With a leading financial centre and a highly developed capitalized economy, Hong Kong is renowned as one of the ‘Four Asian Tigers'. Under the principle of ‘one country, two systems' Hong Kong runs under the mini-constitution of People's Republic of China which guarantees a “high degree of autonomy”. The unique feature under this system is that China and Hong Kong deal with two currencies. Since 1983, the Hong Kong Dollar (referred as HKD hereon) has been pegged to the U.S. dollar at HK$ 7.85/USD. This linked exchange rate system has lead to many debates in terms of its long term stability and whether it should peg its currency to Chinese Renminbe (CNY; also referred as Yuan hereon) or allow its currency to float freely. In this report I would discuss these three options, evaluating the current political and economical factors affecting the territory of such movement.

Since the implementation of linked exchange rate system, the HKD has maintained a greater amount of stability. During the fourteen year period from its inception (from 1983 to 1997) HKD has never exceeded 2 percent either side of the official parity (Kwok, 1997). The currency has survived through major turmoil in the global economy from Black Monday US stock market crash in 1987, the Gulf war in 1990, the Exchange rate mechanism turmoil in Europe in 1992 and the Mexican currency crisis of 1994 (Yam, 2005). However, during the Asian financial crisis HKD suffered enormously due to its peg to the US dollar. In contrast to this, the fact that currency has remained stable over these political and economical events with a major backing up of dollar reserves proves that the link has functioned well.

Hong Kong with a flexible real sector maintains a relatively responsive domestic wage and inflation. For such an economy fixed exchange system is more optimal compared to floating system due to its ability to absorb external shocks; nominal prices would not be affected as the real sector will quickly adjust to such shocks (Tsang, 1999; Rajan & Siregar, 2002). In order to maintain a stable position in the fixed regime the Hong Kong Monetary Authority (HKMA) has developed many schemes such as Negative Interest Rate Mechanism, the New Accounting Arrangements and many more in order to strengthen the value of their currency. With these arrangements the country has been able to limit the speculative pressures on the HKD and as long as it defends itself from such pressures people will have the confidence over the currency (Kwok, 1997). Hausmann et al (2000) states that financial autonomy of the Hong Kong economy is doubtful with a floating regime and thus fixed system is more applicable.

As Williamson (1995) notes the link compiles to the “natural candidate” as one third of the manufacturing exports are absorbed by the U.S and thus pegging of the territory's currency to the dollar ensures the competitiveness of Hong Kong exports among other economies. It reinforces Hong Kong as a stable financial centre. With a strong and solvent banking system the economy is well weathered to fight over any interest rate differences that would occur under the linked regime (Yam, 2005). However, during the U.S recession of 1990s, the two economies were not moving in tandem and thus Hong Kong was tied to the low interest rate of U.S when its own domestic economy was in need of high interest rate in order to restrain growing asset bubble. Thus the commitment to linked rate restricted the economy from preventing itself from inflationary pressures during the crisis (Tsang, 1998). The following graph illustrates this factor.

Lu & Yu (1999) argue that the pegging of the Hong Kong currency to the dollar is a costly and an inefficient regime. The HKD became highly vulnerable on 20th October 1997 as speculative pressures started mounting on the currency leading to heavy sales of US dollars by the HKMA. The economy underwent most dreadful experience over time as they had to engage in “double play” of shorting the HKD and Hang Seng Index. After a very costly and risky tact of preventing the fall of share market, the government ended up spending HK$118 billion to buy back the securities. This was equal to the 15% of Hong Kong's total foreign reserves during that time.

With these drawbacks, many argue on the alternative systems for Hong Kong currency. Under a floating exchange rate regime the monetary authority will have control over stability of price movements. However, with an externally oriented economy, the country is vulnerable to external shocks; in which case monetary authorities would have to involve in hedging strategies to prevent any unfavorable exchange rate fluctuations. As Obstfeld & Rogoff (1995) state, exchange rate uncertainties reduce international trade and discourage investment. Moreover, speculative attacks on currency are less likely to be protected under a floating regime unlike in fixed regime which diverts away such pressures away from exchange rate regime to other aspects of the economy (Tsang, 1999). If Hong Kong is to dismantle the peg and let the currency to float freely in order to adjust interest rate accordingly, Sheng (1995) showed contrasting results as countries with floating regime were unable to avoid inflationary pressures. Thus it is likely that Hong Kong would not gain from a floating regime.

Another alternative that has been widely argued is the HKD's possible link to the currency of mainland China. Yam (2005) states that the choice of an anchor currency should be based on the extent to which Hong Kong's external trade and financial transactions are denominated, and should also depend on the monetary regime of that country. However, economic arguments for changing the anchor currency to renminbi are not well supported.

Yue & He (2008) argue that Hong Kong and China hardly form an optimal currency area due to their distinct economic factors. Despite the fact that both the economies are open to foreign trade and investment, most of the shocks confronting China come from within the country unlike Hong Kong where most of the shocks are external due to its status as a financial hub in the region. Moreover, the depeg would have an adverse impact on China since Hong Kong is reputed as the financial center for mainland. Hong Kong plays a pivotal role as a financier, trading partner, middlemen in commodity and services trade for China (Sung, 1991), all of which are enhanced through the currency board system. Thus if they dismantle the link, Hong Kong would lose its attractiveness as the financial center for China (Cheng et al, 1999).

The Hong Kong dollar which operates under the currency board system is a fully convertible currency unlike Chinese Yuan which is yet to be convertible. Thus a linkage between these two currencies is impractical given China's capital market is less developed and illiquid for the Yuan to be a reserve currency. A key issue that should be considered is the exit cost of de-pegging from dollar. “If more is invested in building confidence in the system, more has to be forgone when it is finally deemed necessary to change track” (Tsang, 1999). As Suttle & Fernandez (2005) state the long run challenge for Hong Kong would be to develop an exit strategy from dollar and integrate it to a monetary union.

Conclusion

As noted by Tsang (1999b, 2002) the loose legal policy for exchange rate system in Hong Kong requries the economy to be backed by a 100% reserve fund, without specifying the reserve assets. Thus legally it appears that system can be fixed, pegged to any currency or floating as long as it is fully backed with the reserve currency. In regard to this, the HKMA ensures the stability of the currency by excessive injection of dollars to the economy.

The territory will enjoy capitalist way of life at least 2047, after which it will be under the control of People's Republic of China; thus there exist a real need of linkage between Yuan and Hong Kong in the future. However the economy of Hong Kong is vastly more advanced than that of China. Nevertheless, for the first time in three decades, GDP of Shanghai exceeded that of Hong Kong during the first quarter of 2009 (grew by 8.2% compared 2.7 contraction in Hong Kong).Some argue that the smoothest way to introduce Yuan in Honk Kong is to promote people to increase the usage of Yuan. The launch of “Renminbi business” in February 2004 is a step forward by Mainland China. Under this scheme, banks in Hong Kong offer five types of services in Renminbi and by the end of 2005, 38 banks were involved in the Renminbi business (HKMA, March 2006).This increasing use of Chinese Yuan is expected to smoothen out the linkage of Hong Kong currency to Yuan and enhance the financial and economic integration between the two countries.

In conclusion, dismantling the peg with dollar and re-pegging with Yuan seems impractical at the foreseeable future while the optimal decision would be to maintain under “one country, two currencies”. As stated before the Yuan status as a reserve currency is questionable since it lacks the recognition, translatability and free movement of the currency which lead to acceptance. In the long run, from a political perspective, a link between yuan and HKD seems possible.

Source: Essay UK - http://turkiyegoz.com/free-essays/economics/leading-financial-centre.php


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