Cut the cord.

Photographer: PHILIPPE LOPEZ/AFP/Getty Images

Hong Kong's Peg to Instability

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For years, any call for Hong Kong to scrap its peg to the U.S. dollar was deflected with a single word: stability. The city's monetary authority has consistently treated the 32-year-old link as the linchpin to the economy's international credibility. But with Chinese money now swamping the city, the opposite may be true.

China this week announced limits on mainland visitors to Hong Kong, who have been a longstanding source of tension in the city. But the flow of money from the mainland shows no sign of slowing. Politically-connected Chinese tycoons, who have a longstanding habit of squirreling their money abroad (the better to hide it from authorities in Beijing), are increasingly turning to Hong Kong's stock and property markets. As Louis-Vincent Gave of fund manager GaveKal puts it: "In its troubled marriage with China, it looks very much as if Hong Kong is about to get more money and less mainlanders."

And this is likely only to increase tensions in Hong Kong. Although last year's enormous protests in the city were presented in the international press as a call for democracy, they were as much about income inequality fueled by money from the mainland. As of 2011, Hong Kong’s Gini coefficient, a measure of inequality, was 0.537. That was the highest since record-keeping began in 1971 and puts Hong Kong well above the 0.4 level analysts associate with social unrest. 

It's no coincidence that record protests flared up at the same time as residential home prices surged by 13 percent. By the start of 2015, prices had more than doubled since 2009, spurred in part by money flowing in from China.

To their credit, locals officials tightened rules in February to keep homeownership from rising further out of the reach of local residents. But those efforts will likely soon be overwhelmed by tidal waves of mainland cash. It's safe to expect higher living costs in a city already plagued by a scandalous rich-poor divide.

If Hong Kong authorities want to cool down their overheating economy, they should start by addressing its undervalued currency. That's a key reason why Hong Kong's inflation is growing 4.6 percent compared with 1.4 percent in China and 0.4 percent in South Korea. It has also forced the Hong Kong Monetary Authority into an increasingly uncomfortable position. Since August, it has been forced to defend its conversation rate to the U.S. currency by selling off massive amounts of Hong Kong dollars.

But those efforts have allowed mainlanders to get a cheaper conversion rate than if the Hong Kong dollar traded freely. Unsurprisingly, they’ve been rushing to take advantage of it, by pouring more money into the city.

Hong Kong's peg, in other words, has outlived its usefulness. But Hong Kong authorities have been reluctant to scrap the peg, because they see it as the source of their credibility with western investors. Chinese President Xi Jinping -- who has ultimate authority over Hong Kong -- might have his own reasons for feeling risk-averse, given the magnitude of economic challenges facing China at the moment.

But there are options available to Hong Kong short of a sudden abandonment of the dollar peg. The city could shift to a basket of currencies, like Singapore. Even better, it could begin laying the groundwork for a peg to the Chinese yuan. There would be important prerequisites, including China making the yuan more freely convertible. But if China is serious about its bid to internationalize the yuan, its economy will eventually need to become far more transparent anyway; a Hong Kong-yuan peg could spur that process along.

Hong Kong, for its part, would be far more stable if its peg to the dollar weren't acting as a transmission device for China's imbalances. Local residents may greet the news that there will be fewer mainland tourists in the years ahead, but they would do better to worry about the mainland money that's been visiting their shores.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Willie Pesek at wpesek@bloomberg.net

To contact the editor on this story:
Cameron Abadi at cabadi2@bloomberg.net