Hong Kong debates its currency's peg to the US dollar
When Capt Charles Elliot clambered ashore at a rocky outcrop in western Hong Kong in 1841, he claimed the island for the British Empire and established a free port that still serves as a centre for global trade.
Since Capt Elliot founded modern Hong Kong, the city has evolved from a pirate-infested backwater to one of the world's leading financial capitals, changing hands from Britain to China in the process.
But throughout that tumultuous time, one fact has remained relatively constant - a linked exchange rate regime of some kind.
Over the past 30 years, Hong Kong's currency has been pegged to the US dollar at a rate close to 7.8 - making $10 equal to HK$78.
The US dollar peg, which effectively ties Hong Kong to America's monetary policy, has helped the semi-autonomous territory navigate successfully through the Asian financial crisis, the outbreak of severe acute respiratory syndrome (Sars) and the collapse of investment bank Lehman Brothers in 2008.
That is why this city's financial sector was taken utterly by surprise when Prof Joseph Yam, the former head of the Hong Kong Monetary Authority (HKMA), recently published a working paper suggesting a review of the dollar peg.
"There is a need to address the questions as to whether the monetary system of Hong Kong, as currently structured, can continue to serve the public interest of Hong Kong in the best possible manner," wrote Prof Yam, of the Chinese University of Hong Kong.De-peg?
Prof Yam's comments came as a surprise because he was one of the architects of the US dollar peg and has been a stalwart defender of the policy.
In his new paper, he outlined several options, including increasing the level at which the Hong Kong dollar would be allowed to trade against the greenback, pegging the currency against the Chinese yuan or perhaps allowing it to trade against a number of other currencies.
End Quote Erik Lueth Royal Bank of Scotland
To say it upfront, I also don't believe that the peg will be abandoned over the next seven to ten years and [Prof] Yam's intervention should be read as the views of a man that misses the spotlight”
When asked why he was making such a dramatic public reversal of opinion, Prof Yam told Hong Kong media it was because times had changed.
The US dollar peg had contributed to inflation and asset bubbles in Hong Kong because of the policy of quantitative easing the US Federal Reserve adopted following the global financial crisis, he said.
"Clearly, both have unsettling and possibly debilitating consequences for society," Prof Yam wrote.
Hong Kong's economy has grown rapidly during the past 30 years. Its financial centre is the envy of the world. In the past three years, more money was raised at the Hong Kong Stock Exchange than at any other bourse.
But it remains a small, trade-dependent economy vulnerable to changes in capital flows, which is why many economists have played down Prof Yam's controversial comments.
Erik Lueth, a Hong Kong-based economist at the Royal Bank of Scotland, believes the peg will stay for the foreseeable future.
"To say it upfront, I also don't believe that the peg will be abandoned over the next seven to 10 years and [Prof] Yam's intervention should be read as the views of a man that misses the spotlight," he wrote in a note to clients.
Hong Kong's top officials - including the incoming chief executive, the financial secretary and Prof Yam's successor at the HKMA - have all publicly announced their support for the US dollar peg in response to the academic paper.Link to yuan
But Mr Lueth and Frances Cheung, a strategist with investment bank CLSA, also believe that, while the dollar peg is currently the best choice, Hong Kong could one day link its currency to the Chinese yuan instead.
"I will be surprised if the HKMA is not prepared for a change some day," Ms Cheung wrote in a note to clients.
Of course, this would only be an option if the Chinese yuan were fully convertible, which economists estimate could happen as early as 2015.
From a historical point of view, this option is plausible. Small, open economies such as Hong Kong, Singapore and Panama all have fixed or hybrid exchange rate systems to reduce volatility.
In the early days as a British colony, Hong Kong's currency was linked to silver. Then, it was pegged to the British pound and, later, to the US dollar.
For about 10 years in the 1970s, the Hong Kong dollar was allowed to float freely.
But, in September 1983, investors panicked during negotiations between Britain and China over Hong Kong's future, triggering capital outflows and a sharp depreciation in the value of the Hong Kong dollar.
The depreciation was so sudden and severe that officials decided to impose the strongest form of fixed exchange rate systems, the currency board.
In the subsequent three decades, China's economy has grown from strength to strength, overtaking Japan as the world's second biggest income generator in 2010.
At the same time, growth in the US economy has slowed and its currency seems to be showing signs of a long-term downward trend.
With more than half of Hong Kong's exports going to the mainland, and with financial engagement between the two sides deepening, Hong Kong's currency system is likely to become ever more linked to China's.