The debate on our peg to the United States dollar continues with monetary chief Joseph Yam Chi-kwong weighing in on his weekly Web site column to discuss continuing deflation in Hong Kong. Mr Yam covers a fair deal of ground in that column, more than I can deal with in this one, but a few comments merit further discussion. 'I should add here that Hong Kong's monetary arrangements have not been contributing to deflation in Hong Kong, notwithstanding the sporadic and understandable claims to the contrary,' he said. 'Readers may not be aware of this, but the real effective exchange rate of Hong Kong has actually depreciated since the crisis period in 1998 by about 12 per cent, although our nominal exchange rate against the US dollar has remained fixed. The linked exchange rate has therefore not, at least in recent years, undermined our competitiveness.' Now I do not have floor upon floor of number crunchers at my beck and call, as Mr Yam does, to work out if this is true. It requires calculating inflation rates for all of our trading partners, giving each an accurate trade weight, adjusting their nominal weighted currency movements for it and then adding it all up. I shall therefore do it the simple way against the US dollar alone. Let us assume that prices in the US and Hong Kong were the same for the same goods at the beginning of 1984, just after the peg was adopted. Now work out the difference in inflation rates since then and pose the question: what would our exchange rate have to be now to make prices in the US and Hong Kong the same again? Your answer on this admittedly simplistic measure is shown in the middle line of the chart. As of July it would be HK$11.38 to US$1, quite a difference from the actual rate and, if you assume that we are headed back to price equilibrium and that deflation alone will bring us there, then we still have a great deal of deflation to come. Mr Yam is right that we have already come a long way since 1998, more than 12 per cent on this measure in fact, but let us keep in mind what went before. Let us keep a few other things in mind too. First, as the chart also shows, it was housing inflation that really pulled this figure up but housing inflation does not have much impact on exchange rates for the simple reason that you cannot pull your flat out of your block, ship it to the US and sell it there. For a measure with which you can actually do that, look at the bottom line of the chart. If our notional exchange rate were based on inflation differences in consumer durables, which are easily shipped, it would be only HK$8.42 to US$1. In other words, we are already much closer to equilibrium if you take into account only price differentials in things on which the exchange rate has an impact. Remember also that we assumed prices were in equilibrium in 1984. Were they? Hong Kong was still a shoppers' paradise back then. And who says equilibrium is the natural state anyway? All the evidence suggests that such a state is rarely attained. It is all rather confusing, isn't it? What it really says is that you cannot really tell whether the peg has lost us competitiveness or how much longer deflation is likely to continue because of the peg. These measures are not as precise as they seem. Graphic: jake22gbz