ETF Trends
ETF Trends

The prospect of higher US interest rates and August’s shock devaluation of the Chinese currency has raised fresh questions about the sustainability of the Hong Kong dollar peg.

Every currency needs an anchor – either an external one, such as a fixed or managed peg to a major currency, or an internal one, such as a monetary or inflation target (with the exchange rate allowed to float).

The external anchor or peg ensures that the inflation rate remains basically in line with that of the major currency to which it is pegged.

In the case of an internal anchor, inflation targeting becomes the responsibility of the central bank, so it must have the necessary tools to control the growth of overall money and credit.

The Hong Kong Monetary Authority (HKMA) has those tools, so an internal anchor is feasible.

Inflation concerns

However, the problem with an internal anchor or inflation target for Hong Kong (HK) is that the combination of wide import price movements and a floating exchange rate for a small, open economy like HK would likely lead to a very variable inflation rate — sometimes exceeding the target, and at other times undershooting the target.

Moreover, HK’s experience with a floating exchange rate before 1983 was a disaster, with double-digit inflation and a very variable currency value, so it is very unlikely that the HK authorities would want to repeat the experiment.

Convertibility

Much of the success of the current HK dollar peg to the US dollar depends on the ability of lenders and borrowers (banks and non-banks alike) to arbitrage interest rates in these two currencies.

As long as the yuan is not fully convertible for capital account transactions, this kind of equilibrating capital flow would be impeded, and could not be expected to work well.

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