This blog post was originally published on Nikkei Asian Review.
Twenty years after the handover of Hong Kong to China from Britain, it is time for a radical rethink of the local currency's peg to the dollar. A new regime pegging the Hong Kong dollar to a basket composed of the dollar and euro would better serve the self-governing territory's emerging needs.
The Hong Kong economy has changed enormously since it was handed back to China by the U.K. in 1997, but its currency has remained pegged to the dollar and subject to the tight regime of a currency board. With the economy now more synchronised with China than ever before, the dollar peg may no longer provide an accurate reflection of the real value of the Hong Kong dollar.
The currency was one of the key pillars of stability after the handover. The success of Hong Kong's currency board is a textbook case: A pegged exchange rate regime is the best option for a small, open economy if the credibility gained by importing monetary policy outweighs the cost of giving up the exchange rate as a policy tool. Hong Kong's role as a financial center is more important than its trade competitiveness, implying that the peg to the dollar has so far been a wise option.
Within this context, it is important to understand two different aspects of Hong Kong's currency board: The first is the nature of the board itself -- a peg regime within which the territory has to hold sufficient foreign reserves to cover its monetary base. This implies that capital outflows can bring the currency board to an end if foreign reserves fall below the required level.
The second aspect is the choice of currency for the peg. While the dollar may seem obvious, since it is the world's reserve currency, other considerations are also important. The reference currency should belong to an economy closely linked with Hong Kong, with the highest possible synchronicity in business cycles. This is because a country that pegs its currency to another gives up monetary policy and its ability to steer the economic cycle.
The liquidity of the currency of reference is also important; it must allow for swift intervention in foreign exchange markets, at low cost. But the dollar is not the only currency that offers this benefit. A handful of other currencies offer foreign exchange market liquidity and low transaction costs. Notably, the euro is just behind the dollar in such terms.
In recent years, China has eclipsed the U.S. in its significance to Hong Kong's economic cycle. This should not be surprising since as much as 10% of Hong Kong retail sales are attributed to Chinese tourists (tourism receipts from China account for 8% of Hong Kong's gross domestic product). Furthermore, a good part of inward investment into Hong Kong emanates from Chinese companies.
Another important aspect is financial ties. For many years, Europe and the U.S. have been two of the largest suppliers of cross-border bank credit to Hong Kong, while today an estimated 50% comes from mainland China. The other side of that story is a rapid increase in Hong Kong's liabilities to China, from some 20% of the total in 2015 to nearly 30% in the first quarter of 2017.
Hong Kong's banking sector is heavily exposed to China through cross-border lending and local operations. Cross-border mainland-related lending reached nearly $218 billion (or 67% of total cross-border loans) in March 2017. Rising financial integration between China and Hong Kong has also boosted portfolio flows. China's share in Hong Kong's total portfolio flows has hovered between 60% at the peak and 20% more recently.
In light of these factors, Hong Kong policymakers must think of different strategies to deal with the choice of currency peg, while maintaining the currency board regime that has benefitted the city for so long. The additional difficulty in Hong Kong's case is the non-convertibility of the yuan. This means that a switch to a yuan peg would not be viable as long as foreign exchange intervention is needed to keep the peg. Even pegging to a basket of dollars and yuan might result in similar difficulties, although to a lesser extent since the dollar could be used for intervention.
Still, given the importance of foreign exchange market liquidity and transaction costs, an interim solution can be implemented while the yuan moves toward convertibility. The objective would be to reduce Hong Kong's vulnerability to U.S. monetary policy from 100% to 50% while maintaining the Hong Kong Monetary Authority's ability to control the peg through intervention in liquid foreign exchange markets.
The best option to do this is to choose a major currency that is uncorrelated to the dollar but linked to the yuan. The winner is, without doubt, the euro. There are two key reasons for that.
First, the euro is structurally uncorrelated to the dollar. The two are the most traded currencies with fully flexible exchange rate regimes, but their correlation has been close to zero for the last 10 years. At the same time, the euro appears to be somewhat correlated to the yuan. Data show around 30% correlation between the euro and the yuan since the latter moved from a full peg in 2005, and close to 80% correlation in the last six months, as both currencies have decoupled from dollar weakness.
Second, the euro is the second largest reserve currency in the world with 33% of global payments carried out in the currency, followed in the distance by the British pound with about 7% and the Japanese yen with barely 3%, according to data from SWIFT, a financial messaging service provider. In addition, the euro is the currency most commonly traded in foreign exchange and bond markets after the dollar.
Introducing the euro as the second currency in a dual-currency basket pegged to the Hong Kong dollar could provide a quick and relatively cost-free fix to meet the needs of the Hong Kong economy today. Such a basket would better serve a Hong Kong that is becoming economically dependent on China, even as its currency and interest rates are determined by actions in the U.S.
The volatility of the Hong Kong dollar in the last few months -- flirting with a decade-low against the dollar in August and then spiking to its highest level since July on Sept. 8 before receding slightly on Sept. 11 -- should be seen not as a risk but as an opportunity for the HKMA to rethink its strategy. This is because the movements of the Hong Kong currency show how well anchored it is. Investors wish to hold Hong Kong dollars because they expect any losses to be outweighed by future appreciation, which has now started.
The currency's forward exchange rate remains within the expected band, which points to the enormous credibility the HKMA has gained over these years. Changing its peg to a basket of 50% dollar and 50% euro would strengthen the Hong Kong dollar, in line with yuan trends, and stem the potential overheating of the economy.