The Hong Kong yuan?

By Craig Stephen,  MarketWatch  Apr 8, 2007

Ten years after political control of Hong Kong was returned to China, the island state's currency is facing a sea change of its own.

As the yuan, bolstered by China's hypergrowth, gathers strength against the once-dominant Hong Kong dollar, residents are being forced to make painful choices.

How best should inhabitants and investors alike try to preserve their wealth in the face of their incredible shrinking currency?

Looking at currency markets today, we seem to be at a polar opposite from a decade ago. Then when Thailand tipped off an Asian financial crisis, the Hong Kong dollar withstood intense gravitational pull to decline. Bow-tied Chief Executive Donald Tsang at the time was at the helm as financial secretary who audaciously spent HK$120 billion buying equities to stave off hedge funds attacking the currency.

Today just about all Asian currencies appear to be heading north, bar the HK dollar with its peg to the weakening greenback. This is having some unusual effects that portend change to come.

Significantly, as China has moved to allow a gradual appreciation of the yuan, it has now overtaken the HK dollar as it crawls upwards. It now takes 7.81 HK dollars to buy one greenback but just 7.72 yuan. Further moves upward are widely expected and being called for.

For many years the currencies had assumed a de facto peg to the HK dollar within a dual currency regime. But now it appears the HK dollar is being shunned.

The South China Morning Post recently ran stories that Chinese over the immediate border no longer want the HK currency. Not just taxi drivers but Starbucks in Shenzhen are turning their noses up at it and the US dollar -- both of which were previously freely acceptable.

And in Hong Kong some shops are refusing to accept physical coins, due to higher bank charges for handling this depreciating tender.

Nomura Securities, in a recent strategy note, highlighted these anecdotal events to question if we could be seeing the demise of the HK dollar.

In a situation where people can opt for two currencies, according to Gresham's Law, bad money forces good money out of circulation. It may be early days, yet in January the Hong Kong Monetary Authority (HKMA) reported the biggest jump in yuan deposits since accounts were launched two years ago, rising to 24.2 billion, up from 22.7 billion in January. Nomura strategist Sean Darby notes "the perception that one currency will appreciate over another is enough to cause a self perpetuating cycle of appreciation."

For Hong Kong, one very noticeable impact is building inflationary pressures from being tied to a depreciating US dollar. This is likely to be further fanned as even goods from low cost China begin to cost more.

Money supply growth has been in the high teens this year and bank lending to deposit ratios are at record lows, leading banks to further cut mortgage rates below prime. The rapid creation of money has flowed into financial assets; bad if you are on fixed HK dollar wage and renting property, but it has been good for physical property and equities.

Today the peg is taking the strain of adjustment in reverse to 1997-1998. Then, while asset prices plummeted 60% or more in some cases, if you kept your job, avoided a wage cut and were renting rather than a property owner it was actually pretty good. Rents were cheaper, so were holidays with the baht at 50 to the dollar.

Borrowing in a weak HK dollar with funding rates below U.S. Libor makes the Hong Kong currency arguably one of the best funding vehicles for global currency traders, say Nomura.

Of course that prognosis still rests on the HK's peg to the U.S. dollar remaining intact as the currency of its largest trading partner powers ahead.

HKMA chief Joseph Yam said recently Hong Kong would retain its currency even if the yuan was stronger, although you would expect nothing else.

In private, you do begin to hear comments from economists that the HK dollar has at most five years to go and will be folded into yuan -- the HK yuan.

Of course for now the yuan is not a convertible currency and China has considerable work to do to clean up its financial system before that can change.

Arguably, the drift in the currency mirrors political drift as it becomes more apparent ultimate decision making always rests in Beijing. As Hong Kong's erstwhile competitor, Singapore sets out to attract regional corporates and expatriates with a vision for the future, the difference is starkly brought home. Politically, Hong Kong cannot really control its future; immigration for one is limited under an agreed policy of 100 Chinese a day never mind the lack of commitment to elections. And the pillars of its economy -- a cyclical property market and a venue for Chinese companies listing overseas, both look vulnerable to China's own development.

Under the Donald Tsang government, Hong Kong is likely to stick to the past -- it was he who defended the peg last time around.

But if more Hong Kong inhabitants vote with their pocketbooks for the yuan, the HK dollar may well end up being little more than a relic from colonial times gone by. Much like Mr. Tsang and his bow ties.