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  • Jul 13, 2014
  • Updated: 2:05pm
PUBLISHED : Tuesday, 05 February, 2013, 12:00am
UPDATED : Tuesday, 05 February, 2013, 5:02am

A peg to the yuan would not solve Hong Kong's property problem

A link to a non-convertible currency will bring little benefit to the city, and may even result in money flooding in or flowing out

When people look for the cause of Hong Kong's property market ills, they often point to the city's currency peg to the US dollar.

Because of the peg Hong Kong automatically imports US interest rates, which at a whisker above zero are far too low for the city's relatively vigorous economy, they argue.

The result is a ballooning local property market, which has seen home prices double in four years, with the typical flat now costing 13.5 years of median household income.

To some critics the obvious answer is to ditch the link to the US currency and instead peg the Hong Kong dollar to the yuan.

In response, peg enthusiasts argue that a link to the yuan would be unworkable. However, their main argument - that the Hong Kong Monetary Authority wouldn't be able to intervene in the market to keep the Hong Kong dollar in its permitted band because the yuan isn't freely convertible - is complete nonsense.

The monetary authority wouldn't need to buy and sell yuan to maintain the Hong Kong dollar's fixed exchange rate against the Chinese currency. If it wanted to weaken the Hong Kong dollar to keep it in its band, it could just as easily sell Hong Kong dollars against the US currency, which would automatically push the local currency down against the yuan too.

So defending an exchange rate peg to the yuan would be no trouble even if the yuan isn't convertible.

The problem would be setting Hong Kong's interest rates. The yuan's non-convertibility means we couldn't automatically import China's interest rates, as we now import US rates. Because of Chinese capital controls, there would be no arbitrage mechanism to keep them in line.

We can see that today. In Hong Kong a 12-month fixed yuan deposit earns you just 0.6 per cent interest. On the mainland you would get 3 per cent.

Nor could the monetary authority set interest rates in line with Chinese rates by decree. It wouldn't work.

To see why, imagine a situation like today's where Chinese rates are higher than US rates, but where the market expects the yuan to strengthen by around 5 per cent against the US dollar over the next 12 months.

Investors would be able to fund themselves in US dollars at close to zero, in order to buy Hong Kong dollars for an expected annual return - yield plus currency appreciation - of 8 per cent.

Money would flood into Hong Kong at a pace even faster than we've seen over the last six months. Either the monetary authority would have to soak up the inflows by issuing exchange fund notes at premium yields, which would cost it a fortune and only encourage yet more inflows, or the extra liquidity would soon force down market interest rates making a nonsense of the monetary authority's target.

Alternatively, picture a situation where the Chinese economy slowed and the mainland authorities cut rates just as activity in the US picked up and the US Federal Reserve tightened its policy.

Money would soon begin to flow out of Hong Kong's financial system in anticipation of a weakening of the yuan, and hence the Hong Kong dollar, against the US currency. As a result, market interest rates here would rise just as economic activity was softening.

In short, a currency peg to a non-convertible yuan would mean the worst of both worlds for Hong Kong. We would end up getting the mainland's exchange rate policy along with US monetary policy, with results that would threaten the city's economy with an even more vicious pro-cyclical whipsaw effect than the present arrangement.

So while a peg to the yuan might sound like the answer to Hong Kong's exaggerated property market cycles, the chances are that it would only make things much worse.



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This article is now closed to comments

Tom, thank you for the as always clear, analytical argument. However, you have just proven why the bottom line is that we can't peg to the RMB until does become fully convertible, which is indeed the mainstream pro-peg argument, and rightfully so. Perhaps there are some 'peg enthusiasts' who repeat the convertibility line dumbly without much or any understanding of currency boards, but I'd like to think that most of them cite the (lack of) convertibility reason because they have also gone through the reasoning you present, or some variant of it.
If and when the RMB would become fully convertible, the argument will change though. Sure, we would still have to be 'importing' the mainland's interest rate policy, but since money can then flow in/out of the mainland freely, I doubt we would see any disproportionate flow into/out of HK compared to those into/out of the mainland.
So the bottom line is that the peg enthusiasts are right: we can't peg to the RMB as long as it is not fully convertible. The bigger question is: when the RMB does get fully convertible in some (many?) years, do we want to peg to it?
Even if it takes another 20 years, eventually this question will rise. If the answer is 'no, never' - then fine by me, but we do have to think of some more sustainable strategies for this long-term commitment of keeping Hong Kong synced with US monetary policy. If it is a 'yes,' then it is probably worth to start thinking about how, under what conditions and so on.


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