to US$1 would not be a hard thing to pull off?' our reader asks. Well, a one-time revaluation would certainly be possible technically. But there are a couple of major problems with the idea. First, there is the impact a revaluation would have on Hong Kong's financial system. Hong Kong's banks are sitting on a mountain of Hong Kong dollar deposits - more than they can lend out at home. As a result, they lend out the extra abroad in US dollars, offsetting their local currency liabilities with foreign currency assets. The amount involved is considerable. At the end of June Hong Kong banks had net Hong Kong dollar liabilities - and net foreign currency assets - of HK$251 billion. Revaluing the Hong Kong dollar would increase the size of the banking system's liabilities relative to its assets, opening up an unexpected mismatch. Admittedly, the mismatch resulting from the revaluation our reader suggests would be small relative to the banking system's capital base. But bank stocks would inevitably suffer. As a result, you could hardly expect shareholders in the banks, which includes everyone who owns a local equity fund, to cheer the move. And it's not just banks and their shareholders that would feel the pain. Hong Kong's population owns sizeable foreign currency assets through insurance companies, pension funds and mutual funds. Again, the amounts are large. At the end of last year, Hong Kong's portfolio investments in the rest of the world came to more than HK$7 trillion. Some of that consisted of official reserves managed by the Exchange Fund. But the vast majority of those assets were private sector investments. A revaluation would knock a hole in the Hong Kong dollar value of these investments. And while Hong Kong's people might like to see the purchasing power of their Hong Kong dollar cash holdings increase as a result of a revaluation, the loss they would take from the corresponding decrease in the value of their foreign currency investments would be at least as great, if not much greater. As a result there would be few, if any, immediate benefits from revaluing the Hong Kong dollar. And in the longer run a revaluation would throw up other problems, too. It would set a disastrous precedent. A revaluation would tell global markets that the Hong Kong government buckles under pressure. Ever after, whenever the Hong Kong dollar began to look undervalued with consumer inflation and asset prices rising, hot money would flood into the city in anticipation of another revaluation. That would pump inflation and asset prices up even more, making a further revaluation inevitable. Worse, the same dynamic would equally well work in reverse. Every time Hong Kong began to look uncompetitive, international investors would start pulling money out of the city in the expectation that the government was about to devalue the local currency to restore Hong Kong's competitiveness. It would be like the 1998 attack on the peg all over again, except this time around the speculators would be assured of victory. In short, a revaluation of the Hong Kong dollar might sound like a neat solution to the city's current economic stresses. But even a one-off revaluation would destroy faith in the city's currency peg. And that would cause far more problems than it solves.