A lot of nonsense has been talked in the past few weeks about the future of the Hong Kong dollar peg. People who should known better have looked at the steep rise in Hong Kong property prices and argued that our exchange rate peg to the US dollar is inflating a dangerous asset price bubble. And people who are otherwise quite sensible have noted the rapid growth of yuan deposits in Hong Kong, and concluded that the city should bow to the inevitable and abandon its long-standing currency link to the US dollar in favour of a peg to the yuan. These ideas have become so widespread that even HSBC, an ardent promoter of yuan business in Hong Kong, has felt compelled to pour cold water on the speculation. In a research note sent to clients on Friday, Richard Yetsenga and Dominic Bunning, the bank's Hong Kong-based foreign exchange strategists, debunk some of the more common misconceptions about the peg and its future viability. First, they rebut the often-repeated charge that since the 2008 financial crisis Hong Kong has decoupled from the US economic cycle and that as a result a peg to the US dollar is no longer appropriate. In fact, as the first chart below makes clear, the divergence between the two economies has been much greater in the past, for example during the Asian crisis of the late 1990s. At the moment, with both economies in recovery mode, by historical standards they are tightly in phase. Next, Yetsenga and Bunning take aim at the idea that the recent rise in consumer and asset prices in Hong Kong is anything out of the ordinary. At 2.6 per cent, consumer inflation is running below its 20-year average of 3.1 per cent and is a far cry from levels as high as 12.5 per cent experienced in the early 1990s. And although the 43 per cent increase in property prices since the start of the recovery cycle might sound excessive, in fact it looks rather modest compared with the increases of well over 100 per cent seen in the mid-1990s and following the Sars outbreak of 2003. Next, the HSBC analysts dispute the idea that since the financial crisis Hong Kong has experienced exceptionally strong flows of foreign capital into its asset markets. They argue that the recent increase in Hong Kong's monetary base has occurred not because inflows are unusually big but because near-zero interest rates around the world mean that the interest rate arbitrage mechanism that would usually trigger countervailing outflows has broken down. Yetsenga and Bunning also give short shrift to the notion that Hong Kong would be better served by an exchange rate regime that linked the Hong Kong dollar to a basket of currencies instead of just the US dollar. China's restrictions on convertibility rule out the yuan as a candidate for any reference basket. That leaves just the euro, the yen and possibly sterling as potential components in addition to the US dollar. Other currencies, like the Australian or Singapore dollars, are simply too unimportant in terms of Hong Kong's trade and investment flows to be worth considering. The trouble is that with the European Central Bank, the Bank of Japan and the Bank of England all running benchmark interest rates of 1 per cent or less, shifting to a basket peg would do nothing to lift Hong Kong's rock-bottom interest rates. Nor would moving to a basket peg do anything to deter inflows or cool the local property market, as the Monetary Authority of Singapore can testify. The switch would merely exchange simplicity for complexity - and volatility - without achieving any of the desired results. Finally, HSBC's analysts shoot down the notion that the recent doubling in yuan deposits held in Hong Kong indicates that the yuan will inevitably displace the Hong Kong dollar as the city's currency of choice for day-to-day business transactions. They point out that the proportion of Hong Kong's deposit base held in Hong Kong dollars has actually risen, not fallen, over the past couple of years. Far from displacing the Hong Kong dollar, as the second chart shows, the yuan has merely been added to the city's mix of foreign currency holdings, which have typically made up around 45 per cent of the total deposit base. And even if Hongkongers did begin to switch from the Hong Kong dollar into yuan on a large scale, the shift would create a shortage of Hong Kong dollar liquidity, which would push up local currency interest rates and make holding Hong Kong dollars more attractive again. In other words, despite all the speculation, it's very much business as usual for the Hong Kong dollar peg.
