The Future of Hong Kong Linked Exchange Rate
System: RMB or USD?
My Facebook Page: PageThe Glocal: The Glocal
Author: Dasein
Recently,
Sir David Li Kwok-po, the chairman of Bank of East Asia and former Legislative
Council Member (Constituency: Finance), has called for a review of Hong Kong
Linked Exchange Rate System before its 30th birthday. He has
expressed his opinions about the system in an interview conducted by Hong Kong
Economic Journal. He believed that Hong Kong dollar should link up with RMB instead
of USD in the future.
As
the same time, Norman Chan, the Chief Executive of Hong Kong Monetary Authority
(HKMA), stated that Hong Kong did not have right conditions for linking up with
RMB. Also, Dr. John Greenwood , who is well known as “father of Hong
Kong-dollar peg”, has shared similar points of view. Dr. Greenwood said Hong
Kong could link up with RMB if 4 conditions will be satisfied in the future. 1.
RMB should be freely traded and transferred. 2. RMB has become international
common reserve currency. 3. Mainland China has replaced the U.S. as global
economic leader. 4. Central Bank of China can use interest rate adjustment as primary
monetary policy.
In this article, I am going to show you why
Hong Kong should link up with USD instead of RMB.
Exchange
Rate and Finance
In
economics, the exchange rate is determined by the supply and demand of two
currencies. However, the supply and demand would be influenced by domestic
interest rate. Regulatory Institutions such as Federal
Reserves will adjust interest rate based on government needs and financial
situation. In general, low interest rate can boost economy and high interest
rate can press down inflation and hot money. Although interest rate is not the
only option for the institutions, it is one of the most important primary
monetary policy tools.
For
big economic entities, interest rate can be purely determined by domestic
economy. However, it is not easy for small economic entities to play this way,
because small economic entities do not want large variation of their exchange
rate. Therefore some of the small economies, such as Hong Kong, would fixing currency
exchange rate with big economic entities, such as the U.S..
Hong
Kong Linked Exchange Rate System
Hong
Kong Linked Exchange Rate System is pegging with USD for HKD: USD = 7.8:1. USD
is a large liquidity global currency with high stability, therefore this
pegging system has created a good investment and business environment for Hong
Kong.
In
order to make the arbitrage works for the pegging system, HKMA has a
USD 300 billion foreign reserve, mainly funded with USD assets. If HKD is going
to link with RMB, it is very likely for HKMA to short USD and long RMB as
foreign reserve in the future.
Number
Fact: Correlation of % of GDP Change
As
I have mentioned before, economy, interest rate, and exchange are closely
related. It is important for regulatory institutions to launch their own
monetary policies based on their needs. However, linked exchange rate will make
the domestic interest rate go with foreign interest rate. Hence, linked
exchange rate system can only be conducted for 2 economy system sharing similar
conditions. Otherwise, the domestic interest rate could be forced to go up in
economic downturn or vice versa.
To
make it simple, the GDP change of Hong Kong should be similar with linked
country. The consistency of GDP change
can make sure the same monetary policy is favourable to both economies.
(Picture 1 - % Change of GDP)
(Picture 2
– Net Difference of % Change of GDP between HK and respective region)
%
of GDP Change
|
Data: World Bank
Calculation: Author |
|
Average(91-12)
|
Average(00-12)
|
|
China
|
0.14333904
|
0.157174696
|
United Kingdom
|
0.039586119
|
0.037081148
|
Hong Kong SAR, China
|
0.055921184
|
0.035580766
|
United States
|
0.04560696
|
0.040197705
|
World
|
0.05383893
|
0.063902779
|
Mean Square Difference of GDP change (%)
|
||
Average (91-12)
|
Average(00-12)
|
|
China
|
0.014089588
|
0.016294639
|
United Kingdom
|
0.009804006
|
0.008256297
|
Hong Kong SAR, China
|
0
|
0
|
United States
|
0.003407349
|
0.001300086
|
World
|
0.004533891
|
0.002924684
|
In
the graphs and tables, we may conclude that China’s GDP change has not been
consistent with Hong Kong’s GDP change. However, it would be important to you
to understand the limitations of my analysis method.
1 China economy is reforming,
and it may lead China economy to be consistent with the rest of the world.
2 History may not tell future.
3 Hong Kong and the U.S. should be more
consistent because we are sharing similar monetary policy.
However, the data of the U.K. and the world can show us China is relatively not
consistent with Hong Kong.
4 Hong Kong is converging her industries.
Also, many industries in Hong Kong are now heavily depended on mainland China.
We may predict that Hong Kong and China will have a higher economic consistence
in the future.
To
conclude, Hong Kong and China could be more consistent in terms of % of GDP
change, but Hong Kong economy will dance in the same pace with other free
economies better instead of mainland China because of China’s financial
structure and unique regulations.
Number
Fact: Debt-to-GDP
Ratio
Choosing appropriate exchange rate
link is similar to buying stocks. We have to ensure the financial health of
linked country in order to avoid exchange rate crisis.
We
have already known that both the US and China are suffering from serious debt
issue. However, who is the better one?
According
to the average number of the data from CIA and IMF,
the US debt-GDP-ratio is about 80% in 2012 while China is 27%.[2]Although
the US is not in the top of the debt list, the debt of the US is in
historically high level. Dr. Anis Chowdhury and Mr. Iyanatul Islam from
The University of Western Sydney expressed their theory in “Is There an Optimal debt-to-GDP ratio?”[3],
they concluded that there is no optimal debt-to-GDP ratio yet in academic
researches. However, over 60% debt-to-GDP ratio is statistically high if we
look into global data.
（Picture 3
– Map of Debt-to-GDP ratio）
However,
the debt of China has not taken local government debt into account. In fact, many
organization have estimated China debt-to-GDP ratio (included local government
debt) from 45% to 78%. This large estimation interval suggests
that the debt issue in China is not clear enough, it is possible that China is
in debt as much as the US. More importantly, it is hard to believe the central
government of China can handle the problem if no one can tell an accurate
number of local government’s debt.
（Picture 4 – Estimation of
China’s debt）
Also,
even the central government of China suspects that the GDP of China is
generally overestimated. Some of the news have discovered the administration of
China does not believe in their GDP value but the consumption of electricity, they
believed that the consumption of electricity was directly proportional to the
real productivity of respective area. If the GDP of China is overestimated, it
is possible for China to have a higher debt ratio than the US.
As
I have mentioned, would you buy a stock without knowing its debt issue?
Financial
Stability: RMB and USD
Financial
stability is owning a high weigh in determining exchange rate,
however, financial stability is affected by many factors. In general, financial
system with larger quantity of currency issued will be more stable from
external effect.
Nowadays,
USD is used to trade in different market, therefore the quantity of issued USD
is very large. Therefore, USD is more stable from external
effect relative to other currencies. We may conclude that linking with USD is a
better option because we are looking for exchange rate stability in the first
place.
Also,
RMB cannot be transfer and trade without restrictions, this would limit the attractiveness
of China market to foreign investors. This makes RMB ever worse for being a
linked currency.
Foreign
Reserve: Liquidity Risk, Credit Risk and Inflation Risk
HKMA
have to bear liquidity risk, credit risk and inflation risk of linked country
because HKMA must hold foreign currency in reserve.
With reference to current regulation, RMB has
worse liquidity than USD because there are many restrictions for transferring
and trading RMB.
Also, the credit risk of RMB bond may
directly caurse credit crisis in China. This may lead to hyperinflation if the
default risk is not controlled. HKMA’s RMB reserve would be greatly affected if
there is a hyperinflation in mainland China.
It is basically impossible for RMB to be a
better option for linked currency if China is using planned economy and
exchange rate control. [4] This is why Dr. John Greenwood has given 4
conditions for RMB to achieve before HKD links it.
Pillar
of Financial Hub:
Exchange Rate Transparency and Market Oriented
As
a financial hub, it is important for Hong Kong to have high exchange rate
transparency. Market oriented financial system and high transparency can let investors
to estimate their risk and market trend. These 2 conditions are very important
in quantitative financial and risk management models.
If
HKD links with RMB, the transparency of Hong Kong exchange rate
will be greatly harmed because RMB cannot be freely traded.
Pillar
of Financial Hub:
Trust, Stability and Administrative transparency
If HKD and RMB are
linked, Hong Kong financial system will be affected by the lack of trust to
mainland China, the political stability of China and China’s administrative
transparency.
It
is hard to make subjective judgement about 2 political systems, the US and
China. However, I believe the emigration history of Hong Kong can tell how Hong
Konger believe in mainland China.
Pillar
of Financial Hub:
Financial
System
If
HKD and RMB are linked, this is no doubt that Hong Kong financial service will
merge with mainland China. It is hard to believe Hong Kong financial industry can
maintain high standard, because corruption and financial regulation
incompleteness are well known in mainland China.
It
would be no harm to merge with mainland China if and only if they are having
similar financial regulatory standard to Hong Kong.
After
Linking:
Hong
Kong and Shanghai
If
HKD and RMB are linked, the competitive advantages of Hong Kong will diminish.
The
first reason is worsening financial standard; Also, Hong Kong is less
attractive for mainland investors for avoiding risk;
Besides, it is more risky for foreign investors taking part in Hong Kong’s
financial activities.
Compare
to China supported Qianhai area and Shanghai,
Hong Kong has given up our own advantages but not gaining “Chinese background”
advantages. If you are the CEO of Goldman Sachs, do you think you will be
interested in Hong Kong?
After
Linking:
Chinese Clients Only
If HKD and RMB are linked, the risk of having
business between Hong Kong and foreign country is higher,
but less for trading with mainland China because of the fixed exchange rate. Hong
Kong will be a so-called financial hub with mainly mainland Chinese clients.
Huge proportion of Chinese clients is not
only a diversity problem, but also a political problem. I am sure this point
can be easily understand if we looking into the independency of Hong Kong
policy.
After
Linking: Foreign Inflation
The
value of HKD would not constantly go up after linking with RMB. Hong Kong
people have to deal with inflation even linking up with RMB.
The
Hong Kong monetary policy have to be made based on Hong Kong’s financial needs
but not administrative needs. Link Exchange Rate System should not be used to
relieve the administrative pressure from inflation.
In
fact, linking up with RMB is not an only option if we want to deal with the
inflation. Adjusting the fixed exchange rate with USD can do the job, questions
should be asked why inflation of Hong Kong is raised as a reason for linking up
HKD with RMB.
Benefit
for Linking up with RMB
In
a short run, the CPI of Hong Kong would be lower, this is certainly a good news
for Hong Kong government. For the businessmen, their China business could be
benefited from diminished Hong Kong financial market because they are usually
having good relationship with China administration.
For
general public, the price of China goods would be stabilized but not the
foreign goods. It is hard to tell if stable IPhone price is more important than
Chinese water price. It is all about your social status and consumption habit.
The
Future of RMB: Prof Chen Zhiwu: China Model Never Exists
This
is a fact that RMB will stop raising someday, also it is not
known if China can continuous her development. The proportion of consumption of
China’s GDP is going down recently [5], her GDP is leaded by investment (46%),
this is not common in neither developing nor developed countries. Without the
strong support of consumption, many economists are worrying about China’s
GDP growth. Furthermore, China is now famous for “reconstruction economy”, China
local government are looking for an opportunity for reconstruction, so that
they can have GDP from infrastructure investment. Although some people believe
that China is no longer needed to keep 8% economy growth [6],
people are generally worrying about the slowing down economy growth in China.
In
fact, some of the China local GDP was raising while the electricity consumption
was going down. The central government of China is having questions for local government
financial health.
The professor Zhiwu Chen, from
Yale School of Management, was questioning the future of China’s economy in his
book “China Model Never Exists”. He
did not believe that the fast growing China economy would be sustainable
without true economic and political reform.
It
is clear that it is not wise to link up with RMB without further observation
and discussion.
Conclusion
Hong
Kong monetary policy should be made based on Hong Kong’s financial needs. Today,
Hong Kong and China are having a complicated financial relationship, hence, it
is also a better idea for us to listen the opinions from the both side.
In
my points of view, linking with RMB is not a mature option yet. It would be a
possible option if China makes serious changes in financial system and
political system.
Picture Source:
[Picture 1, 2]: by Author. (Data: World Bank)
[Picture 4]: Richard Silk, How Big is China’s debt? The Best Guess, The Wall Street Journal,
Viewed 15th Oct, 2013, http://blogs.wsj.com/chinarealtime/2013/07/30/how-big-is-chinas-debt-here-are-the-best-guesses/
Reference:
[1]: GPD History: The World Bank, Viewed 15th
Oct, 2013, http://data.worldbank.org/indicator/NY.GDP.MKTP.CD
[2]: Debt to GDP Ratio, Viewed 16th
Oct, 2013, http://en.wikipedia.org/wiki/List_of_countries_by_public_debt
[3]: Anis Chowdhury and Lyanatul Lslam, Is There an Optimal debt-to-GDP ratio?,
Viewed 16th Oct, 2013, http://www.voxeu.org/debates/commentaries/there-optimal-debt-gdp-ratio
[4]: David Pauly, China’s State-Planned Economy is Doomed to Flop, Bloomberg, Viewed
16th Oct, 2013, http://www.bloomberg.com/news/2010-11-23/china-s-state-planned-economy-is-doomed-to-flop-david-pauly.html
[5]: Duncan Freeman, China’s Consumption to the Rescue?, Viewed 16th Oct,
2013, http://www.understandingchina.eu/Chinaideascommunity/LatestresearchonChina/tabid/887/PostID/2754/Default.aspx
[6]: Shaun Rein, Viewpoint: Why 8% may not be the magic number for China, BBC News
Business, Viewed 16th Oct, 2013, http://www.bbc.co.uk/news/business-21055964
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