Singapore's economy became marginally larger than that of Hong Kong in 2010 for the first time. The lead continued to widen in 2011, with Singapore generating a gross domestic product of US$259.8 billion versus US$243.3 billion for Hong Kong. A 2011 survey of expatriate pay conducted by ECA International indicated that Singapore expatriates are enjoying a higher take-home salary than their Hong Kong counterparts. Expatriates' salary in Singapore was ranked fifth in Asia versus 10th for Hong Kong in the survey. It wasn't so long ago when it was more financially rewarding to be posted to Hong Kong. According to a cost of living survey conducted by the consulting group Mercer, Singapore overtook Hong Kong in March 2011 to become the world's eighth most expensive city to live in. It was 11th in 2010. Hong Kong slipped from eighth to ninth place. So what has changed the positions of Hong Kong and Singapore? While Hong Kong's GDP growth has lagged behind Singapore's over the past decade, another key reason for all of the above is that the Hong Kong dollar peg has locked the local currency in lugubrious embrace with US greenback. In recent years, that has not been a great pairing for Hong Kong, as it has contributed to a decline in the Hong Kong dollar against virtually all major currencies, even minor ones like Singapore's. The Singapore dollar has appreciated by about 45 per cent against the Hong Kong dollar over the past 10 years, according to Bloomberg data. This helps to explain why its per capita income is about 40 per cent greater than Hong Kong's. Under the currency board system, every Hong Kong dollar is backed by foreign currency reserves (plus a margin for error). Whenever there is a decrease in demand for Hong Kong dollars, the Hong Kong Monetary Authority will buy Hong Kong dollars with its foreign currency reserves. This leads to a decrease in the supply of Hong Kong dollars and higher domestic interest rates. This attracts capital inflows to maintain the fixed exchange rate, and vice versa. Hong Kong is one of few major economies still relying on fixed exchange rates. Even the mainland has moved to a more flexible system, albeit under tremendous pressure from the US over trade imbalances. The other exception is the euro zone, which has amply demonstrated the deficiencies of the fixed exchange system. The Greek tragedy is still causing havoc on the markets three years after the crisis began. The problems with fixed exchange rates are a matter of basic economics. First, interest rates cannot be adjusted as that would affect the fixed exchange rate. As Hong Kong has subcontracted the management of its monetary policy to the US, it is unable to lower interest rates during a recession to stimulate the economy or raise rates to combat inflation. During the 1997 financial crisis, overnight interest rates in Hong Kong touched a high of 18 per cent as speculators shorted the Hong Kong dollar and sent the stock market reeling. Second, Hong Kong loses the ability to rely on the exchange rate as a price adjustment mechanism. It can only adjust prices through inflation and deflation domestically. If the Hong Kong dollar is overvalued, exporters may have to cut prices and reduce wages to stay competitive with exporters from other countries. This can be wrenching for individuals coping with wage cuts or job loss. This was exactly what happened from 1998 to 2004, when Hong Kong suffered a prolonged and painful bout of deflation (with a subsequent drop in wages, property prices and so on) as regional currencies were hit first by the Asian financial crisis and second by the global technology recession. The opposite took place in the early 1990s, when the rapid economic development of the mainland and massive infrastructure spending in Hong Kong contributed to high economic growth and inflation. At the same time, the Hong Kong dollar depreciated in line with the US dollar, making imports more expensive. Because the interest rates in Hong Kong are pegged to the US, the high inflation turned real interest rates negative, making it highly attractive to invest in property. In recent years, the undervalued Hong Kong dollar made the city's real estate relatively inexpensive in the region. This attracted significant purchases from foreign buyers and speculators, and driving up prices beyond the reach of the average Hongkonger. The elevated property prices and rents distorted the local economy and fuelled inflation. The history of Hong Kong's peg goes back to the 1980s when the acrimonious negotiations over Hong Kong's sovereignty affected market confidence. In September 1983, the Hong Kong dollar fell to HK$8.7 to the US dollar, compared with the HK$6.5 level that was the norm back then. To restore confidence and ensure stability, the government decided to peg the Hong Kong dollar to the US dollar at the rate of US$1=HK$7.8, a rate that has remained unchanged for almost 30 years notwithstanding some colossal crises that have unfolded in the city over that time. The peg might be appropriate if the structure of the Hong Kong's economy and cycles were in synch with the US. But this has clearly not been the case. That is why Hong Kong alternated between chronic inflation in the early '90s and deflation after the 1997 financial crisis. So why is Hong Kong still standing by the fixed exchange rate system? The government obviously still believes that the currency board system is the best way to maintain exchange rate stability given the small size and openness of the Hong Kong economy. The city's flexibility on prices, its rock-solid banking system, its strong fiscal discipline and massive foreign exchange reserves means it is has the resources to make the fixed-rate regime work. Cynics would point out that most popularly elected governments would not have been able to survive the erratic bouts of high inflation and deflation that Hong Kong has experienced. Moreover, it is counterintuitive that Hong Kong, a leading financial centre, does not have the capability to run a credible independent monetary and foreign exchange policy, as Singapore has done for decades. It is probably also a case of bureaucratic inertia at work: don't fix it if it isn't broken. Khor Un Hun is a former investment banker who was born in Singapore and is now resident in Hong Kong 16.5b - Difference in GDP between Singapore and Hong Kong in 2011 (in US dollars)
