A Singapore-style system just wouldn't work in Hong Kong
The city state's managed currency float has worked for it in the past, but its performance since the financial crisis has not been spectacular
I was a bit disappointed," writes a dissatisfied reader in response to Tuesday's Monitor column, which aimed to debunk the notion that Hong Kong should peg its currency to the yuan.
Although he accepted that a yuan peg would be a non-starter, he pointed out that Hong Kong's current peg to the US dollar or a link to the mainland currency are not the only possible exchange rate regimes for the city.
What about a Singapore-style managed float?
At first, that sounds an eminently sensible idea. Singapore has long managed its exchange rate against an undisclosed basket comprising the currencies of its major trading partners and competitors.
The idea is that in a small, open economy, domestic interest rates have only a limited effect on local inflation. So rather than managing the economy by raising and lowering interest rates, instead the monetary authority steers the Singapore dollar higher or lower against its basket in order to contain imported inflation, keep interest rates low, and maintain Singapore's competitiveness.
By and large the mechanism has worked fairly well. For much of the past 30 years, Singapore has steered its nominal effective exchange rate - the value of its currency against the basket - higher. Meanwhile, because of its US dollar peg, the Hong Kong dollar has declined in value against its own trade-weighted basket (see the first chart).
As a result, historically Hong Kong has tended to suffer greater extremes of inflation, and much wilder swings in its property prices.
Take the nominal effective exchange rates for the two cities and factor in those relative price changes, and you come up with something called their real effective exchange rates (see the second chart).
As you can see, since the introduction of the peg, Hong Kong's currency has actually been far more volatile in real effective terms than Singapore's, which does rather suggest Singapore has a better exchange rate regime.
But just because a managed float has worked well for Singapore in the past doesn't mean a similar mechanism would suit Hong Kong well in the future.
For one thing, the merits of Singapore's system have become less obvious since the financial crisis. In the post-crisis world of super-abundant liquidity, Singapore's policy of appreciating its currency to contain imported inflation has simply encouraged capital inflows.
As a result, Singapore's domestic inflation has differed little from Hong Kong's, and its housing prices have risen almost as much, forcing the government to impose drastic restrictions on speculative property buyers.
And there are big drawbacks to a Singapore-style system.
For one thing, the complexity of the mechanism means that even though the local currency is managed smoothly against its basket, it can still be volatile against individual currencies like the US dollar. As a result, businesses can find themselves suddenly facing unpredictable exchange rate risks.
And for another thing, managed floats are vulnerable to political interference.
The great merit of Hong Kong's peg is that it operates automatically, free from official meddling.
With a managed basket float, however, decisions about when to switch the direction of crawl, say from a tightening bias to a neutral or loosening bias, can have a big short-term impact on living standards. That means they can be the subject of intense political pressure.
That means if Hong Kong were to switch to a Singapore-style system, we would have to trust our officials always to make the right decisions for the long-term interests of the city as a whole, and not to be swayed by narrow short-term political considerations.
That's just too big a leap of faith.