Why the Hong Kong Peg Can’t Stay in Its Current Form
The Hong Kong dollar is the solution to China's currency problem. Over the last few weeks the territory's monetary authority has had to intervene in markets to stop the currency from rising against the U.S. dollar. Some HK$14.3 billion ($1.85 billion) has been spent to preserve the peg. In these times of economic uncertainty, the need for an investable hard currency is so intense that even our little Hong Kong dollar is seen by some as a safe haven.
The peg is going to stay, of course, because policymakers are terrified of the unknown. The prevailing view about depegging is that it would be too dangerous. In fact, the Hong Kong dollar itself is a dead unit having been pegged first to the pound and later to the U.S. dollar with the current rate fixed in 1983. The unit only floated for a relatively short period from 1974-1983 with volatile results so there is a great fear of the unknown.
Yet the monetary authority is going to have to face the facts that we are now a RMB-dominated city and that we will have to find a way to move alongside the Chinese currency sooner rather than later. The most obvious change will come from the increasingly urgent need for the Chinese Renminbi to internationalize.
The U.S. election debate has raised the issue that China is liberalizing its currency too slowly for the West. Indeed, this is true also for China, who wants to make the best of a good crisis by advancing the claims of their redback against the greenback. The Chinese must have a convertible currency in the next decade to take their place as the – soon to be – largest economy in the world.
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The claim that the Chinese currency is very much undervalued is economically obvious. It is not possible to turn back 30-odd years of double-digit economic growth, while your trading partners have grown at 2 – 3 percent annually, and still retain a broadly similar exchange rate. In the last 18 years, the currency has appreciated just 28 percent to around ¥6.30 to the US dollar. China's foreign exchange reserves remain massive while domestic inflation remains high, driven by the pressure cooker of a closed economy, heavy wage hikes and growing domestic demand.
These imbalances will not fade overnight even though net exports are currently slowing. China is following the path of all economic superpowers to emergence and will not be able to resist revaluation any more than Japan could some 35 years ago. The Japanese yen was fixed at a post-war rate of 360 yen to the dollar and was floated in 1973 at 271, falling to 78 yen today. This revaluation did not do Japan any harm; Japan's enduring economic problems started later and for different reasons.
(Read More: Will Yuan's Decline Reignite Trade Tensions With US?)
To assist the development of the Chinese currency for overseas trading, the authorities have established a new currency called the CNH, the Chinese Yuan in Hong Kong. This RMB is not fungible with the CNY (the Chinese Yuan in China) and, at present, the two trade very closely in value.
The obvious answer is to combine the dead Hong Kong dollar with the embryonic CNH. This would be a completely independent, floating currency not fungible with the CNY. The CNY would be used for current account transactions such as exports and imports, whilst the new "Chinese Dollar" (combining HKD and the CNH) would cater for capital account financial transactions.
It would establish a currency unit of sufficient liquidity to make it immediately investible. If we take World Bank estimates of M2 money as a proxy, the new "Chinese Dollar" would have a M2 of some US$830 billion, placing it within striking distance of the Swiss Franc at US$940 billion. It is an elegant solution by being both international yet also Chinese.
I would expect the Chinese Dollar to appreciate sharply and become a haven like the Yen and the Swiss Franc leaving the domestic Chinese economy largely unaffected. China (as well as many countries including the UK and France) has experimented with dual exchange rates before. An unsophisticated system existed from 1986 to 1994, when the two were unified at ¥8.70. In the fullness of time, the Chinese Dollar and the Chinese Yuan will come close enough in value to merge the two currencies.
The currency could be managed by a Central Bank in Hong Kong, a subsidiary of the People's Bank of China. The Central authorities would adhere to HK's de facto constitution, the Basic Law (1984), agreed for the handover from Britain to China in 1997, which does not prevent the People's Bank of China guaranteeing the Hong Kong Central Bank's liabilities. To all intents and purposes it does that anyway. Hong Kong would no longer have the 'wrong' interest rates and the 'World City' would continue to be an international favorite for global stock and bond listings.
China is comfortable with "one country two systems" and many countries have made successful economic transitions using a dual currency regime. There are many changes likely to come from a floating Hong Kong dollar, but few tragedies.
Richard Harris is Chief Executive of Port Shelter Investment Management. He has lived in Hong Kong for 42 years. firstname.lastname@example.org