Positive Short Term Impacts

Before the RMB move, the Hong Kong Monetary Authority promptly introduced three new measures to help fend off speculations that the HKD's Peg might face after the RMB reform. As a result, the HKD only rallied briefly and then settles at around 7.7700, well within its trading band. Its one-year forward discount also narrowed from 445pips to 250pips. And the inter-bank liquidity still stood at HKD1.2bn. The Linked Exchange Rate has seemingly sailed through the RMB's major reform effortlessly. The success owes both to the HKMA's three new measures gaining credibility in the FX market, thereby smoothing the HKD's volatility, and China's success in managing and guiding market expectations.

If there are still expectations left about the HKD's valuation, they are believed to be on the upside toward the upper limit of the trading band. In this regard, the pressure on the Linked Exchange Rate is markedly smaller than that of the Asian Financial Crisis, making the defense much easier. Last time when de-link and devaluation pressure mounted, massive selling of the HKD and related assets pushed Hong Kong's interest rates higher. And capital fights ate into our foreign reserves. Hong Kong paid heavy prices for defending the Peg. But this time, the opposite happens and Hong Kong benefits in general. The HKMA's measures limited the HKD's appreciation and discouraged currency speculations. The open market operation also makes the defense easier without inflicting the same pains.

Most importantly, the measures help bring Hong Kong's interest rate cycle in line with that of the US, putting an end to the unusually low interest rate environment that prevailed in the past one and a half years, and deflating the potential asset bubbles that massive capital inflows might produce. The synchronization of the US and Hong Kong's economic cycles this time is a sound reason for synchronization of the rate hike cycles. Looking back, the outbreak of the Asian Financial Crisis sent Hong Kong into recession in 1998, when interest rate cuts could be a timely cure. But in the US, efforts to cool the economy and stock markets resulted in six rate hikes starting in June 1999, totaling 175bp. The divergence in economic growth as well as necessary rate actions in both economies ended up with Hong Kong having to raise rates along as required by the Linked Exchange Rate System, prolonging the pain of deflation. Fortunately, this scenario will not happen this time.

During the crisis, Asian currencies plunged against the USD. The HKD pegging to the USD means that macro adjustments in Hong Kong has to take place outside the HKD, namely in asset prices including stocks, properties, and commodities. The five-year and eight-month long deflation was originated from there. On the contrary, the RMB gaining flexibility empowers Asian currencies to pursue currency revaluations to some extent without losing competitiveness. Thus, the HKD depreciates not only against the RMB but also against other competitors' currencies. If adjustments are warranted, they will take place in the form of asset price appreciation, the exact opposite to before. Since July 21, the Hang Seng Index rallied 5.7% till August 12 and the Centa-City Leading Index for residential properties rose 0.2% till August 7 despite series of rate hikes in Hong Kong. These could be partially traced back to the Peg's mechanism. As long as there are still expectations about further RMB revaluation, Hong Kong could continue to experience rising interest rates but steady asset prices.

Further Impacts are Difficult to Predict

In the medium to long run, the impacts of RMB reform on the Linked Exchange Rate will depend on the prevailing fundamentals as well as the market conditions. According to the IMF, some 139 countries, most of them small, moved from fixed to flexible exchange rates between 1990 and 2002. But well over half of the switches were delicately categorized as disorderly, i.e. under economic or financial crises. This is a testimony to the RMB reform's smoothness and success, and further highlights the uniqueness of the HKD's Peg. As the only Linked Exchange Rate System left in Asia, the HKD's Peg will become vulnerable to speculative attacks if our economic fundamentals and the value of HKD are disjointed.

Shortly after the reform, China introduced RMB forwards and swaps trading, providing the necessary tools to manage exchange rate risk. This implies that the RMB could gain further flexibility against the USD, and it could trade either up or down with wider fluctuations. Moreover, Asian currencies could rise or fall against the USD, making the HKD's relative value increase or decrease by significant margins over an extended period of time. If the extremes take place, the HKD could become grossly under or overvalue and vulnerable to speculative attacks.

In the case of undervaluation, heavy bets could pile on its upside. Even though the HKMA has unmistakably pledged to limit the HKD's rise to 7.75, speculators may not believe it could hold and continue to accumulate the HKD to bet on further revaluation. This could also test our Peg System. In the past one and a half years, similar operations were abundant in Hong Kong. Whether such pressure on the Peg could be neutralized depends on the degree of HKD undervaluation, the degree of resulting imbalance in the Hong Kong economy, and the credibility of the HKMA's policy and intervention.

The RMB's initial appreciation of 2.1% against the USD was moderate at best. Even if China permits, the RMB's further upside should be limited in order to maintain growth. Asian currencies should fare more or less the same. Therefore, the HKD should not reach the level of grave undervaluation. The risks of massive capital inflows, ensuing asset bubbles, overheating economy and surging inflation are still minor. And the normalization of interest rates should further damp such extremes. The prolonged USD decline since early 2002 has resulted in twenty to thirty percent or more in cumulative devaluation against major European currencies, even after considering the recent rebound. But at the same time, Asian countries have worked hard to depress their own currencies' gains to maintain export competitiveness. Consequently, their rise against the dollar was only half of their European counterparts. Take the Singaporean dollar as an example, it is currently trading at HKD4.7. When compared to the HKD4.2 level recorded in early 2002, although one could say that the HKD has devaluated by about 10% against the SGD in three year, it is still a long way from the HKD5.5 level reached prior to the Asian Financial Crisis when the HKD was super competitive. In this case, the HKD is not grossly undervalued against Asian currencies, and the pressure should be handled easily.

Also, the HKMA's three new measures combined with the normalization of Hong Kong interest rates should help limit the risks of economic overheating, surging inflation and assets bubbles.

Another extreme will be the devaluation pressure similar to that of the Asian Financial Crisis and Hong Kong dollar crisis when massive capital fights brought speculative attacks on the Peg. The triggers to such a scenario could include large-scale cross border capitals retreat from Asia, the bursting of Hong Kong asset bubbles, and grave overvaluation of the HKD. However, post crisis reforms in Asia have successfully limited the chance of another widespread economic and financial crisis. Although Hong Kong stock and property markets have accumulated hefty gains, they are not believed to have bubbles yet. The HKD nominal and real effective exchange rate indices are also a long way from their respective 1997 or 2002 heights. Therefore, the HKD is far from overvalued. The threat against the Peg is arguably the lowest since the handover.

The Debate on the Peg's Fate

As the RMB is moving toward becoming a convertible and free floating currency, Hong Kong must consider what to do with the Peg once that is achieved. A popular argument states that after the RMB becomes convertible and free floating, Hong Kong should somehow link the HKD to RMB due to further economic and financial integration. By then, China will become the most influential force to our economy and dominate our economic cycle, replacing the US. Therefore, the HKD should peg to the RMB instead of the USD, or peg to a basket of currencies dominated by the RMB, or Hong Kong should simply replace the HKD with the RMB. This argument has a point, and the scenarios it foresees could well be the actual development trend. However, there are more to be considered when it comes to decide whether to change the HKD's Linked Exchange Rate System.

History tells us that the Peg has experienced ups and downs in its twenty plus years of implementation since October 17, 1983. The greatest pressure of de-link and devaluation came during the 1997-1998 Asian Financial Crisis and Hong Kong dollar crisis, and the greatest pressure of de-link and revaluation came in the past one and a half years derived from speculations on the RMB appreciation. It has survived each crisis even though the prices we paid were sometimes heavy. Each time, lessons are learnt and measures are taken to reinforce and perfect the system further. Thus it can arguably withstand the same pressure much easier today. And more works are still underway to continue to improve it well into the future. Stable exchange rate is Hong Kong's primary choice, even though it means there is no independent interest rate policy, and economic imbalance has to be addressed by asset prices fluctuations. It is the foundation behind Hong Kong's success. This choice dictates that no matter what happens externally, the HKD remains stable against the USD. In this regard, even with a convertible and floating RMB, the HKD's Linked Exchange Rate can remain unchanged.

Macau's experience serves as a good reference. Before the liberalization of gambling, Macau's economy relied heavily on Hong Kong, and the HKD circulation in Macau exceeded that of the Macau dollar. Yet Macau chooses to maintain its own currency, basically creating a twin currency regime. As the RMB becomes convertible and China's economy grows further, it is conceivable that the RMB circulation in Hong Kong may overtake the HKD. But like Macau, as long as Hong Kong chooses to retain the HKD, it is possible for both currencies to coexist. The market force of the RMB trying to drive out the HKD will test the administrative resolve to maintain the HKD's Linked Exchange Rate. There is no way of telling the end result of this battle for certain.

When Hong Kong chooses to peg the HKD against the USD, it knew the tradeoffs. Yet there are more to consider than the prices to pay. In the foreseeable future, the US shall remain the largest economy in the world and the USD still the primary reserve currency in the world. China and the RMB simply will not be able to replace them. Before this landscape is fundamentally altered, Hong Kong's decision to link itself to the US economy and the USD still makes a lot of sense. Besides, a Linked Exchange Rate System places strict requirements on a government fiscal discipline. Nowadays, Hong Kong society is very vocal about the Government fiscal policy, the Government is not burdened by large foreign debt, and it possesses large amount of fiscal reserves. All these can be traced back to the requirements of the Linked Exchange Rate System. The consequences of tinkling with the currency regime on government fiscal disciplines have to be carefully considered. Moreover, Hong Kong needs to maintain its uniqueness. As China is closing the development gap between Hong Kong, the only way for us to avoid being marginalized is to maintain and leverage on our advantages. Our long term and irreplaceable advantages lie in our high degree of internationalization and economic freedom. No matter how well China is developed, Hong Kong remains its best gateway to the world. The HKD's Linked Exchange Rate System could be a symbol of our internationalization and economic freedom. We must therefore carefully study whether pegging to the RMB or adopting the RMB could transform Hong Kong to merely a city of China in the eyes of international investors, and whether Hong Kong's advantages could still be showcased before making any decisions.

Fortunately, the direction and pace of the RMB reforms are becoming more transparent, and Hong Kong has sufficient time to study the impacts and makes necessary preparations. The initiatives of whether to change the Peg or not lie firmly in the hands of Hong Kong. As most of the changes to fixed exchange rate regimes were forced and paid with heavy price, China's reform was proactive and successful. Hong Kong's Linked Exchange Rate System will continue to face such a dilemma. That is the rationales to proactively make the change are not sound enough. But if the change is forced, the price could be heavy. Advanced studies must be carried out on all aspects involved.