Hong Kong May Drop Its Dollar Peg for Yuan Within Two Years, Barclays Says

Hong Kong is likely to ditch its currency peg to the U.S. dollar within two years in favor of a link to the yuan, according to Peter Redward, head of Emerging Asia research at Barclays Plc.

“It could happen quite quickly given the very rapid rise in the circulation of the currency here,” he said today at FinanceAsia’s ‘RMB Rising’ conference in Hong Kong. “We’re probably looking at a 12-to-24 month horizon. Probably not less than 12 months, but I think it could happen sooner than people think.”

The city’s currency has been kept at about HK$7.80 versus the greenback since 1983 and from 2005 allowed to trade up to five cents either side of that level. The yuan has strengthened 24 percent to 6.6616 per dollar since China scrapped a peg in July 2005. Hong Kong’s dollar was little changed at HK$7.7585 as of 4:20 p.m. local time and 12-month forwards were also steady at HK$7.7396, reflecting bets for a 0.2 percent appreciation.

China has ruled Hong Kong since July 1, 1997 and the mainland is the biggest source of visitors to the city and No. 1 trading partner. Yuan deposits in Hong Kong more than doubled to a record 130 billion yuan ($20 billion) in the first eight months of 2010, according to Hong Kong Monetary Authority data, and China’s currency is increasingly being used for cross-border trade and fund raising.

“Watch the volatility,” according to Redward. “When the volatility starts moving that’s the markets telling you something is going on.”

Rising Volatility

One-year implied volatility on the city’s currency, a measure of price swings cited by traders when pricing options, has climbed 0.45 percentage point this month to this year’s high of 1.18 percent. It’s poised for the biggest monthly increase since October 2008. Still, the measure is below the average 1.26 percent reading for the past decade.

Hong Kong’s existing currency peg ties its monetary policy to that of the U.S., which has adopted near-zero interest rates to sustain economic growth following the global financial crisis. Cheap borrowing costs are driving asset prices higher in the city and HKMA Chief Executive Norman Chan said Oct. 18 that a housing bubble poses the biggest threat to financial stability in Asia.

Chan took office in October 2009 and pledged to maintain the city’s fixed exchange rate.

Basic Law

Tim Condon, ING Groep NV’s chief Asia economist, said five years to 10 years is a more realistic timeframe for Hong Kong to link its exchange rate to the yuan, because such a shift can’t happen until China’s currency is fully convertible.

“As I understand it, the Basic Law requires that the Hong Kong dollar has to be linked to a convertible currency,” Singapore-based Condon said at the conference today. “That requires that the yuan become convertible and I think that one to two years seems to be a little bit on the quick side for that process to take place.”

Silver dollars were used as legal tender in Hong Kong until 1935, after which the local currency was fixed to the British pound until 1972 and then U.S. dollars for the following two years, according to the HKMA’s Web site. After 1974 and until 1983 the city allowed its currency to float.

To contact the reporter on this story: Shelley Smith in Hong Kong at ssmith118@bloomberg.net

To contact the editor responsible for this story: James Regan at jregan19@bloomberg.net

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