I. Curbing Speculation

The major refining measure to the Linked Exchange Rate system is the introduction of strong-side convertibility undertaking at 7.75. This clarifies the intervening level by the HKMA and would help stabilize market expectations, curbing speculation on HKD appreciation.

In addition to targeting H shares or domestic enterprises that would benefit from RMB revaluation, anticipation of a simultaneous appreciation of the HKD has also been a major incentive for the massive fund inflows during the past year or so. The massive inflow of funds resulted in the divergence of local and U.S. interest rates. Low interest rates contribute to the boom in domestic real estate and property markets, enhancing the risks of creating "bubbles". The HKMA's measures, hence, would curb speculation and mitigate such risks, favorable for the healthy development of the domestic economy.

Rising interest rates amid outflow of funds would inevitably cause near-term shocks. This, nonetheless, should be surmountable, with the economy still on the up trend and little "bubble" element created so far. So long as the economy keeps growing normally, increase in personal income and corporate profits should be able to offset the negative impact of rate hike.

Being put forward at a time when anticipation of RMB revaluation still lingers, the HKMA's refining measures are bound to be conjectured as accommodating the reform of the Mainland currency system. Though ensuring the stability of the HKD, the measures fuel further expectations of imminent RMB revaluation, as evidenced by the divergent performance of HKD futures and RMB NDF. Potential speculation on HKD appreciation cannot be ruled out. Judging from this perspective, the RMB issue remains the crux to the effectiveness of the HKMA's measures as well as the prospect of the HKD's Linked Exchange Rate system.

II. Limited Impact from the RMB

Currently, the relationship between the RMB and the HKD's Linked Rate system focuses on two areas. Firstly, there should be no imminent adjustment to the RMB system. Otherwise, this would not only confirm the speculators' actions, but also seem to validate the doubts about the HKMA's measures to accommodate RMB revaluation, thereby shrinking the confidence on the independence of the HKD. Secondly, the persistence of significant revaluation pressure on the RMB would have profound implications on the sustainability of the "upper bound" of the HKD and the necessity of further adjustments to the HKD Linked Exchange Rate system, and hence its vulnerability to speculations in future. Therefore, it is crucial to assess the RMB factor.

1. Exaggerations to the Urgency of RMB Reform

Currently, the market seems to have assumed that RMB revaluation has been on schedule. However, though reform should be the correct way forward, it is necessary to discern its direction and urgency. The urgency, judging from both internal and external environment, has certainly been exaggerated. Current problems in the Chinese economy range from overheating in specific sectors, disturbance of exploding FX reserves on monetary policy, inflationary pressure aggravated by rising oil prices, increasing political pressure from the U.S., etc. Specifically, the overheating is mainly attributable to over-investment, which is more related to the economic system, particularly the role of government. The exchange rate plays only little role. Inflationary pressure is also concentrated in the domestic economy, mainly from food and property prices as well as the upward pressure of some public products. Impact from international prices such as crude oil has not been significant. An inflexible exchange rate would certainly hamper the independence of central bank monetary policy. Yet, the major impediments to Mainland's monetary policy effectiveness mainly come from the "under-development" of the market. Exchange rate, again, should be secondary. As for the pressure from the U.S. or speculators, their impacts should be far more limited, for an independent, large but still not fully open economy like China.

Besides, among the various reform needs in the Mainland, the priority of exchange rate reform should be rather low. Reforms concerning the state enterprises, fiscal system, banking, capital market as well as social security is all essential to the healthy and stable development of the Chinese economy. Some of them are even under the most crucial and difficult stage. Importance of exchange rate reform, which only affects the external economy, is not comparable. There is no evidence that the above reforms are being hindering by the exchange rate system. On the contrary, reforming the latter may bring about unanticipated consequences to the overall economy.

2. Politics and Speculation has become the focus

In addition to the preparatory works in exchange rate reform, market speculation and international pressure, especially from the U.S., have given rise to the expectation of an imminent RMB revaluation. However, the pressure from the U.S. is mainly a political gesture. Since Sino-U.S. trade is actually complementary in nature, the U.S. would probably not expect the revaluation of RMB to resolve their employment and trade imbalance problems. On China's part, as exchange rate reform is not that urgent, the major agenda would thus be dealing with overseas political pressure and combating speculation. In fact, political factor and speculation have lowered the possibility of imminent RMB appreciation.

3. Limited RMB revaluation room, devaluation pressure may emerge

RMB revaluation expectation only reflects part of the economic scene in China, mainly the rapid growth and international account surplus. At the same time, there exist problems associated with the growth mechanism, structure and economic system. These would add to the uncertainty of long-term economic development, and thus also for the RMB. Firstly, the quality of RMB assets remains worrisome. Besides the banks' NPL, hidden fiscal deficits should not be overlooked. A recent report from the Department of Commerce pointed to the issue. According to the report, the NPL of China's banking system totaled RMB 1.56 trillion, the potential liability to settle retirement social security payment reached RMB2 trillion, much higher than the currently estimated RMB500 billion. These are potential defects to confidence on the RMB.

On the other hand, relatively low prices in the Mainland would probably be unsustainable in the long-term. While a low price level forms the fundamental support to a strong RMB, it is related to imperfect economic system and markets. For example, amid the lack of environmental protection and social security for the working class, prices fail to reflect these costs. In other words, the Mainland's economic costs or prices have failed to reflect the actual costs fully, leaving part of them as implicit environmental or social costs. Hence, alongside the creation of price advantages, hidden problems in resources utilization, environmental protection and social stability have been brought about. This is certainly unsustainable in the long-term and would be corrected through future reforms. Along with the improvement in environmental protection, resources management and social security, costs of factors of production as well as commodities would increase, implying the reduction of purchasing power of the RMB. Therefore, chances for significant RMB revaluation should be slim, while the pressure to devalue could even emerge in future.

Judging from the above, it can be seen that though the RMB issue remains an important variable to the HKD's peg, the pressure mainly comes from market speculation. An imminent RMB revaluation is unlikely. Even though China's exchange rate reform could take place, the flexibility added should be relatively small and there will be a long way before free float can be achieved. In the medium run, there is still no basis for sustained and significant RMB revaluation. Thus under normal circumstances, the RMB issue should not result in substantial shocks on Hong Kong's Linked Exchange Rate system.

III. The HKD will not be a persistent "proxy"

The study on the Linked Exchange Rate system and speculation against the HKD would call for the consideration of a more in-depth issue - how the HKD should better reflect the China factor and whether it should be ultimately linked to the RMB. The issue can be viewed from two angles. Firstly, the US economy is arguably more stable than the Chinese economy, which is currently under transformation. Its international influence will be difficult to replace even in the very long run. There is no reason to consider adjustment the link currency. Secondly, with globalization and China's further opening, economic interaction will deepen between these two economies, possibly leading to convergence of economic cycles. Consequently, divergence of their interest rates and exchange rates movements could diminish, and the dilemma of the two currencies moving in opposite direction currently faced by Hong Kong could end naturally.

It seems unnecessary to worry too much about the impact of RMB on Hong Kong's pegged rate. Worthier of attention is the future status of Hong Kong as well as its currency. Apart from Hong Kong's economic fundamentals, an important reason for hot money chasing the HKD in recent years has been the imperfect and relatively closed Chinese domestic markets. The HKD has become the "proxy" of RMB assets. Nevertheless, it is a matter of time such role will fade. Eventually, China would reform and its markets would become completely open, and foreign investors will no longer target the HKD as a proxy for the RMB. In the absence of such demands, Hong Kong will face her real challenges, i.e. how to maintain the intermediation role between China and the world. Therefore, the focus should be shifted from speculating on the RMB to Hong Kong's economic transformation, which hinges upon continuing to provide unique services and retaining competitiveness amid China's further opening and development. Curbing speculation, the recent refining measures by the HKMA would help Hong Kong refocus on this key issue.