Hong Kong would be an interesting front in a potential currency war between the US and China. The economy of the Special Administrative Region (SAR) has become increasingly dependent on mainland demand, but its monetary system is still firmly anchored to the US dollar. Underlying monetary arrangements imply that when and if China retaliates against pressure for the appreciation of the RMB or trade protectionism in the US, Hong Kong would be caught in the crossfire.
Where it comes to the real economy, Hong Kong’s fortunes are increasingly linked to the mainland: its manufacturing base is located across the border, in 2009 mainland tourists accounted for well over half of all arrivals and spending, exports to the mainland accounted for more than half of the total, mainland purchasers accounted for about one-fifth of real estate demand, and mainland firms accounted for more than half of total issuers and market capitalization in the Hang Seng. Mainland monetary and credit policy are thus of crucial importance for local financial markets and the financial services firms that are a pillar of Hong Kong’s services economy.
At the same time, Hong Kong remains “a vital testing ground for the liberalization of our nation’s national account”, to quote SAR chief executive Donald Tsang. Taking this statement a step or two further, Hong Kong’s economic future and the status of its capital markets depend as much, if not more on the pace and scale of capital account liberalization on the mainland as they do on US Federal Reserve monetary policy and the status of the US dollar. We expect that the Hong Kong dollar exchange rate will continue to function under a currency board for the indefinite future. However, a combination of shifting economic and political realities begs the question of when and how the Hong Kong may one day adopt the currency of its sovereign parent as the anchor for the SAR’s money supply.
Joseph Yam, now former head of the Hong Kong Monetary Authority (HKMA), has at times waxed to the local media about a day when the RMB circulates on the streets of Hong Kong as a unit of ordinary exchange. In certain cafes on Hong Kong Island and in the tourist traps in Kowloon Yam’s vision is already slowly becoming a reality. To date, institutional similarities between Hong Kong and the US, not to mention the paramount importance of free convertibility, have made the US dollar a suitable base for the SAR’s monetary system. However, on the economic side of the base currency equation, Hong Kong’s real economy is now clearly driven by the mainland, as are its financial markets. As growth prospects between China and the US diverge, the relative cost of the current currency board system in terms of the relative purchasing power of the Hong Kong dollar will rise. The HKMA have been good stewards of the SAR’s financial economy, but the future may hold political and economic reality that are entirely out of the hands of the SAR government.
A Legacy of Policy Credibility
Hong Kong has maintained what is perhaps the world’s most credible exchange rate peg – the Linked Exchange Rate System (LERs) with the US dollar – for more than 25 years. Globally, dozens of currency boards have broken down during this time. Since 1983 the Hong Kong dollar has been pegged to the US dollar under a rule-based currency board system that stipulates that Hong Kong’s monetary base must be completely backed by US dollars held by the monetary authorities. Hong Kong inherits US monetary as a result of the dollar peg, and historically there has been a natural correlation between interest rate and business cycles in the two economies. Assuming that currency and trade tensions between the US and China do not escalate too much further, there is no urgency behind any adjustment of the LER mechanism. They could, however, and as economic cycles between the SAR and Hong Kong continue to converge it will probably become increasingly uncomfortable for the HKMA and citizens of the SAR to remain sandwiched between two of the world’s dominant central banks.
Hong Kong’s economic structure is a natural fit for a pegged currency: a small, high income and highly open economy. On institutional grounds, the US dollar, even in 1983 and the early stages of its proliferation as the world’s reserve currency, was an obvious fit for the SAR. Then as now, the micro-economic benefits of reduced exchange rate uncertainty and lower average annual rates of inflation have outweighed the macro economic costs in the form of in the form of forgoing monetary independence and other traditional macro policy tools. Conservative fiscal management by the SAR government and reserve accumulation has sustained market confidence in the LERS system. This structure has endured Hong Kong’s return to the mainland and the gradual relocation of the SAR’s manufacturing base to Guangdong. More broadly Hong Kong’s growth story has been part and parcel to that of globalization and increased trade and financial links between the world’s major economies, perhaps most notably between the US and China. However, the reality today is that the relative contributions to global growth from these economic poles will be very different: China will continue to contribute a share of global growth far above its share of output, whereas the contribution to growth from the US will lag its global output share considerably.
Real Values and Welfare Gains
So far, capital account controls in the mainland have allowed authorities to prevent the normal tendency for rapid output, productivity and income growth to result in exchange rate appreciation. This cannot go on forever. As a historical window to China, Hong Kong has served as a pass through point for producer and consumer price differentials between China, the US and other major trading partners, with the Hong Kong dollar (and in reality local real wage levels) absorbing the difference. China effectively pegs to the US dollar on the downside, and manages the real appreciation of the RMB on the upside, both of which are trends that would be compatible with the trade competitiveness of a Hong Kong dollar more directly linked to the path of the RMB.
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The Hong Kong dollar is pegged to the currency of a mature sovereign while Hong Kong’s real economy is tied to a global out-performer. With this in mind, it is not surprising to observe that wage and productivity growth in Hong Kong began to diverge around 2002: employers in Hong Kong, especially in manufacturing and services sectors, were able to benefit from the rapid productivity growth and low wages on the mainland, while at the same time granting wage increases to Hong Kong staff more in line with output and inflation trends in the US.
Most of the literature on large adjustments to or regime transitions away from a pegged exchange rate focuses on predictable effects of real overvaluation: excessive borrowing, investment and consumption. On the flip-side of such a scenario, it is natural enough to imagine a scenario where persistent undervaluation would stifle domestic demand in reverse fashion: real purchasing power of local residents is depressed, making investment in domestically oriented sectors less profitable than externally oriented ones.
As noted above, we expect positives differentials to growth, consumer and producer price trends between China and the US to persist in the medium-term. From a welfare perspective, the crux of the issue then becomes the extent to which producers and consumers in Hong Kong may have to absorb these differences. It could well be the case that wage levels in the SAR remain effectively anchored to US productivity growth, while at the same time overall productivity growth in Hong Kong becomes increasingly tied to mainland per capita GDP growth, which is expected to grow at a multiple of the corresponding US rate. From a relative wealth perspective, the accumulated wealth of Hong Kong residents, as well as their future income flows, could potentially be worth more if they could follow the path of the Chinese economy and the RMB rather than being weighed down by the performance of the US economy.
One facet of the prevailing wisdom regarding the success of Asia’s export-led development model has been the fundamental proposition that over-valued exchange rates are bad for growth. However, the converse statement – that an undervalued exchange rate is beneficial for growth – may not necessarily fit a high-income services exporting economy, such as Hong Kong. That is to say that the undervaluation of the Hong Kong dollar means that the SAR is to some extent borrowing demand from elsewhere at the expense of the reduced wage levels and purchasing power of local SAR citizens.
Undervaluation has also meant that Hong Kong has been able to borrow purchasing power from mainland and European tourists. However, narrowing the purchasing power gap between the Hong Kong dollar and RMB via an adjustment to the exchange regime would not necessarily reduce incentives for mainland shoppers to splurge while visiting Hong Kong in the future: any appreciation of the RMB relative to other major world currencies would increase purchasing power for imported goods, like flashy watches and designer handbags. Additionally, the mainland authorities’ management of the RMB real exchange rate has meant that when the US dollar sinks in value relative to other major currencies, the RMB falls too. If the Hong Kong dollar were more closely aligned with the RMB the SAR would remain an attractive shopping destination for mainland tourists when the RMB strengthens. At the same time, when the US dollar weakens, authorities on the mainland would work to preserve the general competitiveness of the currency relative to the rest of the world, supporting Hong Kong’s exports.
Re-pegging the Hong Kong dollar to the RMB would be a potential means of hedging the negative wealth effects that would occur in Hong Kong if there were a US dollar crisis, for example. Additionally, in its own explanation of the potential consequences of such a one-off adjustment to the value of the Hong Kong dollar relative to the US dollar, for example, the HKMA acknowledges that this could alleviate the pain of the price and wage adjustments required to maintain the LER. For the time being, however, such a step would be counter to the overarching policy goals of stability and free convertibility. One practical matter – the relatively small scale of total RMB deposits in the Hong Kong banking sector – has been cited as a practical obstacle to the conversion to an RMB-based monetary system in the SAR. This argument is, in our opinion, rather spurious, as, for example, any country that has ever acceded to a currency union did not have to wait until it accumulated an adequate level of the right deposits or reserves in the financial system before they could transition towards new monetary arrangements. If the SAR and the mainland wanted to pull off such a conversion the infrastructure (not to mention political will) is adequate for this to be achieved swiftly and decisively provided there was adequate alignment between real economic cycles in the two regions.
Another oft cited intermediate option is the creation of a currency basket regime to guide the adjustment of the value of the Hong Kong dollar. Although such a mechanism would likely help to preserve the relative purchasing power of local wages – especially relative to the euro – it would not solve the underlying problem created by growth divergence between the mainland and the OECD, and greater convergence between the mainland and Hong Kong economies. Additionally, the removal of the US dollar anchor (or the absence of such an anchor, USD or RMB) would subject the Hong Kong dollar to new speculative pressures without a hard option for responding to them.
Numerous households and companies in Hong Kong have acquired assets on the Mainland, in part as a hedge against the long-run depreciation of the Hong Kong dollar relative to the RMB. The HKMA’s Exchange Fund, however, does not have the luxury of being able to hedge in favor of an appreciating RMB or against a large and sudden depreciation of the US dollar. So what if a real currency war broke out? Not one where countries intervene to hold down the relative values of the currencies, but one in the spirit of Lenin where countries try to overturn the “existing basis of society” by debauching the currencies of their rivals? In a grandiose act of magnanimity the mainland could offer to swap RMB for foreign currency assets of Hong Kong citizens, but this would leave it with even more unwanted foreign paper and could serve to strengthen, rather than weaken the US dollar. In the absence of some sort of engineered financial protection from the mainland, little Hong Kong (and for all of its sophistication and glamour, it is, after all, little), could be toast.
Curiously, demand for real assets in Hong Kong has been strongest from Mainland purchasers, serving as an indicator that the RMB is a long way from being a “safety play”. At the same time however, citizens of the SAR have been big buyers of real estate throughout China, and demand for RMB denominated insurance and other financial products in the SAR has been growing quickly. One has to distinguish, however, between the potential revaluation to assets in Hong Kong linked to the mainland associated with the appreciation of the RMB, and trends in household income in the SAR. For example, shares of companies whose core assets and operations are on the mainland but whose shares are listed in Hong Kong may benefit from a stronger RMB. A stronger RMB would also make property investments in Hong Kong relatively cheap for mainland buyers. However, as described above, household income flows (as opposed to stocks of financial or real assets) have not performed more like those in the US than those in the mainland in recent years.
In the longer-term, the mere question of increasing competition between Shanghai and Hong Kong implies that the regional financial hub of the future could be the one that provides the best RMB financial services at the lowest cost. To meet this challenge, economic policy makers in Hong Kong have proposed that the SAR can become an offshore RMB center, similar in function to the role that London plays as an offshore financial center for the US dollar. While this is a possible outcome that Beijing appears to be considering, it presupposes that the RMB will have become adequately convertible for capital account transactions (a large assumption), and that the flow of RMB transactions in Hong Kong’s capital markets will no longer be dependent on the preferences of regulators in Beijing. Frameworks to enable the growth of RMB securities business in Hong Kong are in place and local banks are staffing up ahead of this prospective market, but to date the deal flow has been sporadic.
Suppose for a minute that the RMB eventually becomes adequately convertible to create on or off-shore markets for RMB securities more successful than those for the yen, and that global issuers (including mainland ones) can freely choose the timing and location of their RMB deals. If these conditions are met, then the underlying rationale for the US dollar as the anchor for Hong Kong’s monetary system would be even more of a political determination than it is now.
As we have written elsewhere, thinking about currency wars and arrangements in simply economic terms is inadequate: there has to be some accounting for the underlying politics, which do not have to (and rarely do) follow strict economic logic. Hong Kong is and will be a highly useful laboratory for experiments related to the incremental liberalization of the RMB. When that utility is exhausted, however, it could well be the case that mainland authorities decide that ‘one country, two currencies’ has outlived its political usefulness.
Disclosure: No positions