Buckle up, crystal ball shows roller coaster may crank up again

'Now that it looks like we may be heading into another period of US dollar decline, likely combined with the appreciation of East Asian currencies, could I suggest you treat us to your thoughts on how the Hong Kong dollar should deal with this. Or will deal with this.'

E-mail from a reader

May 17

YES, SPEAK, O GURU, you who told the punters that gold at US$400 an ounce was overbought and would have to go down, you who said it was time to dig the grave for the Shanghai stock market when its A-Share Index was below 1,100 points last year only to see it rocket straight up to more than 1,700.

Oh well, win some, lose more, and if there is anyone out there who still rates this columnist as a crystal ball gazer, be it on your own head. Here goes.

For the Hong Kong dollar, it all comes down to the workings of the peg against the US dollar. If you fix your currency to the greenback, you surrender one of your two tools for making price adjustments in your economy and you then have to lean on the other. What you could do in part with exchange rate movements you now have to do directly with the trend of inflation.

The first chart shows you just how true this was for Hong Kong after the Asian financial crisis of 1997. Note that I take the record here only for smaller Asian countries and have excluded China and Japan. These two march to their own drummers.

In June 1997, the region paid the price for monetary negligence over the previous 10 years and exchange rates collapsed against the US dollar. The sinners had let their domestic prices get out of line with the rest of the world. They got those prices back in line again by letting their currencies fall against the rest of the world's currencies.

All but Hong Kong. We had sinned in domestic prices too but the peg stopped us from devaluing the Hong Kong dollar. We could get our prices back in line only by dropping those prices directly and that is what the chart shows you we did. Other countries could let their inflation rates continue going up. We had to go into deflation.

But now here is the question. By holding to our $7.80 peg while other countries let their currencies fall, we rendered ourselves distinctly uncompetitive against them. How much then has our deflation versus their inflation restored our competitive edge against them since that time?

The blue line in the second chart gives you your answer. We have clawed it all back and then some. They may have let their currencies fall but we have made up for it entirely with direct price adjustment.

And now we have the opposite conundrum. The US dollar is weakening, the rest of Asia shows increasing currency strength against the dollar and we are still pegged to the dollar while having fully made the price adjustment for that peg. What does it mean for us now?

Here are three scenarios, the first a drastic one. Let's say we repeg to a stronger level against the dollar. Then again, let's say we don't. All bets are off if we do. My already faulty crystal ball is thoroughly opaque on this scenario.

The second scenario is the ho-hum one. We stay pegged, our interest rates go up with US rates, our property market comes off and our economy slows down. Ho-hum.

I think my third scenario is the more likely one and certainly more in line with the Hong Kong experience. We stay pegged, the speculators say they don't believe we can resist the trend elsewhere and they pour in money betting on a repeg.

We are soon so awash in the stuff that our interest rates cannot follow US rates up. Money is out there for old rope. The property market booms, inflation rises in an ever steeper curve, soon outstripping inflation rates elsewhere in Asia and Joe Yam at the Monetary Authority thunders away about how he won't stand for it. No one pays him any attention. He talks big but swings a small stick.

And then it all goes pear-shaped again. We make our inflation adjustment the other way round, the speculators give up, interest rates finally start to rise and don't stop rising when we think they should, the property market tumbles and we go into recession for a while.

Recognise the ride? Do you really think that the Hong Kong one will ever stop being a roller coaster?