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Economic Commentary

Will Hong Kong Follow China and Kuwait?

Fri, May 25 2007, 09:51 GMT
by Jay H. Bryson

Wachovia

China and Kuwait Make Changes to Their Exchange Rate Regime

What do China and Kuwait have in common? If you answered that they both recently made changes to their respective exchange rate regimes, then you are right on the money. On Friday May 18, China widened the daily fluctuation band of the yuan/dollar exchange rate from 0.3% to 0.5%, which, in theory, gives Beijing the ability to speed up the rate of renminbi appreciation that has been painfully slow to date.1 Three days later, Kuwait dropped the fixed exchange rate of the Kuwaiti dinar versus the U.S. dollar to a peg based on a basket of currencies. Thus, both the renminbi and the dinar could now move more against the dollar than in the recent past.

When we look around the world, there are not many currencies that remain fixed to the dollar. There are the other countries of the Gulf Cooperation Council, and Kuwait’s decision to move to a peg based on a currency basket raises the probability that some of these countries may follow suit.2 Another major economy with a fixed exchange rate is Hong Kong, which has effectively maintained a fixed value of the Hong Kong dollar to the U.S. dollar since 1983.3 Could Hong Kong be in line to make a change to its exchange rate regime?

Cyclical and Secular Reasons for Currency Appreciation

Before we attempt to answer that question, let’s quickly review why China and Kuwait each made a change to its respective exchange rate regime. Although the Chinese government did not offer an official explanation for its move, we have our hunches. First, a faster rate of appreciation would serve China’s economic interests. As shown in Exhibit 1, CPI inflation in China is on the rise again, and faster exchange rate appreciation would help to restrain inflationary pressures. Indeed, Chinese officials worry about overheating. Second, Beijing’s geopolitical interests are served by widening the exchange rate band. The Bush administration and many U.S. lawmakers have been calling on China to speed up the pace of renminbi appreciation. With a delegation of high-level Chinese officials on its way to Washington this week, the timing of last week’s announcement is no mystery.

Kuwait’s decision to change its exchange rate regime from a dollar peg to a peg based on a basket of currencies also was done because of economic reasons. Exhibit 1 shows that CPI inflation in Kuwait has consistently exceeded the central bank’s target of 2% over the last three years. About one-third of Kuwait’s imports come from the European Union. The depreciation of the dollar vis-à-vis the euro over the past few years, which has resulted in dinar depreciation versus the euro, has raised import prices, thereby helping to feed inflation. By pegging the dinar to a basket of currencies rather than exclusively to a weakening dollar, Kuwaiti authorities hope to reduce imported inflation.

Moreover, China and Kuwait are both experiencing fundamental economic changes that bolster the economic case for real currency appreciation. Kuwait is a resource-based economy whose chief export (petroleum) has experienced a price boom over the past few years. Kuwait’s current account surplus has shot up to about 40% of GDP. Money is just pouring into the country, and the sound economic policy response is to allow the currency to appreciate on a real basis. Likewise, the Chinese economy is undergoing a long-run structural transformation. As the productivity gap between China and the rest of the world narrows, the currency should appreciate.

Case for Currency Appreciation in Hong Kong Not as Clear Cut

With that overview in mind, let’s return to the original question. Could Hong Kong make a change to its exchange rate regime? Although anything is possible, we think the probability of a change is very low, at least in the foreseeable future. First, inflation in Hong Kong is not much of an issue at present (see Exhibit 1). The low rate of inflation over the past three years follows nearly six years of deflation. Indeed, the overall level of consumer prices in Hong Kong remains more than 10% below the peak in 1998.

Moreover, there are not the same secular reasons for currency appreciation in Hong Kong as there are in China and Kuwait. Yes, real GDP growth in Hong Kong has been strong over the past few years, due in part to robust growth in mainland China.4 However, the structure of the Hong Kong economy is much closer to the U.S. economy than it is to either the Chinese or Kuwaiti economies. That is, Hong Kong is a developed economy that is driven almost exclusively by services, not by resource extraction or a booming manufacturing sector. The economic rationale for real currency appreciation in Hong Kong is not as clear cut as it is in China and Kuwait.

Finally, Hong Kong’s fixed exchange rate to the U.S. dollar has served it well over the past twenty years. The old American saying of “if it ain’t broke, don’t fix it” may apply in the case of Hong Kong’s exchange rate regime. Therefore, we expect that the Hong Kong Monetary Authority will maintain the effective peg of the Hong Kong dollar to the U.S. dollar for the foreseeable future.

However, that does not mean the peg is forever immutable. As Hong Kong’s economy becomes even more integrated with the economy of the mainland, an alteration of the exchange rate regime becomes more likely. Perhaps Hong Kong authorities will someday decide to tie their currency more closely with the yuan by, say, pegging to a basket of currencies that includes the yuan.

In the longer-run there is also the possibility that the Hong Kong dollar will someday simply cease to exist. China will regain full sovereignty over Hong Kong in 2047. Will Beijing allow one city in China to retain its own currency? Probably not. The Hong Kong dollar may not even make it 40 years longer. As the renminbi becomes convertible, Hong Kong residents may start to transact in yuan instead of Hong Kong dollars. To paraphrase General Douglas MacArthur, the Hong Kong dollar may “just fade away.” To reiterate, however, the Hong Kong dollar will be a viable currency for the foreseeable future, and it very likely will remain pegged to the U.S. dollar at its current exchange rate for some time.

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