A milestone of sorts was reached this month when the dollar hit a multiyear low on a trade-weighted basis and set record lows against Asian currencies, led by the Singapore dollar.
The drop in the dollar was especially remarkable because it took place against a backdrop of geopolitical uncertainty, which usually triggers a flight to haven currencies – which in the past would have meant a rush to the dollar. Meanwhile, the currency of the special administrative region of Hong Kong moved not at all. But that is because the Hong Kong dollar is pegged to the US dollar, not because the people of Hong Kong are enamoured with it. Indeed, Hong Kong citizens are increasingly turning their backs on the US dollar and momentum to reject the dollar peg is developing.
That momentum comes from the people of Hong Kong, but it has support from respected economists, including some at multinational organisations such as the Bank for International Settlements. Hong Kong, of course, hardly matters in the larger scheme of things. But it has a powerful demonstration effect. If Hong Kong were to abandon the dollar peg, it is likely others would follow – particularly in the Gulf. Kuwait has already depegged from the dollar and others are likely to follow suit.
The basic law says that Hong Kong needs to peg to a freely convertible currency. Since the Chinese renminbi still has capital controls and does not trade freely, the renminbi cannot replace the dollar, despite the fact that many people in Hong Kong wish it would.
But there is increasing support to peg the dollar to a basket of currencies, as Singapore does, rather than to tie Hong Kong to the US dollar and easy American monetary policy. That policy is meant to help a weak US economy recover – but is clearly inappropriate in vibrant Hong Kong.
By including the renminbi in that basket, Hong Kong would not be violating the basic law. And as Hong Kong’s economic fate becomes ever more closely tied to that of China, and far less tied to that of the US, a flexible basket that can be altered in the course of time to include the renminbi makes sense.
Strains on the current dollar peg are intensifying by the day. Because few residents of this pragmatic city have faith in the dollar, they prefer to hold renminbi. Renminbi deposits in Hong Kong now total some Rmb400bn and are expected to increase fivefold to Rmb2,000bn by the end of 2012. That growth has taken place even though savers are paid virtually nothing on those deposits and there are only about Rmb100bn of assets in which to invest.
Nor does that number capture the renminbi bank accounts Hong Kong residents keep in China where the rates they can earn are marginally better.
Property purchases swell by the day, in large part because exposure to property is seen as a way of being long the Chinese currency over time. Even with mortgage interest rates under 2 per cent, monthly mortgage payments can be 2-2.5 times monthly rent for flats as a result.
The strains will only intensify still further. In the past, Hong Kong imported deflationary pressures from China. Today, inflationary pressures in Hong Kong will become more intense both because of imported inflation from China and because of the appreciation of the renminbi against both the Hong Kong dollar and the greenback.
The rejection of US dollar deposits has become so widespread that smaller local banks in Hong Kong are being forced to go into the wholesale market to procure dollars, wreaking havoc with their finances.
Of course, any transition will be difficult to manage. The biggest challenge is that if the market were to anticipate a switch, Hong Kong asset values such as property would inflate even more rapidly as the market front-runs the monetary authorities who are already unhappy at the level of real estate prices. And there are technical issues that would need to be resolved if the renminbi were to be included in any basket.
The debate over the Hong Kong dollar is taking place against a backdrop of increasing internationalisation of the Chinese currency. Given the expectation that the renminbi will appreciate over time, few borrowers are interested in renminbi loans.
But the number of companies that use the renminbi to settle trade is increasing. Singapore will soon offer renminbi clearing, another step in the steady march toward internationalisation of the Chinese currency.
Many observers have been calling for the end of a dollar-based world for many years – and have been proved wrong. All reserve currencies are ultimately faith-based, as Jim Grant, the editor of Grant’s Interest Rate Observer, loves to point out.
But the residents of Hong Kong, at least, are losing their faith by the day.