The HK$1 trillion reason to keep Hong Kong's US dollar peg
Logic of switching to a yuan anchor doesn't stand up when that currency isn't freely convertible and its offshore liquidity is shallow
Predictably, the 30th anniversary of Hong Kong's exchange rate peg has prompted calls for the city to ditch its link to the US dollar, and switch to a peg to the yuan.
Alas, the people making these calls have failed to think things through. To abandon the US dollar link would be to court financial disaster.
Critics say the peg may have made sense in 1983, when Hong Kong's economy was still based on manufacturing for export.
But today they blame the link to a weakened US currency for consumer inflation and sky-high property prices, as low interest rates and heavy liquidity inflows have pushed the cost of a typical flat up to more than 13 years of median household income.
With US financial credibility undermined by incessant political squabbling, Hong Kong's economy tied ever more closely to mainland China and the yuan growing rapidly in international importance, it is high time the city switched from a US dollar to a yuan peg, they argue. It sounds, at first, like a reasonable suggestion. But the arguments for getting rid of the peg don't stand up to scrutiny.
For one thing, the peg has had relatively little influence on either consumer or asset price inflation. If the peg caused inflation, prices here would rise faster than in Singapore, which is free to adjust its exchange rate to contain imported inflation. However, as the charts below show, there is little difference between either consumer inflation or property prices in the two cities, despite the 40 per cent appreciation of the Singapore dollar against the US currency over the past 10 years.
For another, pegging to the yuan would confer few economic benefits on Hong Kong. Although it no longer manufactures for export, the city's economy is still driven by the global trade cycle. And global trade is still denominated overwhelmingly in US dollars.
Yes, it's true China says 15 per cent of its foreign trade over the past 12 months was settled in yuan. But allowing for double counting, roughly 7 per cent of the mainland's trade, as recorded by the General Administration of Customs, consists of mainland-made goods shipped to Hong Kong and then re-imported to the mainland. Factor those in, and more than 90 per cent of China's trade is still settled in foreign currencies, mostly in US dollars.
As a result, with most of China's trade - and the region's - still denominated in US dollars rather than yuan, it makes sense for Hong Kong's currency to remain pegged to the US dollar.
But if there are no obvious advantages to switching from a US dollar peg to a yuan peg, there would be clear drawbacks.
First, Hong Kong would lose its interest rate anchor. Under the current system, a risk-free arbitrage opportunity ensures that Hong Kong's interest rates faithfully track US rates.
The yuan, however, is not freely convertible, and the pool of offshore liquidity is far too shallow. At best, the arbitrage opportunity would be limited.
As a result, Hong Kong interest rates would tend to be more volatile, fluctuating with the unpredictable currents of market liquidity, imposing an additional cost on businesses and consumers.
Second, pegging to the yuan would threaten Hong Kong's financial system with a gaping asset-liability mismatch.
With no currency risk to worry about, for years Hong Kong has outsourced its bond market to the US. As a result, while the city's financial institutions - its insurance companies and pension funds - have Hong Kong dollar liabilities, their assets are denominated in US dollars.
The sums are enormous. At the end of June, Hong Kong investors had foreign portfolio investments worth HK$7.5 trillion, or 360 per cent of the city's gross domestic product.
As a result, dropping the US dollar and pegging to a rising yuan would blow a huge hole in the balance sheets of Hong Kong's financial system and its investors. The cost could easily exceed HK$1 trillion. It's time to ditch this silly idea.