Stop bad mouthing the peg

Former Harbour Times columnist David O’Rear returns! During his 30+ years in Hong Kong, David O’Rear was the regional economist for the Economist Group and chief economist for the Hong Kong General Chamber of Commerce. The views expressed here are entirely his own.

The surprisingly broad and persistent protests that erupted in Hong Kong in early June and into July call into question a host of established institutions and familiar arrangements, and rightly so. This is not that story. Rather, it is a warning about the dangers that arise when amoral profit-seekers play fear games.

In a nutshell, the Hong Kong dollar’s peg to the US dollar is not one of the things that needs to change right now. It’s just fine the way it is, and any tinkering will bring grief, uncertainty, and poverty. The only ones who benefit – and the only ones who seem to be calling for action – are currency speculators. Once you understand their motives, it is best just to ignore them.

Hong Kong’s political evolution stalled some ten years ago, at the same time as the onset of the Great North Atlantic Financial Crisis. That’s just a coincidence, much like the Handover and the Asian Financial Crisis occurring in the same week in 1997. Nevertheless, things have gone downhill in the past decade and appear likely to continue on that trajectory. Without new thinking on all sides – government, business, protesters, and political parties – there is little to suggest any kind of positive breakthrough might be on the horizon.

So, given that things are very dicey in the political sphere, let’s not mess around with in the exchange rate regime. Hong Kong’s currency has been linked to the US dollar since October 1983, and over more than 35 years it has proven to be a marvelous anchor in rough weather. It is not yet time to cast it aside. To wit:

  • During the tumultuous days of Handover negotiations, Tiananmen and the Asian Financial Crisis, the peg provided the stability Hong Kong needed.
  • It kept things relatively stable during the July 1st march in 2003, and again as chief executives came and went.
  • The worst-in-75-years economic chaos that enveloped the US and Europe from 2008 doesn’t even register on a Hong Kong dollar exchange rate graph.

Time and again, when the peg comes under attack it is due to speculation rather than on the basis of unbalanced economic fundamentals. Those who warn that the peg is at risk are far more likely to be talking up their own book than they are to be concerned for the best interests of Hong Kong. To bow to their desire to make a pile of cash would be folly. To tinker with (or abandon) the peg when the fundamentals are good and the politics are not would be suicidal.

During the long run-up to the Handover the colonial government stockpiled cash in anticipation of severe economic turmoil. The guns were aimed in the wrong direction (targeting domestic capital flight), but still managed to swivel to fight the enemies that did emerge. The shock of the Asian Financial Crisis, and the depression-induced fiscal deficits that emerged some 20 years ago (yes, kids, Hong Kong actually had budget deficits at one time), gave added impetus to the notion that the government must hold ever larger sacks of ready cash to protect us all from evil speculators.

Never mind that the currency board exchange rate system is a self-correcting one (interest rate adjustments defend the value of the currency; large foreign exchange reserves are actually counterproductive). Ignore the fact that the Exchange Fund has adequate reserves to replace every 7.8 Hong Kong dollars with a US dollar, several times over. The mindset has been established. All hail the mindset.

Don’t worry, be happy (with the economy)

If Hong Kong were a normal economy, at this level of income the government would have issued some HK$1 trillion in debt (40% of GDP). Instead, it has done the opposite, and now holds more than $1 trillion in fiscal reserves. However, and in great contrast to financial secretaries who repeatedly say otherwise, that money isn’t needed – or intended – to support the peg. Even if the HKMA hasn’t the nerve to use interest rates to defend the Honkie, it still has both the Exchange Fund and command over the foreign exchange reserves (see table).

The current account balance stands at +5% of GDP. Flip that into a 5% deficit, and we might begin to think that something’s not right. As noted above, sovereign debt is minimal and the fiscal reserves are an embarrassment (what’s the point in extracting money from the economy for no stated policy purpose?). The various money supply indicators have been growing at 4-6% per annum over the past two years, or slightly less than nominal GDP (an average of +6.3% p.a., Q-1 2017 to Q-1 2019). Inflation is slightly lower than the unemployment rate. 

In other words, the key economic indicators are leaning hard in the opposite direction of what would be expected if there were any reason to change the value of the Hong Kong dollar. Those who would buck such numbers do so at their own peril.

Latest data HK$ Billion US$ Billion
Nominal GDP (latest 4 quarters) 2,871 = 366.2
Fiscal Reserves 1,177 = 150.0
Exchange Fund Bills and Notes 1,112 = 141.7
Foreign Exchange Reserves 3,425 =  436.4
Monetary Base 1,630 = 207.6
Backing Assets 1,809 = 230.4
Outstanding Government Bonds 101 = 12.9

To honestly advocate a change, one must first answer the most obvious questions: why now? And, how should the currency be managed, if at all? We’ve (hopefully) laid to rest the first matter, so just for practice let’s look at the alternatives.

  • Free float. The value of the currency is determined by supply and demand, and policy makers are largely limited to using interest rates to influence the pace of change. Ideally, intervention is very rare. 

Because the flow of capital into and out of Hong Kong is so large in comparison to trade or domestic needs, a floating rate would begin life as a disaster, and it would only get worse after that. Absent an anchor, the Hong Kong dollar’s value would soar and crash on a near-daily basis, making any kind of risk mitigation nonsensical. Since 2000, when data were first collected, Hong Kong’s international investment position inflows and outflows – direct trade, portfolio transactions, cross-border derivatives and similar capital movements –have averaged around 10 times GDP. The demand for Hong Kong dollars with which to purchase shares of mainland companies has become so large that policy wonks are considering yuan-denominated listings, solely to ease the pressure. Unless we really want speculators, IPOs, and flash panics to determine our economic stability, the entire notion of a free float is a non-starter.

  • Managed float. Under this regime, monetary authorities establish the rate on a daily basis based on the value of a basket of currencies. Movement beyond the desired range is controlled by regular intervention and occasional direct restrictions (capital controls). The central bank guides the exchange rate in a bid to achieve certain policy objectives such as lowering inflation or unemployment or stimulating demand. 

This is China’s way of handling the renminbi, and it inevitably leads to exchange rate manipulation accusations. Since Hong Kong imports everything and local demand is just 20% of the economy, the goals don’t seem worth the risk. Moreover, rate management takes great skill, and Hong Kong has the same number of central bankers with the required experience as it does moon colonies. Zero.

  • Re-peg. Those who don’t like 7.8 need to both explain why and come up with a better figure. The arguments for stronger (say, 6) or weaker (10?) are equally good, and equally awful. That should be the end of the discussion, because it is absolutely necessary that the pain of a change has to out-weigh the pain of not making a change. If there is no clear direction, then the minimum requirement for making any change at all has not been met. Moreover, if the rate is changed once, it will be changed again and that opens up great opportunities for speculators to try to profit by forcing unnecessary adjustments.

Up, down or sideways? 

Increasing the value of the Hong Kong dollar vis-à-vis the greenback would raise the dollar price of services exports such as insurance, tourism, shipping, and transport. It would also reduce the cost of consumer imports, and likely result in another brutal round of deflation. Imagine what happens to the property and equities markets when everything is suddenly 10-20% more expensive in dollar terms.

Conversely, a Hong Kong dollar priced at 9 or even 10 to the greenback (that is, 13% to 22% cheaper) would raise the price of everything Hong Kong families buy while at the same time making real estate look cheaper to everyone except local residents. Those who remember the days of double-digit inflation will also recall that salaries never keep up with prices.

Why not peg to the Rmb? Let’s not even think about how well a Yuan peg would go down with those marching in the streets. Rather, remember that pegging to an unconvertible currency is a very special kind of stupid. Financial hotshots wanting to speculate on the value of the Rmb would simply use the Hong Kong dollar as a proxy, causing daily battles to defend the exchange rate. Moreover, most of the world’s trade is still dollar denominated, and trade is 80% of the economy, four times as large as the domestic side. Considering that the renminbi itself is priced to the greenback, we’d just be adding massive costs and uncertainty in exchange for nothing at all.

One day, maybe…

One day, perhaps before July 1, 2047, it may be prudent to reconsider how the currency is valued. That day is still a long way off, but it is useful to think about it early. If the edges of permissible trading were to widen by, say HK$0.05 per year, the market might be persuaded to accept a bit more flexibility without going overboard. If that margin were increased steadily and according to a well-articulated and coherent plan, the gap between the buying and selling rates might be as wide as 3% in five years, 10% by the mid-2030s and perhaps double that by the middle of 2047.

The world was different back in the Cold War years, when the peg was established. China was only about 8% of the size of the US economy and almost entirely closed to the outside world. Two-way trade in the years before Deng Xiaoping’s reforms began in 1978 averaged less than 20% of the mainland’s GDP. Today, the economy is about 65% as large as the US economy, and the country is the largest trading economy on earth.

One day, Hong Kong will need to reconsider its peg, but not anytime soon.

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davidorear

David O’Rear moved from his native California to Asia in 1980, first to Taiwan for language study and later to Hong Kong where he worked in the areas of economic, political and business conditions analysis. After 18 years with The Economist Group, he accepted the post of Chief Economist at the Hong Kong General Chamber of Commerce in 2002. In 2015, he resigned to follow his wife to London, where he exercises his analytical skills on a more ad hoc basis. David has bachelor’s and master’s degrees from the University of California, Berkeley, and is a regular commentator on current events in print and electronic media. He is married to Bonny Fay Landers.
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David O’Rear moved from his native California to Asia in 1980, first to Taiwan for language study and later to Hong Kong where he worked in the areas of economic, political and business conditions analysis. After 18 years with The Economist Group, he accepted the post of Chief Economist at the Hong Kong General Chamber of Commerce in 2002. In 2015, he resigned to follow his wife to London, where he exercises his analytical skills on a more ad hoc basis. David has bachelor’s and master’s degrees from the University of California, Berkeley, and is a regular commentator on current events in print and electronic media. He is married to Bonny Fay Landers.