The Demise of the Hong Kong Dollar Peg -- CBR Mar-Apr 2003

Chi Lo

he Hong Kong Dollar Link, as the local currency peg to the US dollar is officially called, was set up in 1984 to guarantee currency stability in the run-up to the handover of Hong Kong to China in 1997. No one doubts the fundamentals behind the peg in the short term: Foreign exchange reserves are ample, government debt is small, and Hong Kong is a net external creditor (see "Hong Kong's Peg"). But there are signs that the government is losing faith in the currency peg, and it may be considering delinking the currencies in the medium term to escape the effects of what is becoming a widespread expectation of prolonged deflation in the world economy.

The single most important factor that makes a strong supporter of the Hong Kong dollar peg, including myself, rethink its viability is the threat of entrenched global deflation. The Achilles heel of the peg is the Hong Kong government's worsening fiscal position, which is tied to unfolding deflationary forces. Crucially, the recent rise in Hong Kong's fiscal deficit reflects the government's unwillingness to suffer more economic adjustment pains than it already has under the peg.

Why deflation makes the peg a burden
Since the share of land premiums and stamp duties account for a big chunk of total fiscal revenues in Hong Kong, the collapse of the property market since the 1997 Asian crisis has significantly slowed government revenue inflows. In the current climate of deflation, the days of rampant property price growth are unlikely to return soon. The shrinking of revenues from the local property market suggests that Hong Kong's budget deficit has become structural under the peg.

The rising fiscal deficit and consequent erosion of fiscal reserves are undermining the foundation of the Hong Kong dollar peg. This is because the fiscal reserves form a major part—almost 40 percent as of late 2002—of the Exchange Fund that underpins the peg. If the annual fiscal deficit remains at around HK$70 billion ($8.98 billion), as the current trend indicates, Hong Kong's fiscal reserves will be depleted in four years. But investor confidence will crumble before the fiscal reserves run out, causing massive capital outflows that will pressure the peg.

The view that a complete depletion of the fiscal reserves, which will still leave HK$570 billion ($73.11 billion) in the Exchange Fund, will not necessarily crush the peg is naive. When it comes to defending the Hong Kong dollar peg, it is not what the Hong Kong Monetary Authority (HKMA) expects to commit in case of a crisis that matters. Rather, it is what the HKMA eventually would have committed—defined as the amount that depositors would withdraw from the banking system in case of a loss of confidence—that matters.

The Exchange Fund (excluding fiscal reserves) amounts to 240 percent of Hong Kong's monetary base, which includes notes and coins in circulation, banks' aggregate balance with the HKMA, and Exchange Fund securities. But the survival of the peg in a crisis of confidence would involve the whole Hong Kong dollar deposit base. Yet, the Exchange Fund covers only 30 percent of all Hong Kong dollar deposits. So if every holder of Hong Kong dollars were to convert their deposits into US dollars or other hard currencies, there would not be enough foreign reserves to meet demand; the Hong Kong dollar peg would break. Local public confidence is indeed fragile—the growth of Hong Kong dollar deposits has fallen steadily since the Asian crisis and has been negative since January 2002. As a result, falling fiscal reserves will erode public confidence and the margin of safety provided by the Exchange Fund and impede the authorities' ability to deal with contingencies effectively.

If the government resorts to borrowing to plug the deficit hole, the rise in public debt will only exert more stress on the Exchange Fund and erode public confidence further. The fund will either act as a direct lender or a guarantor for borrowing. Both acts will require it to commit more resources to fund the fiscal deficit, thus reducing its ability to protect the peg.

Forcing a choice
The combination of deflation and Hong Kong's structural fiscal deficit are forcing the government to choose between lowering the external price of money (un-pegging the Hong Kong dollar) and lowering asset prices (chronic asset price deflation). Re-setting the peg is not an option because re-setting the peg once would create expectations that the government would re-set it again. The currency link system would lose credibility and speculative attacks on the peg would follow, leading to its eventual collapse.

The survival of the peg thus depends on the political will to tolerate the economic adjustment pains that are necessary under the currency peg. This means the government cannot intervene in the economy even at times of economic stress. The persistent rise in Hong Kong's public spending to boost growth is the most notable sign of recent interference. Since 1997, fiscal spending has risen from 17 percent of GDP to 24 percent—one of the highest ratios of nondefense public spending to GDP in Asia.

Large fiscal spending looks likely to stay, as government policy has shifted from laissez-faire to hands-on. From the currency peg perspective, however, any market-supporting measures distort the peg's adjustment mechanism. To keep the territory competitive when other Asian currencies depreciate, Hong Kong prices need to fall under the currency peg. But the government's supportive measures are preventing the necessary decline in the city's domestic prices, thus distorting the peg's adjustment mechanism. These supportive measures also show that the authorities are hitting their tolerance limit for economic pain caused by the peg and, hence, may be mulling a policy shift. All this is best summarized by Antony Leung's anti-peg comments since he took over as financial secretary in late 2000—in essence, he has said that the peg is an obstacle to Hong Kong's development.

No constitutional backing
Indeed, it would be easy for Hong Kong to sever the peg because the Hong Kong dollar peg does not have robust constitutional backing. Article 111 of the Basic Law only guarantees the Hong Kong dollar as the legal tender in the Hong Kong Special Administrative Region and ensures that the issuance of Hong Kong dollars is fully backed by a reserve fund. It does not guarantee the Hong Kong dollar peg and its convertibility rate of HK$7.80 per US dollar. On the other hand, the Argentine peso peg unraveled under severe economic stress, even though it was enshrined in the constitution and approval from both houses of Congress was needed to scrap it.

The fate of a currency regime is more a political choice than an economic one, and the advent of a new era of prolonged low inflation, with periodic deflation, has cast doubt on the desirability of the Hong Kong dollar peg. The government is increasingly uncomfortable with the long-term burden the peg imposes on the economy under deflation. But it will likely do nothing in the short term, if only because of the difficult steps that would be required, among them reforming the HKMA into an independent monetary policy manager.

Hong Kong’s Peg

   Hong Kong has had a fixed exchange rate system since 1983, when the value of the Hong Kong dollar was fixed at HK$7.80 per US dollar in response to currency instability and general uncertainty about Hong Kong's future in the years before its return to China. Under this system, all notes and coins in circulation are backed by US dollars. The three banks that issue notes in Hong Kong—Hong Kong and Shanghai Banking Corp. Ltd., Standard Chartered Bank, and Bank of China—must, for each 7.8 Hong Kong dollars they issue, deposit a US dollar in what is known as the Exchange Fund. In return, they receive a Certificate of Indebtedness, which allows them to redeem US dollars when they pull Hong Kong dollars out of circulation.
   Good pegs have currency boards. Currency boards keep a fixed exchange rate, ensure that every note and coin of local currency issued is backed by the anchor currency, and exchange the local and anchor currencies on demand. They do not participate in monetary policy and are independent of the government. The Hong Kong Monetary Authority (HKMA), set up in 1993, oversees the Hong Kong peg system. But because HKMA performs some of the functions of a central bank, such as regulating banking and financial systems, it is not a true currency board.
   In addition, most currency boards have a firm legal base—that is, their role is written into law. Hong Kong has no such law, other than the Exchange Fund Ordinance. This ordinance gives the financial secretary not only control of the fund (no separation from government) but also rather broad, but vague, powers: "...the Financial Secretary may...use the fund as he thinks fit to maintain the stability and the integrity of the monetary and

financial systems in Hong Kong." On the other hand, HKMA is not a true central bank either, as it does not issue notes or act as a banker to the government.

How the peg works
   As HKMA explains, "Under the currency board system, ...interest rates rather than the exchange rate ... adjust to inflows or outflows of funds. The monetary base increases when the foreign currency ... to which the domestic currency is linked, is sold to the currency board for domestic currency (capital inflow). It contracts when the foreign currency is bought from the currency board (capital outflow). The expansion or contraction of the monetary base causes interest rates for the domestic currency to fall or rise respectively ...[causing investors to move funds]..., while the exchange rate remains stable. This process is very much an automatic mechanism, which does not require the HKMA to exercise any discretion." (Hong Kong's Linked Exchange Rate System)

Benefits of the peg
   In Hong Kong's case, one of the most important benefits of the peg is still the guaranteed currency stability in a time of political uncertainty over Hong Kong's future. Though Hong Kong has now been a special administrative region of China for more than five years, new sources of uncertainty—such as interpretation of the Basic Law, recent proposals for an anti-sedition law, and lack of confidence in the current Hong Kong government's ability to keep the economy running smoothly—show that the peg is still useful.
   As a center of international trade and finance, Hong Kong is extremely vulnerable to external economic shocks. The linked exchange rate guarantees a stable

currency, which eliminates much of the foreign exchange risk faced by actors in Hong Kong's small, open economy. According to HKMA, local markets respond quickly to economic pressures: Prices adjust fairly rapidly to restore competitiveness without changing the exchange rate. Yet the smaller number of economic levers available to policymakers in Hong Kong compared to economies with floating exchange rates means that Hong Kong's economy must make structural changes to cope with economic pressures. Though painful in the short run, such changes benefit the economy in the long run.

Drawbacks
On the downside, internal wage and price adjustments may be more wrenching than they would be if the exchange rate were free to adjust. The linked exchange rate also effectively links the interest rates of the US and Hong Kong economies, which prevents HKMA from using interest rate adjustments as levers on the Hong Kong economy. And when the economic cycles of Hong Kong and the United States are out of synch, US interest rates may not be at levels appropriate for Hong Kong. Indeed, a few years ago, the United States raised interest rates to cool down its overheating economy just when Hong Kong was struggling to recover from a recession brought on by the Asian financial crisis.
Another drawback is that the Exchange Fund ties up reserves that, some have argued, could be put to better use—invested in the local economy or spent on improving Hong Kong's education, health, and welfare systems, for instance.

—Virginia A. Hulme

Virginia A. Hulme is associate editor of The CBR.

Rationale remains
The above argument does not deny the merits of the Hong Kong dollar peg for Hong Kong's small, open economic system. After all, scrapping the peg will not solve Hong Kong's structural problems, among them a rising skills mismatch, an education system in dire need of reform, and an outdated economic model based on asset trading.

Moreover, the alternative currency regimes are unlikely to be any better for the Hong Kong economy. The volatility that characterizes a floating exchange rate would hurt the city's competitiveness as a financial center, while a managed float (which would entail frequent government interventions to keep the exchange rate from moving freely) would risk over-politicizing the exchange rate.

If the peg goes
Given the signs of wariness about the peg, investors would be wise to prepare for its demise. The immediate effect would likely be a sharp drop in the Hong Kong dollar-US dollar exchange rate. In such a case, how would Hong Kong's asset prices behave? As a reference, we can look at stock market behavior in Argentina and the United Kingdom, both of which have broken their currency pegs in recent years.

Argentina
Argentina pegged its currency to the US dollar in 1991 to combat hyperinflation and stabilize the economy. The peg succeeded for a few years, but because of imprudent economic policies, it came under pressure in the late 1990s. The peso peg severely damaged Argentina's export competitiveness and its ability to repay foreign debt. The government eventually defaulted in November 2002 and abandoned the peg in January 2003. Argentina's stock market surged 100 percent in the month before the peso-dollar peg was scrapped, as the markets expected major relief from the economic pains of deflation, bankruptcy, unemployment, and economic contraction that the adjustment mechanism was inflicting.

For the same reason, Hong Kong's asset prices could also start rising if signs emerge that the government may decide to sever the peg. What would happen next to asset prices would depend on whether Hong Kong was able to restructure to survive in the new economic era. In Argentina's case, hesitation to eliminate structural woes in the economy caused asset prices to plummet after the peso peg was abandoned. The Argentine government imposed strict capital and deposit controls and created a dual exchange rate to skirt full devaluation and restructuring pressures. But these measures have only postponed thorough adjustments, and thus have haunted the markets.

United Kingdom
Britain's experience was very different. Britain had joined the Exchange Rate Mechanism (ERM), which fixed European currencies' cross-exchange rates within specific bands, in 1990. During a speculative attack in September 1992, the Bank of England decided to drop out of the ERM. UK stock prices rose steadily after the British pound dropped out of the ERM. The ascent of UK equity prices lasted until late 1999, when the global investment bubble burst. This sustained rise of British asset prices after the break of the peg from the ERM was a result of successful economic restructuring, notably in the rigid labor market. Britain's productivity and economic growth have consistently outperformed many other European economies and thus supported asset price growth.

The upshot
What all this means is that though severing the peg may give an initial push to Hong Kong's asset prices, what happens in the post-peg era would depend on the city's restructuring efforts and the macroeconomic environment. Because the macroeconomy is outside of Hong Kong's control, the territory's ability to reinvent itself would determine whether Hong Kong's asset markets would revive in a post-peg era.

Chi Lo
former chief economist at Standard Chartered Bank and research director at HSBC,
is an independent economic strategist based in Hong Kong.

March-April 2003 THE CHINA BUSINESS REVIEW

Last Updated: 18-Mar-2003