Hong Kong – The Peg is Not Likely to be Changed
By Peter T. Treadway
July 15, 2014
In my opinion, the Hong Kong dollar peg, which has been set since 1983 to the US dollar at 7.80:1.00, should and will remain unchanged. There are sound economic reasons for this but I believe the primary reason is political. The current Hong Kong political system is dysfunctional and the Territory is deeply divided on just about every issue you can think of from disturbing dolphins at the airport to that of the choice of a Chief Executive.
As a foreigner who has spent considerable time in Hong Kong, I have spent many nights watching (without comprehending) Cantonese TV news programs in which Hong Kong legislators threw things at one another and disrupted legislative proceedings.
If it Aint Broke, Don’t Fix It
The last thing Hong Kong needs is for its currency to be added to the list of political controversies. Hong Kong operates on a type of monetary autopilot called Linked Exchange Rate System (LERS) which is basically a modified currency board. For all practical purposes, the Hong Kong dollar is simply an alternative version of the US dollar. From time to time noted outsiders, for example legendary hedge fund manager Bill Ackman, have predicted that the Hong Kong currency in some fashion would be revalued against the US dollar. The Chinese renminbi in particular has slowly moved up from over 8 against the dollar in 2005 to 6.20 today. Hong Kong’s economy becomes increasingly integrated with China each year and the revaluation camp has some good arguments on its side.
But revaluation isn’t the only rational alternative. If the currency is held down by the LERS system, the monetary pressure has to show up somewhere. And that is what has happened. Prices have risen in Hong Kong, particularly for goods that the hordes of visiting Mainlanders buy. Houses, clothing, food – go down the list. Consumer price inflation was up yoy 3.7% in May vs numbers below 2% in the US. Prices, not currency, are doing the adjusting.
This price adjustment is causing some unhappiness in Hong Kong. Locals blame visiting Mainlanders for higher house, food and pharmaceutical prices and some dubious legislation has been enacted to discourage Mainlander purchases. Mainlanders have been villainized for their supposed lack of civilized behavior and arrogance. But the numbers suggest local complaints are overdone. In recent years wage increases in Hong Kong have consistently exceeded the rate of inflation. The most recently released unemployment rate was 3.1 percent (that’s basically zero after allowing for so-called frictional unemployment with people changing jobs),2014 per capita income estimated by the IMF is US $ 40,175 vs US $54,980, and Hong Kong is doing very well on such indicators as education, internet access, and health. Moreover, as a recent article by economist Jake van der Kamp in the South China Morning Post argues, one third of Hong Kong residents live in very subsidized public housing, the “cheapest urban accommodation on earth” to quote van der Kamp. (To be sure the subsidized units are far from luxury accommodations.) Blending into this in Hong Kong, as there now is everywhere else in the world, is no end of grousing about income distribution. The global complainers don’t take into consideration the massive growth in non-salary benefits or the marvelous improvement in technology and health related items over the last twenty years. But that’s another story.
Some proponents of a revaluation for the Hong Kong currency advocate the Singapore system of a very controlled and very opaque float against a basket of currencies. Well that may work for Singapore which is a well-run technocratic place. But again, to put it kindly, Hong Kong does not have the political maturity to run a successful float. Hong Kong does not need to have its legislators throwing tantrums and tossing things at one another over its currency. It should be pointed out that yoy as of July 4 Hong Kong’s monetary base was up only 3.2 %, belieing the view that the US QE has flooded Hong Kong with excess liquidity.
No Question the Natives Are Restless
Hong Kong is not such a happy place right now. On July 1, which is the annual Hong Kong holiday commemorating the British Handover of Hong Kong back to China in 1997, allegedly several hundred thousand demonstrators staged a protest demanding universal suffrage for the election of Hong Kong’s Chief Executive in 2017. (Actually two fairly dispassionate estimates put the number in the 150,000 area.) The mostly young demonstrators were led by previously unknown teenaged university students. Unless granted all their demands by the central government in Beijing, the demonstrators’ leadership promised to return and shut down the Central Business District.
In my opinion, this crisis and the general problem of Hong Kong governance represents a serious threat to Hong Kong as a global financial center. Hong Kong at the moment is China’s leading financial market and a major global financial market. That is in China’s and Hong Kong’s financial interest. But this depends on a certain amount of tolerance by the undemocratic Central Government in Beijing. It can’t happen otherwise. It boils down to this. Hong Kong must have a leadership that the Central Government can trust. Otherwise, no matter what the cost the Comrades in Beijing are not going to allow what they regard as an unhappy and disloyal city – which by the way speaks a different language (Cantonese) as opposed to the national language (Mandarin) — to be its major financial center. Shanghai will be the beneficiary of course.
The argument has been made that revaluing the currency and/or changing the peg will somehow reduce the general level of unhappiness in Hong Kong. I doubt it. Change prices and somebody will always be angry – retailers selling to the Mainlanders, apartment owners etc. And then the currency becomes one more item of contention in the Territory. Maybe the legislators will throw coins at one another.
The Basic Law – A Good Deal for Hong Kong
In 1984 Margaret Thatcher cut a deal with Deng Xiaoping which came to be known as the Sino British Joint Declaration. This Declaration set forth the “one country, two systems” principle. In keeping with the Declaration the Basic Law was adopted which is Hong Kong’s constitution and now governs what is called the Special Administrative Region of Hong Kong.
I’ll leave it to the lawyers to analyze the details of the Basic Law and the Sino British Joint Declaration. But in plain English it’s the best Hong Kong could hope for. After all, unlike in 1840 when the British took over Hong Kong, this time the Chinese side had all the cards. Skipping the legalese, the deal boils down to this: for fifty years Hong Kong can keep British law, its currency, its financial system, its freedom of speech, and the English and Cantonese languages. Hong Kong people can travel, can say what they want, own all the private property they want, have sex with whomever they want etc., etc. Hong Kong people have more freedoms than virtually any other citizens in Asia. In short not much of a change from British administration.
EXCEPT FOR ONE MAJOR ITEM. It is assumed Hong Kong should be “patriotic”. Patriotic doesn’t mean that all Hong Kongers should have tears in their eyes at the very mention of mother China. (Although Beijing probably sincerely wishes that this would happen.) But Beijing will settle for less. Patriotic really means Hong Kong should not be a source of subversion for the Central Government and, to put things bluntly, WHEN IT COMES TO THINGS CHINA, HONG KONG SHOULD MIND ITS OWN BUSINESS.
The world isn’t perfect. But I don’t think it’s surprising that Beijing wants some kind of veto power over the selection of Hong Kong’s Chief Executive. It cannot risk having an overtly hostile or subversive (in its eyes) Chief Executive in Hong Kong. Again, the People’s Republic of China, which ultimately holds all the power over Hong Kong, is not a democracy. China has thousands of years of dynasties, one after the other. It’s a rich history but none of dynasties were democracies. That goes for the current PRC dynasty which is still a lot more tolerant than its Qing, Ming, Yuan, Song, Tang, Sui, Han and Qin ancestors.
The founders of the American Republic were not all democrats either. They preferred a republic and were afraid of the then current excesses of Robespierre, the French Revolution and democracy. In the early twentieth century American President Woodrow Wilson wanted to make the world safe for democracy. Madison, Franklin and Adams – all eighteenth century guys — probably would have wanted to make the world safe from democracy. Reflecting the Founders views, the American Senate was not popularly elected and the US still has the Electoral College, a remnant of those republic days.
And of course nobody ever elected the British Governors of Hong Kong. They were all appointed by London. Nobody in Beijing today is insisting on that right for China. As their day of departure loomed nearer, the British beginning in the 1980s began to introduce democracy into Hong Kong. Relations between China and Britain turned acrimonious as the last British Governor, Chris Patten, pushed democracy onto a colony where it had been totally absent for the prior 120 years. One cannot help excusing the Chinese leadership for thinking that Perfidious Albion – as in its imperial days Great Britain was sometimes uncharitably called — was up to its old tricks.
At the risk of revealing my curmudgeon proclivities, I think it’s pretty scary when the fate of a major financial center and global city can be decided by a group of teenagers whose major sources of information are Facebook, What’s App and Twitter where they are enlightened by their equally unenlightened friends. I am reminded of similar unhappy moments in history such as the 1968 student revolt in France where the great Charles de Gaulle came close to being kicked out or indeed the Cultural Revolution in China itself where students disrupted society and regularly beat up and murdered their teachers. Compromise is necessary here and these students are loudly proclaiming they won’t compromise. Hong Kong doesn’t need a currency change. It needs rule by adults.
China has more or less respected the Basic Law since the Handover in 1997. Its one big mistake was to push an internal security law on the territory which was rightfully and successfully pushed back against by the Hong Kong populace. On the other hand, Hong Kong has not always minded its own business – for example there are yearly demonstrations on June 4 protesting China’s infamous Tiananmen Square incident – but in general until recently the level of intrusiveness has not exceeded Beijing’s tolerance level.
Hong Kong needs to keep in mind that the 50 year period under which Basic Law operates officially ends in 2047. A renegotiation lies in Hong Kong’s future.
The Chinese do not always see Hong Kong in purely economic terms. In 1997 I can remember asking one Chinese friend who had become an American citizen, suffered under the Cultural Revolution and lived in the United States:
Question: “Are you happy that Hong Kong will go back to China?”
Answer: “Yes as a Chinese, very happy. We finally got to kick the British butt.”
Question: “Do you think it’s a good idea?”
The Peg Benefits the Hong Kong Stock Exchange
One of the great attractions of Hong Kong Stock Exchange (388:HK) to new issuers is that the Hong Kong currency is pegged to the (still almighty) US dollar and there are no capital controls. Fiddling with the currency and the resultant uncertainties would erode this attraction.
There are some curious features to the current structure of Chinese capital markets. For one thing, it is effectively illegal for Chinese citizens to directly own stock in Hong Kong or US traded companies. The situation is odd because the best Chinese tech companies trade in the US and Hong Kong. That situation is about to change partially as a scheme called the “through train” is enacted in China that will allow Chinese citizens to invest in Hong Kong stocks. This is potentially very bullish for the Hong Kong market by the way. But it could be scrapped in a minute by Chinese authorities as indeed an earlier proposal was scrapped several years ago. That could happen if central government authorities concluded Hong Kong was “unpatriotic.”
Moreover, if the renminbi were to become fully convertible Shanghai might displace Hong Kong for the international financing of Chinese companies. A Shanghai international board for equity IPOs could become a major reality. Fortunately for Hong Kong, that day of full convertibility is still far off. But remember before the Communist takeover in 1949, Shanghai, not Hong Kong, was China’s financial capital.
I will conclude by reexpressing my shock at Hong Kong and the HKEx allowing the Alibaba offering to go to the NYSE. China has set the world’s record for its “catch up “economy whereby the bulk of its people have been brought out of poverty in a generation. Amazing. But China, with its restrictions on information flow and its Confucian/Communist need for order and obedience, has yet to show that it can really compete as a knowledge economy. Having the HKEx become a center of high tech IPOs instead of simply offshoring these to the United States would be an essential step forward in creating a genuine knowledge economy in China.
Dr. Peter T Treadway is principal of Historical Analytics LLC, a firm dedicated to global investment strategy. Dr. Treadway spends a substantial portion of his time in Hong Kong and New York and is the author of Investing in the Age of Sovereign Defaults.
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