Sept. 5 (Bloomberg) -- It's a lucky thing for Donald Tsang that he isn't on the ballot for this weekend's election in Hong Kong. The city's chief executive officer would probably lose.

A recent Hong Kong University poll found more people in this city of 7 million expressed no confidence in Tsang than those supporting him. Tsang's 39 percent approval rating may be at even greater risk in the months ahead. The reason: inflation.

``The trend for worsening inflation will continue,'' Tsang said on Sept. 2. ``We haven't seen inflation as high as the current level in the past. This situation will remain at least until the autumn of next year.''

What's discouraging is that Tsang won't take a painfully obvious step to address the problem: Scrap Hong Kong's peg to the U.S. dollar.

Next month marks the 25th anniversary of a policy that has admittedly brought a level of stability lacking elsewhere in Asia. During Asia's 1997 currency crisis, for example, the dollar peg helped Hong Kong avoid the turbulence in Indonesia, South Korea and Thailand.

When the peg came under speculative attack in the summer of 1998, Hong Kong held its ground and pumped untold billions of dollars into equities.

Last week, Joseph Yam, chief executive of the Hong Kong Monetary Authority, said the city hasn't been adding to its $158 billion of foreign reserves. A central banker wouldn't do that unless he was sure that speculators had learned their lesson. George Soros and the like shouldn't even bother.

Drop the Peg

Yet there comes a time when economic strategies outlive their usefulness. Inflation trends in Hong Kong leave little doubt the city needs to retake control of its monetary policy. Consumer prices accelerated to 6.3 percent in July, more than triple the 2 percent pace for all of 2007.

The timing is problematic. A slowdown in the U.S., Europe and Japan will put a drag on an economy that's highly dependent on external trade and financial services for growth. Officials in Beijing, meanwhile, are trying to find a balance between rapid growth and cooling inflation.

Speculators won't force a change in the peg. It's a political decision that will have as much to do with Beijing as Hong Kong policy makers. The city's leader is named by China. Yet looking at what's unfolding in the U.S., does Hong Kong really want to be at the whim of the Federal Reserve in the waning days of George W. Bush's presidency?

Economic Risks

The Fed's next move will probably be to raise interest rates. If the opposite is true and the Fed cuts the federal funds rate to less than 2 percent, Hong Kong's problems will get worse.

As a former finance secretary, Tsang must be well aware of the risks. The economy is just part of Tsang's woes. His administration has been accused of lacking transparency in appointing highly paid political assistants, confusion over foreign-maid levies and other issues.

Accelerating inflation dovetails with slowing growth, falling stocks and a wobbly property market. The benchmark Hang Seng Index is down 27 percent this year, roughly double the loss in the Dow Jones Industrial Average.

Hong Kong is hardly in recessionary territory. It grew 4.2 percent in the second quarter, yet that was the slowest pace in almost five years.

Election Issues

Such conditions should aid pro-democracy legislators in the Sept. 7 election. That may not be the case, though, and the recently concluded Beijing Olympics help explain why. The success of the games, and a resulting boost in China-region nationalism, may do more to help pro-Beijing parties in Hong Kong.

The feel-good factor was reinforced by a well-timed publicity tour of Hong Kong by Chinese Olympic gold medalists. China also managed to take some air out of the pro-democracy movement by saying last year that the process of allowing Hong Kong's citizens to elect their own leaders will begin by 2017.

Of course, Hong Kong also holds off the pro-democracy movement by creating jobs and raising living standards. Over time, inflation may pose problems that are only compounded by a lack of monetary-policy independence. Hong Kong should be tightening credit. Instead, it's stuck with a Fed set on saving Wall Street from ruin with low rates.

So are Persian Gulf economies. Last month, the International Monetary Fund said Saudi Arabia should drop its dollar peg and consider ``alternative exchange-rate regimes'' if inflation persists. States such as the United Arab Emirates have faced calls by economists to scrap its currency peg.

There's no doubt the peg promotes stability. It's that kind of surety that is encouraging Wal-Mart Stores Inc. to set up its Asian headquarters in Hong Kong. Clearly, officials in Hong Kong don't want a change in currency policy to affect perceptions about the economic climate.

Yet the peg has been the cause of many problems in Hong Kong. Early this decade, an overvalued currency caused deflation and worsened employment conditions. Now an undervalued dollar is boosting inflation. Knowing that may only perk the interest of Soros and his ilk.

It's hard to argue the peg didn't serve its purpose. It's harder to argue the policy should stay.

(William Pesek is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: William Pesek in Hong Kong at wpesek@bloomberg.net

Last Updated: September 4, 2008 15:01 EDT