Hong Kong's dollar peg faces uncertainty with some seeing yuan link on the way
In the first of a series of reports on the peg to the US dollar - 30 years old this week - the Post looks at the call for linking to the yuan instead
The Hong Kong dollar's peg to the US dollar has provided the city's exchange rate with certainty for the past three decades but many bankers and analysts now advocate a peg to the yuan, with the mainland currency on the way to becoming an international currency.
Thursday will mark the 30th anniversary of the peg, which was introduced to calm nerves after people rushed to supermarkets to buy daily necessities such as canned food and toilet paper when the US dollar rocketed to HK$9.50, up 60 per cent from the normal trading range of HK$6.
The peg has since become sacrosanct, with any mention of reviewing or changing it viewed as the financial equivalent of repainting the ceiling of the Sistine Chapel or turning the Taj Mahal into a shopping centre.
Financial secretaries from John Bremridge, who announced the peg in 1983, to incumbent John Tsang Chun-wah have repeated the same mantra for 30 years whenever there is a crisis: "The government is fully committed to maintaining the linked exchange rate system".
The source of the 1983 panic - political uncertainty as talks began between the British and Chinese governments on handing the then-British colony back to China - has long since faded. In fact, as the economic relationship between the mainland and Hong Kong has grown ever closer since the 1997 handover, many argue that the local currency should eventually be pegged to the yuan when it becomes fully convertible, which could happen in 2020 according to the central government's timetable.
Hang Seng Bank executive director Andrew Fung Hau-chung said the peg could only be switched to the yuan when the mainland currency was freely convertible because the Exchange Fund would need to invest in yuan-denominated bonds and shares, and the Hong Kong Monetary Authority would need to trade freely in the yuan to maintain the peg.
Until that time, Fung said, it would be better to stick with an unchanged US dollar peg.
"The peg has served the city well over the past three decades," he said. "Without the peg, it is hard to imagine there would be so many fund-raising activities in the city. If a mega-sized mainland company came here to raise HK$100 billion and the exchange rate went down 60 per cent overnight, as we saw in 1983, both the company and investors would have to face serious exchange rate risks."
There is a price to pay, though. Under the peg, Hong Kong has no right to determine its own interest rate because it has to move in lockstep with America's to maintain the flow of funds needed to keep the peg within a narrow range. So even if Hong Kong experiences high inflation, it cannot push the interest rate down.
"The cost of the peg has been the inability to effectively control monetary policy," said Mark Konyn, the chief executive of Cathay Conning Asset Management, who pointed out that in the aftermath of the Asian financial crisis, Hong Kong property prices fell for almost six years.
While other Asian economies were able to devalue their currencies, Hong Kong had its hands tied and was unable to enhance exports or boost its economy, Konyn said.
"More recently, the low interest rates set by the US have exposed Hong Kong to negative real interest rates, encouraging more money to flow into the property market," he said. "Without the peg, local interest rates would likely rise to help cool the market and keep in check the balance between supply and demand."
Many Asian currencies abandoned pegs in 1998, and they were followed by Argentina in 2002. That focused attention on whether Hong Kong - one of only a few advanced economies still using such a system - would abandon its own peg.
But former HKMA deputy chief executive Andrew Sheng, now president of the Fung Global Institute, said Hong Kong was different from those economies.
"There are essentially two primary conditions for maintaining the peg link's stability," Sheng said. "The first is fiscal policy, which is that the Hong Kong government must run a fiscal surplus. The Hong Kong government has a good record of maintaining fiscal prudence and responsibility. Not all governments are so responsible.
"The second condition is a sound banking system. The banks in Hong Kong understand that their prosperity is linked to the stability of the Hong Kong dollar, so market forces and self-interest help to reinforce the stability of the link. Hong Kong has one of the soundest banking systems and very high standards of supervision, and much of that can be attributable to the discipline imposed by the currency board system."
Sheng also defended the peg against those who blamed it for causing inflation, saying the city's high property prices were more related to a lack of land supply and a growing population.
"As the comparison with Singapore has shown, Singapore does not have a superior inflation or asset bubble record relative to Hong Kong, even with a flexible exchange rate," he said. "In other words, there is little difference between the fixed and flexible exchange rate regime for small city economies like Hong Kong or Singapore, as long as the economy is broadly flexible to adjust to changing conditions.
"My own sense is that there is no need to change the peg to the dollar, unless there are special circumstances like disasters happening to the US economy which have international ramifications and affect Hong Kong negatively. Hong Kong's prosperity has been founded on using a currency standard that is international and convenient."
Bruce Yam, a foreign exchange strategist at SHK Forex, said Beijing might consider pegging the Hong Kong dollar to the yuan as an experiment to further internationalise the mainland currency.
"If the yuan is pegged with the Hong Kong dollar, it would be pegged with a currency which can be internationally traded," Yam said. "China may well try to do this to see how it goes before it lets the yuan become fully convertible."
But Brett McGonegal, the executive managing director and chief executive of Reorient Financial Markets, said that pegging the yuan with the Hong Kong dollar would take quite some time.
"You cannot peg a convertible currency to a currency whose exchange rate is supervised daily by a central bank," McGonegal said. "The earliest this could be abandoned is when the yuan becomes a fully convertible currency.
"At that point, after a transition period to watch the behaviour of the yuan exchange rate, the Hong Kong dollar could be abolished and the yuan adopted as the Hong Kong currency."
Principal Financial Group Asia president Rex Auyeung Pak-kuen said international investors would gradually accept a peg to the yuan.
"When the peg was launched in 1983, China was not such a world power," Auyeung said. "Now, China is the world's second-largest economy. To further adapt to the brave new world and to recognise the importance of China to Hong Kong, I believe a review of the peg is necessary.
"Leveraging on the closeness to the Chinese market and reflecting Hong Kong as an entry point to China for many foreign investors, I would not be surprised to see our Hong Kong currency pegged to a mixture of the US dollar and yuan one day, really playing its role as a bridge between East and West."
HOW THE SYSTEM WORKS
- Under the peg, whenever the three note-issuing banks issue banknotes, they are required to submit US dollars at a rate of HK$7.80 per US$1 to the HKMA for the account of the Exchange Fund in return for certificates of indebtedness. Their Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. When the government issues HK$10 banknotes and coins - which it is responsible for - it has to make a similar commitment.
- Under the peg, Hong Kong maintains its interest rate in line with US interest rate movements, a process managed by the HKMA through market intervention and various methods to control the liquidity of the banking market.
- The HKMA operates convertibility undertakings on the strong side and the weak side of the linked rate of HK$7.80 to US$1. The HKMA undertakes to buy US dollars from licensed banks when the rate hits HK$7.75 to US$1 and sell US dollars at HK$7.85 to US$1.
- Within the convertibility zone between HK$7.75 and HK$7.85, the HKMA may choose to conduct market operations consistent with currency board principles with the aim of promoting the smooth functioning of the money and foreign exchange markets.
- The peg is, in essence, a currency board system, which requires the stock and the flow of the monetary base to be fully backed by foreign reserves, which form a major part of the Exchange Fund.