The appreciation and the Peg

In January 2007, the RMB broke the 1:1 all important psychological level against the Hong Kong dollar, marking a reversal of the purchasing power of the two currencies. This is because on one hand it continues to appreciate against the USD, but on the other hand, the HKD is confined to a trading band of 7.75 to 7.85 against the USD by the measures introduced to strengthen the Currency Board System.

On July 21, 2005, the RMB de-pegged from the US dollar and adopted a managed float against a basket of currencies. Meanwhile, it was revalued by a one-off 2.0% against the USD to 8.1100. Since then, it continued to climb higher and reached 8.0702 against the USD by year-end. Within the next thirteen months till January this year, it has appreciated further by 3.7% against the USD and reached 7.7744 or close to the thirteen year high. Before the overnight exchange rate reform in 1994, the official RMB exchange rate was indeed much higher either against the USD or HKD than today's. And in the foreseeable future, it is rather transparent and foreseeable that the RMB will continue its gradual and modest appreciation (3-5% per year) against the USD. But meanwhile, the HKD must observe the 7.75-7.85 trading band against the USD according to the measures introduced by the HKMA in May 2005. This implies that the maximum volatility of the HKD-USD exchange rate is 1.3%. Thus it is simply a matter of time when the RMB breaks parity with the HKD.

In the past two weeks, the HKD showed weakness unseen in seventeen years and diverged from the ever stronger RMB. Against the USD, it slumped below 7.80 to 7.8123 instead of pushing toward the 7.75 strong side of convertibility undertaking. The last time when 7.80 was breached was in early 1990 when the Tiananmen Square incident and the Gulf War was causing concerns. In this regard, the divergence between the HKD and the RMB seems rather unusual.

Market indicators suggest that due to capital inflows, discounts of short term Hibor to Libor widened to more than 140bp in the second week of the New Year, greater than the 1.3% maximum volatility of the HKD against the USD allowed by the Peg. Such discounts triggered interest rate arbitrage trades dictated by the automatic stabilization mechanism of HKD selling and USD buying, resulting in rebounding Hibor and weakening HKD. But since there is still some distance before 7.85, the weak side of the convertibility undertaking, is threatened, the integrity of the Peg was maintained albeit there were some psychological impacts.

The interest rate arbitrages are based on confidence that the Peg will hold and that the HKD will not fluctuate beyond 1.3% against the USD. Yet there is one theory that suggests exactly the opposite. It speculates that due to the market's lack of confidence in the Peg, and that the HKD will rise along with the RMB and breach the 7.75 upper limit of the convertibility undertaking, the HKMA is forced to intervene directly or indirectly to create divergence between the two currencies and defuse any lingering doubts about the Peg. But statistics do not support such a claim as the aggregate balance in the banking system has remained unchanged at HKD1.2bn for quite a while. The HKMA also comes clear of remaining at the sideline even though there is room for intervention. Thus it remains purely speculation.

The different explanations to the HKD and RMB divergence should not be confused with the smooth operation of the Currency Board System under continuous RMB appreciation pressure. The Peg aims at stable HKD-USD exchange rate no matter how volatile the USD gets against other currencies. Even with further integration of Hong Kong and China's economies and financial markets, it is premature to talk about linking the HKD to the RMB because the RMB is not a convertible currency yet. When it becomes convertible, it will still take much time and effort to rival the USD as the preferred currency in international trade, clearing the settlement. And the decision of linking is still Hong Kong's to make once it overtakes the USD. The misunderstandings and speculations about the Peg under RMB appreciation is exactly what the Peg wants to avoid.

The appreciation and Hong Kong economy

An appreciating RMB will impact the Hong Kong economy in direct and indirect ways. Indirectly, it spurs capital inflows into Hong Kong, drives down local interest rates, creates an accommodative monetary environment and yields substantial wealth effects from a surging stock market when economic and corporate profit growths are still robust. Accordingly, domestic investment and consumption are boosted when the stock market rises for a fourth consecutive year, shifting the main growth impetus inward and augmenting the sustainability of rapid growth.

However, it must be pointed out that the appreciation expectation may not be the most important driver for inflows, let alone the only driver. Hong Kong has limited RMB denominated assets. The giant Mainland enterprises IPOs and other H share and red chip companies are priced in Hong Kong dollar. International capitals are chasing China's high growth story and the premiums embedded in Chinese shares due to the RMB appreciation. Rational analysis shows that the appreciation may even be detrimental to some lower value added export enterprises, import replacement enterprises, or commercial banks holding large foreign currency positions, etc. And most Asian emerging market currencies appreciate more against the USD than the RMB. In this regard, it is primarily capital gains that international investors are after the Chinese shares. The RMB appreciation is regularly used as an excuse for funds to enter Hong Kong.

No matter what the real motives are, the result of the inflows is a very accommodative monetary environment in Hong Kong, with M2 and total deposits surging by more than twenty percent, the fastest pace since 1997. M1 even surges 53.8%. Such money creation is very similar to the Mainland's, which spurs stock market frenzy. Hong Kong banks cut lending rates independent of the US Fed in November last year when interbank rates were depressed.

As a result, Hong Kong stocks rose in 2006 for the fourth consecutive year by 34%. Turnover also set records. The wealth effects from the stock market more than make up for the flat property market. Accordingly, investment grew by 8.5% in the first three quarters last year, outpacing consumption's 4.7% growth and boosting the GDP growth to 6.8%. Combined, domestic consumption and investment accounted for two thirds of the growth impetus, overtaking exports. Going forward, even though the trade sector may be affected by exchange rate volatility, the impacts on the overall growth could be reduced, making growth more stable.

Directly, the appreciation affects the trade sector. But since Hong Kong's domestic exports to the Mainland account for only 1.6% of Hong Kong's total exports nowadays, the impacts from the exchange rate change on direct trades between Hong Kong and the Mainland is deemed marginal. As for re-exports, because the Mainland remains our primary destination (accounting for 48% of the total re-exports), there will be offsets in re-exports to and from China. Thus it can be argued that the impacts from modest RMB appreciation on goods trade could be neutral at best.

It is the services trade that benefits the most as visiting Mainland tourists have their purchasing power bolstered, Hong Kong consumers become more inclined to stay in the home market, and our trade, logistics, transportation and financial services become more competitive with the exchange rate change.

The appreciation and Hong Kong businesses in the Mainland

But there are negative impacts from the RMB appreciation on Hong Kong manufacturers in the Mainland who engage in labor intensive processing trade with low gross margins such as clothing, electronics, toys and shoes, etc. Moreover, more stringent policy changes in export rebates, unification of tax rates, minimum wage hikes, environmental protection and energy saving have to be met. If these manufacturers have to cease operation due to inability to adapt or upgrade, it will not only deal a blow to demands for Hong Kong's production services, but will also interrupt the repatriation of investment and consumption funds.

Besides business transformations, there are retail and OTC RMB NDF contracts available in Hong Kong for hedging the RMB appreciation. However, these contracts are fully priced for the RMB's modest 3-5% appreciation a year given its rather transparent and foreseeable gradual and modest appreciation potential. For example, the outright quotes for one year NDF contract for RMB was 7.3710/7.3760 on February 1, 2007, implying a potential 4.9% appreciation within the timeframe when compared to the spot rate of 7.7585/7.7595. Thus the pricing of the hedge is deemed rich unless the actual appreciation exceeds expectations.

For many years, the HKD has been pegged to the USD and so was the RMB until the exchange rate reform in 2005, meaning little exchange risk over those years. But the trend is for the RMB to have more flexibility and greater volatility. It is in this regard that not only the Mainland enterprises and individuals will have to learn to deal with rising exchange risk, so will Hong Kong and Hong Kong businesses in the Mainland. China's decision to control the pace of appreciation buys time for the learning process. But the outcome is inevitable. Hong Kong is an enthusiastic follower of the free market doctrine, and its enterprises and individuals are believed to be able to adapt quickly to this new challenge.

The appreciation and imported inflation

Imported inflation is another concern as Hong Kong imports substantial amounts of food and consumer products from China. In CCPI, food component accounts for 26.94% of the basket, second to housing's 29.17%. As about seventy percent of Hong Kong's food is imported from the Mainland, the 3-5% potential rise of the RMB in a year could propel the CCPI by an extra 0.6-1.0% if being fully transferred to consumers.

But such calculations may overestimate the real impacts on imported inflation due to competition and offset effects. In 2006 when the RMB appreciated by 3.6% against the HKD, Hong Kong's average consumer inflation was 2.0%, accelerating by a full percentage point from the previous year. But it was driven mainly by domestic factors such as rental and miscellaneous services prices. Other categories' prices including food actually decelerated.

Toward the end of last year, Hong Kong's unit import price index from China rose 2.2%, reflecting both the exchange rate change and China's domestic price change. But this was half of the CCPI housing index's 4.7% increase, which has a greater weight in calculating the overall consumer inflation. Thus, the conclusion is still that Hong Kong's inflation is primarily made in Hong Kong.

Nonetheless, as Hong Kong imports about seventy percent of its food from the Mainland, and food makes up the largest proportion of expenditures by lower income households, there are works to be done in order to forge close cooperation between Hong Kong and the Mainland to secure stable food supplies and safety. This should help minimize food price volatility caused by factors other than exchange rate in the pursuit of social harmony.