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.
This is why for many years I have argued that HK should not shift from a US dollar peg to a yuan peg until the Chinese currency is “fully and irreversibly” convertible, with all capital controls removed.
Successful HK economy
HK has been successful in adapting its economy to the fixed exchange rate for over 30 years.
In the 1980s, the economy shifted from manufacturing to services as much of the former was transferred to mainland China.
In recent years, services have become an even more important component of HK’s total trade. Many of these services are provided to companies based outside HK.
Unless these externally based firms can find other providers in the region, HK is likely to maintain its competitive edge.
Moreover, the International Monetary Fund’s assessment of HK’s competitiveness last year 1 concluded that on three different criteria the HK dollar was reasonably valued.
Conclusion
Unless anyone can propose a currency system that is more appropriate for a small, highly open economy with large-scale free capital flows than the currency board system with a peg to the US dollar (still the major trading currency of the world), then it is better for HK to remain with the current arrangements.
1 Source: International Monetary Fund, “People’s Republic of China – Hong Kong Special Administrative Region – Staff Report,” Pages 17-18, May 2014