Yuan poses fundamental questions for Hong Kong
Speculation is unlikely to recede on the possibility of a revaluation or free float of China's currency. Guessing when this will happen, by how much and how to profit from any change is now a recurring investment theme.
A recent report RMB Revisited by Morgan Stanly advocates that one way to play the revaluation trade is to buy regional currencies - highlighting the Taiwan dollar or Korean won as beneficiaries.
Noticeably little mention is made of the Hong Kong dollar - a delicate subject with the Hong Kong Monetary Authority - but it cannot be removed from the equation. Investors must judge whether they are better off with Hong Kong dollar assets or liabilities.
Attention has progressed past the China Business Daily's report two weeks ago of a possible 5 per cent yuan appreciation, recognising that is likely to be inadequate, to what happens if we get a larger move or even a yuan free float.
If history is a guide then China's last change to its official currency peg, depreciating from a 5.8 yuan to the US dollar rate to the current 8.3 yuan - suggests that the impact on Hong Kong should be negligible.
But the mechanics of Hong Kong's financial interaction with China have changed. A decade ago China was still using its dual exchange rate system - money such as foreign direct investment came in at the official rate of 5.8 while foreign banks and joint ventures often used the market-driven rate of 8.69 yuan set at foreign exchange trading centres. The real exchange rate change was effectively overstated.
This discrepancy in values clearly signalled that the yuan was converging with the freely convertible and internationally tradable Hong Kong dollar. Today the two currencies operate under an increasingly intertwined de facto currency union. Be it the one-for-one note exchange in Shenzhen, the trading of Chinese shares on the Hong Kong stock market or the fact that banks on both sides of the border issue dual currency credit cards.
This time, however, we in Hong Kong must contemplate a yuan appreciation. Given that Hong Kong imports a lot more from China than it sells back, it potentially faces higher prices for everything from vegetables to water.
Potentially more damaging is any destabilisation to the Hong Kong dollar (and possibly its currency board with the US dollar) stemming from a stronger yuan or even a managed float within proscribed trading bands. Should the belief spread that the Hong Kong dollar must follow suit then a scramble from Hong Kong dollar debts to US dollars, particularly in real estate, would seem inevitable. The result of this switching would be a huge strain on the Hong Kong dollar to appreciate.
Confusion in the financial markets is easy to imagine. Mainland assets denominated in Hong Kong dollars have for the past decade been considered fungible due to the tight correlation between the two currency units. Destabilising this relationship inevitably introduces additional risk for investors.
Hong Kong's status as an efficient capital raising market for mainland entities might also suffer if it were perceived to have a depreciating currency, due to its link to the US dollar.
Hong Kong's currency arrangements face fundamental questions in the event of a yuan appreciation, inevitably focusing attention on the durability of its US dollar currency board link or at the very least the exchange rate that it employs.
In the end market forces will dictate with capital flows, likely forcing policy makers' hands. In 1993, hot money coming out of China sought refuge from an anticipated yuan depreciation through investment in real and financial Hong Kong dollar assets. The same could happen again (it may already be happening) as the belief takes hold that Hong Kong has no choice but to follow the yuan upwards.