Hong Kong Dollar Peg: The Root of All Evil21 October, 2010, 10:52. Posted by Zarathustra
Tags: Hong Kong, Hong Kong Monetary Authority, Joseph Yam, Norman Chan
Some years ago, I wrote this article to call for abolishment of the Hong Kong Dollar currency peg with the US dollar.
Now the problem of property bubble brings us to the problem of currency peg again, whether it is something good for Hong Kong people at large. Although Joseph Yam has retired from the Hong Kong Monetary Authority, the incumbent Norman Chan is no difference. The Hong Kong Monetary Authority looks increasingly like the British Civil Service, and if Norman Chan were to defend the currency peg, he would look increasingly like Sir Humphrey Appleby.
The Hong Kong Dollar Peg is the root of all evil, as the value of Hong Kong currency is still linked to the currency of an economy which bears less and less relationship with Hong Kong economy, meaning that Hong Kong is importing a monetary policy which is more and more irrelevant to the current situation in Hong Kong.
There are many people who have pointed that the US dollar weakness now per se is fuelling Hong Kong property bubble. But they have only get half the story right in my view: I have already written the argument that the Home Prices in Hong Kong are primarily driven by money supply, not anything else. The Hong Kong dollar peg is officially fixed at HK$7.80 to U$1, with a trading band of 7.75 to 7.85, which are so-called the guaranteed limits. To put the currency peg mechanism in simple terms, if the price of Hong Kong rose to HK$7.75 to US$1, the Hong Kong Monetary Authority will buy USD and sell HKD, creating more HKD money supply in order to restore the price back into allowed range.
Although a weak US dollar will have to mean a weak HK dollar, the situation in money supply terms is not as straight-forward. Although the currency peg is officially fixed at HK$7.80, Hong Kong dollar has rarely been traded at anything above HK$7.80, i.e. for most of the time, Hong Kong dollar has been consistently stronger than the official peg. Only if the Hong Kong dollar is on the strong side limit would Hong Kong Monetary Authority intervene by selling Hong Kong dollar, thereby increasing money supply. We can imagine a situation when US dollar is weak like now, but speculative outflow of HKD weaken the currency to HK$7.85 or below, then in that case the Hong Kong Monetary Authority will have to buy HKD, which essentially means tightening money supply.
So weak US dollar is not the full explanation. To me, the full explanation is that because of the quantitative easing in the United States as well as money from rick folks in China, there is a flood of money in the system. Thanks to the robust economic growth in Asia, Hong Kong included, all these people want to invest here. When they invest in Hong Kong, they have to convert whatever currencies they have into Hong Kong dollar in order to buy stocks or property in Hong Kong. This drives up demand of HKD, thus the price, so the Hong Kong Monetary Authority have to increase money supply to cope with the increase in price. This is how the money supply in Hong Kong increase, which fuelled the property bubble.
As capital flow is unpredictable, we can easily imagine a situation when money flow out of Hong Kong perhaps due to a local crisis or speculative attack on the currency. When investors or speculators sell Hong Kong dollar for whatever currencies they wish, this will create a downward pressure on Hong Kong dollar, so the Hong Kong Monetary Authority will have to intervene by buying Hong Kong dollar, which essentially tightening money supply. It should be noted that this can happen independent of the strength of USD. In other words, US dollar may be weak, but HK dollar can even be weaker.
The risk to the Hong Kong property market, and indeed the economy, is a sudden reversal in the overall trend of capital flow. If, for instance, the property bubbles in China go bust, Chinese investors might sell their stocks or property in Hong Kong to cash-in. Or if there are some major banking crisis in the US or Europe, investors and banks there would cash-in from Hong Kong. Cash-in in Hong Kong and repatriate funds away from Hong Kong will weaken Hong Kong dollar, which may trigger actions from the Hong Kong Monetary Authority to buy Hong Kong dollar, decreasing money supply.
So as we can see, the strengthen of US dollar is just half of the story. The key problem is that the nature of the peg, which makes monetary policy in Hong Kong inherently pro-cyclical, especially in extreme times.