Some speculative pressure on the HKD built up last Friday afternoon. 1-year HKD interest rate forward went up from around 160 to around 270 (implying that the 1-yr interest rate differential between the HKD and the USD has gone up from 25 basis points (bps) to 39bps points). Talks in the market suggest that the speculation was triggered by a hedge fund based in Singapore. The Fund took the view that HK's fiscal deficit would get worse and bet on a de-link of the HKD. This triggered short coverings and drove the forward premiums rapidly upwards. Market anxiety also drove RMB NDF (non-deliverable forward) premiums upwards. 3-mth RMB NDF rose from 99 to 175 on Friday.

This (Monday) morning, the 1-yr HKD interest rate forward was trading at around 260/280, while 3-mth RMB NDF was around 175.

It should be noted that speculative pressure centres on interest rate forwards only. The spot exchange rate of the HKD has remained stable, at around 7.7997/98.

It is very unlikely that Hong Kong would change the link any time in the foreseeable future

There have been rounds and rounds of discussions/debates about the HKD link locally over the years. But it is almost taken for granted by most people in HK that the link will stay in the foreseeable future. Antony Leung also reiterated in his Budget last Wednesday that "the government has no intention of making any change" to the currency link.

Antony Leung also made the point in his Budget that "since our costs are higher than those of our neighbours, ... we need to focus on high-value-added economic activities". Indeed, there was a time when many people in Hong Kong argued strongly that a weaker HKD would enhance the SAR's competitiveness. But over the past few years, this argument has gradually lost out to the argument that there is no way Hong Kong costs could compare with those in the Mainland of China. Therefore Hong Kong could not save itself by depreciation. Restructuring and moving up the value chain are inevitable.

But it does not stop people from worrying about the HKD link, particularly those overseas

However, outside Hong Kong, the mood towards the HKD has been undergoing a gradual and subtle change recently. Most people in HK do not feel it. The financial crisis in Argentina highlighted the risks and problems with a fixed exchange rate. People in Hong Kong would quickly point out that Hong Kong should not be compared with Argentina as the fundamentals are very different. But the mood of overseas investors could be very different. The words from a colleague of mine in London are illustrative of this difference in perception. He reminded me that 12 months before Argentina let go its peg, most economists he talked to said that Argentina would dollarize rather than devalue.

Worries on the HKD link built up in recent weeks as a string of HK economic numbers released were worse than expected -- exports were disappointing, the unemployment rate rose rapidly, deflation worsened, retail sales were poor. The only positive economic news is perhaps the improvement in incoming tourists. And in the past two weeks, talks of a large and structural fiscal deficit in the media fuelled such worries further. It is natural and reasonable for people to start worrying that if Hong Kong's economic downward adjustment persists, then an Argentinian-style downward spiral could not be dismissed out of hand. Furthermore, HK's recent economic weakness contrasts sharply with the economic rebound seen in the rest of east Asia.

Hong Kong's fiscal deficit in perspective

Hong Kong's fiscal problem has to be put in perspective. Antony Leung is exposing the problem because he needs to gather public support for him to take action. In addressing the fiscal problem, it is clear that he will focus on streamlining the public sector. But this is not going to be easy. Mr Tung and Mr Leung do not have a popular mandate through universal suffrage. They could only deal with the difficult problem of public sector reform if they get public opinion on their side.

At the end of the day, one should bear in mind that the aggregate fiscal deficit in the past 5 years in Hong Kong (going through a serious economic downturn not seen in the past 30 years) is less than 8% of GDP. This is relatively small in comparison to most other east Asian economies (eg. 25% for Taiwan, 30% for South Korea and 31% for Malaysia). One could even argue that the HK authorities have exercised too much fiscal discipline in the past few years.

Furthermore, the cumulated fiscal surplus the government is sitting on is around 19 months of expenditure, and this surplus is expected to fall to around 12 months of expenditure by the end of 2006/07. Most governments in the world do not speak in this language; the talk is about ratio of public debt to GDP.

There is another dimension to Antony Leung's fiscal strategy. I think he is gradually returning part of the government's wealth to the public. He believes in small government and one way to ensure that the government remains small is not to allow the government to have access to too much wealth by giving the huge fiscal surpluses back to the private sector.

In the long term, Hong Kong may need an "exit strategy"

It is widely accepted that the cost of a fixed exchange rate is a more protracted and more severe economic adjustment in an economic downturn. In fact, HK also learnt from the past few years that this pain of adjustment has also a social and political dimension in the sense that there is even more pain inflicted on the low skill workers and the under-privileged. In the past few years, this adjustment process was also complicated by the rapid transformation in the economic relationship between the SAR and the Mainland.

However, as with fixed exchange rates elsewhere such as the Euro, a fixed exchange rate also imposes a discipline on the economy to go for structural changes in order to regain competitiveness, rather than relying on a depreciation to get out of trouble. "Increasing value added" has become a popular expression in HK.

In the longer term, I think HK should not take a fixed exchange rate for granted. Most fixed exchange rate systems in history died a tragic death. Coming up with an objective analysis of what the alternatives are for HK is important. Under what circumstance should HK move to a new system should also be explored.

The answers to these questions are not obvious. One should not take for granted that floating the HKD is a simple alternative. HK's economy is relatively small in comparison to the large amount of capital flows in and out of the territory as a financial centre. With capital flow restriction prohibited by the Basic Law, the HKD could also be subject to a lot of volatility and that could inflict a lot of harm to the real economy of HK. Furthermore, in an open economy where the pass-through effect of exchange rate changes on inflation is substantially higher than bigger economies, monetary policy for HK under a floating exchange rate regime is not an easy matter for the authorities. For example, lowering interest rates in an economic downturn could weaken the local currency and hence raise imported inflation.