In defense of the Hong Kong dollar peg: which eventually will cease to exist.

• Author: Lo, Chi

While some countries have engaged in a "currency war" to eke, out short term growth, Hong Kong s currency peg has deprived it of the option of currency devaluation. Some even argue that Hong Kong lost out in the currency war. There is renewed doubt among analysts and politicians at)out me merits of me currency peg, since Hong Kong has developed into a service-based economy which in principle relies less on foreign trade and the usefulness of a fixed exchange rate. In Hong Kong, the peg has been blamed for causing asset bubbles and aggravating wealth inequality, inflation, and economic volatility.

These views ignore economic fundamentals. The endgame for the Hong Kong dollar is already in sight. It will vanish when the Chinese renminbi becomes fully convertible, though that will take many years. Between now and then, the peg is still Hong Kong's best option for maintaining systemic stability. With the peg likely to remain in force in the medium term, Hong Kong will continue to import the massive liquidity impact from the United States' unconventional liquidity measures. This will boost local asset price growth, all other things being equal, and contribute to economic growth.

THE HONG KONG DOLLAR AND THE CURRENCY WAR

Since the subprime crisis, the world economy has been struggling to emerge from the balance-sheet recession. The needed structural rebalancing efforts are painful to implement. Hence, many governments have resorted to the short-term painkiller of quantitative easing, which has manifested itself in currency depreciation to generate short-term growth.

However, it is impossible for everyone to devalue at the same time. So currencies take turns depreciating through rounds of quantitative easing. This amounts to what Brazilian Finance Minister Guido Mantega called "currency war," which is in fact "rotational currency depreciation." This is notable in the U.S. dollar-to-euro and Japanese yen-to-euro cross-rates. The yen has shown persistent strength against the dollar, but the Bank of Japan has started a "war" against the dollar since mid December 2012 by increasing the pace of money printing in order to weaken the yen.

Hong Kong's currency peg with the U.S. dollar deprives it of the currency devaluation option. Hence, its growth impetus in the currency war. Consensus forecast in early 2013 had put Hong Kong's growth at 3.7 percent and 4.2 percent respectively for 2013 and 2014, the lowest non-crisis growth rate in Hong Kong's modern economic history.

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