US quantitative easing is the biggest threat to the viability of Hong Kong dollar’s peg to its American counterpart, says Erik Lueth, economist at Royal Bank of Scotland.
A key reason for this is based on the theory of “optimal currency areas” which dictates that business cycles of the two countries operating a peg need to be in tune.
In the case of Hong Kong, its business cycle is more aligned with China rather than the US. “If one day Hong Kong pegs its currency to the mainland, this will be the main reason. It will ensure monetary conditions in HK are appropriately aligned with the business cycle,” Lueth said.
Loose monetary policy in the US can affect Hong Kong through the impact of interest rate changes. In this instance, low rates in the US are reflected in overnight HIBOR which are stuck at zero.
But Hong Kong’s strong economic story leave it at risk from inflationary pressures as companies, banks and households will find it cheap to take more risks and leverage up.
“Moreover steep property prices will spill over into consumer price inflation as rent contracts are reset-usually every two years,” said Lueth. “With the housing component accounting for 30% of the CPI basket this can make for some ugly and politically challenging optics.”
But the debate is unlikely to move beyond the realm of the academic until the renminbi is fully convertible, something unlikely to occur for at least five years more bullish strategists predict.
Because Hong Kong has an open capital account, heavy inflows would force the Hong Kong dollar up. In order to maintain the peg to the renminbi, the Hong Kong Monetary Authority would have to sell HK$/Rmb to level it out. Without full access to the renminbi this would be problematic.
“China is making tentative steps towards greater convertibility of the CNY, but a currency union with Hong Kong requires an open capital account. This will not happen quick enough to deal with [Hong Kong’s] current situation,” Lueth said.
Beijing would also likely resist a currency peg in the short term as Hong Kong is effectively its proofing ground for the internalization of the renminbi. It is unlikely China would rush itself before it felt all boxed had been ticked.
Lueth said, “Hong Kong is a global financial centre with unrivalled economic freedoms and Beijing retain a degree of influence. The test ground would disappear with a currency union between the two.”