Why Hong Kong Won't Dump the Dollar

The Hong Kong currency's fixed peg to the greenback has contributed to the city's financial stability. Also, a renminbi peg isn't feasible yet

Is a speculative attack on the Hong Kong dollar looming? That's one of the more interesting questions in global finance right now, given the recent disclosure by Hong Kong's former financial secretary Antony Leung that back in 2002 the government seriously contemplated abolishing its currency peg to the U.S. dollar. On top of that, both Kuwait and Syria in recent weeks have dropped their currency pegs, thanks in large part to the weaker outlook for the U.S. dollar and economy at a time of big account and budget deficits.

So there is plenty of market chatter at the moment about the fate of Hong Kong's dollar peg which has been fixed at 7.80 to the greenback since 1983. Back then, it was introduced to stem capital flight caused by uncertainty over the former British colony's future. The Hong Kong Monetary Authority, which acts as a sort of central bank, spent billions for currency interventions to defend the peg during the Asia financial crisis a decade ago and says it has no intention of tampering with the peg now. Here's a quick overview of the situation:

What is the likelihood Hong Kong will abandon or adjust the peg anytime soon?

Almost zero, since there is little need to. Consider that back in 2002 when Leung and Tung Chee-hwa. then Hong Kong's chief executive, considered scrapping the peg, the local economy was in grim shape. Hong Kong property prices were plunging, deflation gripped the economy, and the government was running a budget deficit of $8.1 billion.

Flash forward five years to today: Property prices are buoyant, inflation is mild, and the government is expected to register a budget surplus of $7 billion this fiscal year. Furthermore, the currency can trade five Hong Kong cents on either side of the peg, i.e., between 7.75 and 7.85, but monetary authorities have always managed to keep trading within this band.

Has Hong Kong suffered economically from tying its currency to the changing fortunes of the U.S. dollar?

Though the Hong Kong economy took a hit during the Asian crisis when its defense of the peg caused several years of price deflation, in recent years the arrangement has worked fine. It's true that Hong Kong monetary authorities in theory must keep its interest rates in sync with the U.S. Federal Reserve, but the reality is that the cost of borrowing in both economies has diverged by as much as 150 basis points at times. So Hong Kong has more flexibility than is sometimes assumed to adjust its monetary policy to economic realities on the ground.

Wouldn't Hong Kong be better off pegging its currency to the Chinese renminbi?

It's true that China is Hong Kong biggest trading partner and the long-term outlook for the mainland economy is phenomenal. Yet the reality is that most of the international trade in goods and services is transacted in U.S. dollars. Also, any sort of renminbi peg for Hong Kong is technically impossible until China adopts a freely convertible currency and lifts its capital controls. That is probably many years away from happening.

How vulnerable is Hong Kong to a speculative attack on its currency now?

The Hong Kong Monetary Authority has about $136 billion in foreign reserves, roughly seven times the currency in circulation. Hong Kong successfully maintained the peg throughout the Asian financial crisis when the currency was arguably highly overvalued compared to other regional currencies. The fact that Hong Kong has so rigorously defended the peg for more than two decades is in itself a bulwark against rampant speculation.

What would happen if Hong Kong abandoned the peg?

One big advantage of the peg has been the relative certainty about the direction of the Hong Kong dollar, and that has made the former British territory a good financial center for the region. The virtual absence of currency risk has been one of Hong Kong's biggest selling points. Volatility in the exchange rate could lead to potential capital flight, and could push downward pressure on stocks and property prices.

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