Pax Sinica: Geopolitics and Economics of China's Ascendance

9: The “China Factor” vs. the “US Dollar Peg” in the Success Story of Hong Kong

The Hong Kong dollar was pegged to the US dollar at the rate of HK$7.8 in October 1983. Not long afterwards, commencing in April 1984, China made a decisive move to court more foreign investment by opening fourteen cities along the eastern seaboard.1 Launched with entirely different objectives , these two important policy measures have nevertheless jointly and profoundly affected the performance of the Hong Kong economy over the past two decades. The dollar peg, aimed at stabilizing the Hong Kong currency following the severe loss of investor conÀdence resulting from the deadlock in the SinoBritish negotiations over the future of Hong Kong,2 immediately deprived the Hong Kong government of monetary policy Áexibility in countering cyclical economic movement, and actually contributed to increased economic instability . However, export manufacturers were permitted to relocate to the Chinese hinterland to take advantage of the open-door policy, and thereby avoid the pressures of spiralling wage and land costs. The manufacturers were able to remain competitive, which was crucial to a small, entirely open economy as Hong Kong’s, and the integrity of the peg was upheld. The goal of this article is to study the interplay between the so-called “China factor” and the dollar peg in Hong Kong in the run up to the 1997 handover, through the Asian Ànancial crisis and beyond. The Àrst sections describe the general changes in the economy following the adoption of the peg, and the factors precipitating the complete migration of Hong Kong’s manufacturing * Reprinted from “The interplay of the ‘China factor’ and US dollar peg in the Hong Kong Economy” (coauthored with Raymond Ng), The China Quarterly (CQ), No. 170 (June 2002), pp. 105–30. 9 The “China Factor” vs. the “US Dollar Peg” in the Success Story of Hong Kong* 228 Pax Sinica industries across the border to China. This is followed by a detailed analysis of how the manufacturers’ exodus helped to expand the economic base of Hong Kong’s export industries on the one hand, while keeping Hong Kong’s exports internationally competitive on the other, despite a bout of accelerated domestic inÁation caused by the peg before 1997/1998. The analysis extends to the present, examining how the peg has fuelled deÁation but the “China factor” may have helped mitigate it. Important questions are raised about the peg in light of the disastrous consequences of the Asian Ànancial crisis for some Asian economies, and about the concomitant search for a more viable exchange rate regime. The article concludes that despite the increased integration of the Hong Kong and mainland China economies, the likelihood of the Hong Kong dollar being de-pegged from the US dollar and re-pegged to the Chinese currency is yet remote. Economic instability under the US dollar peg The major features of the US dollar peg as adopted in Hong Kong are familiar, but they will be brieÁy outlined to provide a proper framework for understanding the subsequent economic changes in Hong Kong. In essence, the dollar peg resembles the currency board arrangement. It is a “hard currency ” system which requires the issuing of the domestic currency to be fully supported by the holding of US dollar reserves. Whilst the rate of HK$7.8 per US dollar has been Àxed for the issuing and redemption of the Hong Kong currency, the exchange rate of the Hong Kong dollar is nevertheless freely determined in the foreign exchange market. The desired exchange rate stability is to be maintained through a self-restoring mechanism in the form of cash and interest rate arbitrage.3 The primary and only monetary policy objective is to help stabilize any exchange rate Áuctuations. A country operating such a currency board should normally enjoy a lower and more stable inÁation rate, as a result of the more prudent monetary and Àscal disciplines imposed by the system. A stable exchange rate is indeed considered crucial for Hong Kong, a small and entirely open economy serving as an international Ànancial centre. The major drawback, however, is that the government is effectively deprived of any autonomous control over money supply. It is therefore not in a position to run any counter-cyclical policy. Hong Kong’s money supply is ultimately dependent on its international balance of payments position. In addition, its The “China Factor” vs. the “US Dollar Peg” in the Success Story of Hong Kong...