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A Comment on: The CNY-U.S. Dollar Convergence and the Hong Kong Dollar Entrapment


A Comment on:

 The CNY-U.S Dollar Convergence and the Hong Kong Dollar Entrapment



Christer Ljungwall* and Steven Wang**


December, 2005




Abstract: This paper highlights the ‘entrapment' of the Hong Kong Dollar amidst the Chinese Yuan-U.S dollar exchange rate convergence - that is, what will happen to the HKD if the CNY exchange rate is subject to repetitive revaluation in the future. The analysis suggests that Hong Kong is forced to pay a high price regardless of actions.


Keywords:  Mainland China, Hong Kong, exchange rate

Jel. Classifications: F3, F31, E22,












*Corresponding author. Visiting research fellow, China Center For Economic Research. Peking University,  Beijing 100871, P.R China. Tel.: +86 10 6275 8988; fax: +86 10 6275 1474. E-mail address:  .**Visiting research fellow, CEPAS, Stockholm University, Sweden.

1.         Introduction

After the mounting political pressure exerted by the G7 countries China choose to revalue the Chinese Yuan (CNY) by 2.1 percent in July 2005, abandoning a decade-long peg to the U.S dollar set in 1994, and adopting a managed float but keeping the currency within a narrow band of 0.3 percent on either side of the “parity” rate of 8.11 CNY per U.S dollar. Under the reform, the People's bank of China (PBoC) will incorporate a reference basket of currencies when choosing its target for the CNY (Spiegel, 2005)[1][1]. The timing may have been a surprise but the reform of China's currency regime was anticipated, although the revaluation of 2.1 percent was significantly less than the 15-25 percent revaluation the G7 countries were expecting.

In a recent article, Goldstein and Lardy (2005) argue that the real trade-weighted value of the CNY is undervalued by 20-25 percent which is far in access of what is implied by an initial 2.1 percent revaluation with respect to the U.S dollar.  At the heart of this process we find China's firm controls of capital outflow, surpluses on both the overall current and capital accounts in its balance-of-payments, and the large accumulation in international reserves. Goldstein and Lardy further favour a two-step process to reform China's currency regime in which the first step should be a significant revaluation of the CNY, a sharply widening band, and a switch to a three-currency basket peg with weightings of roughly a third each for the U.S dollar, euro, and yen. Step two should be adoption of a managed float, after China strengthens its domestic financial system enough to permit a significant liberalization of capital outflows. Others (e.g., McKinnon, 2003) argue that moving to a flexible exchange rate is undesirable as it would lead to repetitive appreciation of the CNY. Instead, China should let the long run international adjustment occur by allowing its wages to rise in line with its high productivity growth.

Against this background, we set out to analyze what is often overlooked in the debate – namely the ‘entrapment' of the Hong Kong dollar (HKD) amidst the CNY-U.S. dollar exchange rate convergence; or put differently, what is likely to happen to the HKD in case the CNY would be subject to repetitive revaluation. As we do so, we adopt a broad-brush approach that for now is at some remove from the detailed empirical work necessary to verify or disprove the overall effects that we tentatively identify. As such, our picture of what is going on is painted with a view of generating debate. We explain in our analysis that Hong Kong must pay a high price for its exchange rate adjustment, regardless the circumstances that is.

The second section of this paper outlines Hong Kong's core problem in respect of the HKD-entrapment. The third section is an attempt to evaluate the problems inherited in alternative measures to adjust the exchange rate. Finally, a summary is provided.


2.        The core of Hong Kong's problem

Hong Kong has had a fixed exchange rate system since 1983, when the value of the HKD was fixed at 7.80 per U.S dollar in response to currency instability. Under this system all notes and coins in circulation are backed by Hong Kong's foreign exchange reserve fund, amounting to U.S. dollar 121.9 billion (end-Oct, 2005) ranking 7th in the world. Hong Kong does not have a ‘true' currency board arrangement in that the Hong Kong Monetary Authority (HKMA) set up in 1993 who oversee the system also perform the functions of a central bank such as regulating banking and financial systems[2][2].

A downside of the linked exchange rate system is that it also effectively links the interest rate of the U.S and Hong Kong economies, which in turn prevents the HKMA from using interest rate adjustments as levers on the Hong Kong economy. As a result, the Hong Kong economy has suffered from increased instability, in particular in the past decade. This instability appear because the Hong Kong economy is subject to the U.S economy, and when the economic cycles of the two economies miss-match, U.S interest rate may not be at levels appropriate for the Hong Kong economy (Humle, 2003). This is exactly what happened in year 2000 when the Hong Kong economy was about to recover from a recession brought on by the Asian financial crisis and the linked rate pulled the economy down. The high interest rates prescribed by the U.S Federal Reserve to cool down its overheated economy were contrary to what Hong Kong needed.

Against this background a major divergence in the CNY-U.S. dollar exchange rate necessarily means a loss of market value for Hong Kong's financial and real estate markets. In order for the HKMA to ‘save the market', they have to stabilize the HKD exchange rate, similar to what they did in 1969 and 1997. This scenario opens up the valid question of what to do with the HKD in case the CNY is subject to repetitive revaluation.



3.        A few existing options

Most available options to ‘save the market' fall prey to a number of problems, or costs that must be taken into consideration. Table 1 provides an overview of the few options open to Hong Kong, all of them subsequently discussed in the text.


Table 1. Options and implications: How to stabilize the HKD



1. De-link with the U.S dollar

Nominal anchor? Pegging currency?

2. Devaluation of the HKD

By definition a net loss of market value

3. Swap HKD reserve into CNY

Worse devaluation

4. Float the HKD


5. Mainland China stabilizes the

     CNY and HKD at the same time

Lack of co-ordination. Speculative


Note: Autocratic choice by the authors.


The first option, i.e., the attempt to stabilize the HKD by de-linking it with the U.S. dollar immediately raises two questions of concern; (i) what the nominal anchor should be, and (ii) what would the candidate pegging currency be?

A move to a monetary arrangement that targets some measures of monetary aggregates instead of the exchange rate will call forth some issues to be settled first, such as the appropriate monetary measure to be targeted and its desirable rate of growth as well as Hong Kong's lack of experience in determining and controlling the money supply.  Although a peg to a basket of currencies (under the existing currency board arrangement) would have some clear advantages of alleviating problems arising from non-synchronization of U.S and Hong Kong business cycles, it has the disadvantage of being less transparent to the public and cumbersome in day-to-day operation. Beside the issue of what currencies to be included in the basket, there is the value of their relative weights to be considered. And of course, because the Chinese currency is not fully convertible, the HKD cannot immediately be pegged with the CNY.

The second option is a devaluation of the HKD, which by definition means a net loss of Hong Kong's market value. Here it is not convincing enough to say that both the CNY and HKD should peg with a basket of currencies and form a fluctuation band with the U.S. dollar. Yet, another muddle-minded idea is that the HKD devaluation would be beneficial to Hong Kong's competitiveness in exports. It is true that devaluating the HKD vis-à-vis the U.S. dollar would make Hong Kong goods and services relatively cheaper, and thus has a stimulating effect on the economy. Yet, if there was a positive effect, it could only be transitory, especially when the ultimate problem is a loss in relative productivity in Hong Kong. 

Still, to confirm this, it must be proved that export growth exceeds import growth as a result of currency depreciation, thus improving the trade balance and contributing positively to GDP growth. However, while service trade is on the rise, re-exports remains high on the expense of domestic goods trade which seem to fall back. In addition, re-exports that accounts for more than 90% of Hong Kong's exports, does not have much to do with the exchange rate; rather, it is the ‘China factor' that leads to the re-exports surge. Because 80-90% of Hong Kong's re-exports are China related, it is China's competitiveness instead of the HKD exchange rate that determines the fate of Hong Kong's re-export, and thus the exchange rate factor is only secondary vis-à-vis the China factor.

Moreover, a devaluation, albeit just once, would completely undermine public confidence in the link, which is paramount in a currency board arrangement. Should the official exchange rate be changed once, it would be deemed to be less untouchable. This could invite speculation against the currency and, what is more disastrous, even the general public would believe the authorities might lack the will power to defend the exchange rate.

A third simple-minded, but often suggested, solution to swap the HKD reserve into a CNY one in practice means selling-off more HKD (or U.S. dollar), which definitely would depress the linked rate making the HKD devaluation even more serious.

A fourth option would be the possibility to float the HKD as an alternative to the existing regime. This, however, is no impeccable solution either; the authorities cannot responsibly just renounce the official rate of 7.8 or withhold convertibility undertaking.

Finally, some would argue that the central government of Mainland China has the full commitment to stabilize the CNY and HKD exchange rate at the same time – but again, where would this commitment stem from, and how would it work in practice? Judging from the fact that there is no monetary policy link (or transmission) between Beijing and Hong Kong, it is definitely not safe to deduct that the enormous amount of foreign exchange reserves kept in the hands of Beijing and Hong Kong could be effectively used to stabilize the exchange rates of both the CNY and HKD at the same time. In addition, the lack of coordination would provide a leeway for speculative attacks.



4.        Concluding remarks

This paper has sought to highlight the ‘entrapment' of the Hong Kong Dollar (HKD) amidst the Chinese Yuan (CNY) – U.S dollar exchange rate convergence, and identify what actions would be inflicted on the HKD in case the Chinese authorities would allow repetitive revaluation of the CNY. The root of the problem is the linked HKD-U.S dollar exchange rate, which is backed up by Hong Kong's foreign exchange reserve fund.

For Hong Kong there exist only a few options: de-link with the U.S dollar, devalue the HKD, swap the HKD reserve into a CNY one, float the HKD, and finally, Mainland China's commitment to stabilize the CNY and HKD exchange rate at the same time. We argue that Hong Kong is forced to pay a significant price regardless the solution.


5.        References

Goldstein, M. and N. Lardy (2005), ‘China's Revaluation Shows Size Really Matters', Financial Times, July 22.

Goldstein, M. and N. Lardy (2003), ‘Two-Stage Currency Reform For China', The Wall Street Journal, Sept. 12.

Humle, V.A (2003), ‘The Demise of the Hong Kong Dollar Peg', The China Business Review, March-April.

McKinnon, R (2003), ‘China's Exchange Rate', Asian Wall Street Journal, June 27.

Spiegel, M.M (2005), ‘A Look at China's New Exchange rate Regime', Economic Letter, Economic Research Federal Reserve Bank of San Francisco, No. 2005-23, Sept. 9.