Hong Kong: 'Goodbye U.S. dollar, Hello Chinese yuan'

A look at the changing face of global settlement currency

Hong Kong is Asia’s leading shipping and aviation hub with more worldwide cargo vessel and flight destinations than Chinese ports, and is better able to consolidate smaller shipments and navigate efficient routes, which saves on shipping costs. And because of its unique history and geography, Hong Kong serves as the “gateway” to China for Western companies, and for Chinese manufacturers who likewise rely on Hong Kong to help broker “re-export” arrangements with the West – a process by which Chinese companies export their goods to Hong Kong for preparation to re-export them to their final destination. Re-exportation accounts for about half of Hong Kong’s total trade – HK$2.4 trillion ($310 billion).

Since the handover of this former British colony in 1997, China has grown in its appreciation of Hong Kong as a “mediator” between East and West. That being said, China is yet determined to integrate Hong Kong back into the greater fold. The following is the good, the bad and the ugly of recent developments on Hong Kong, along with details on Chinese efforts to expand use of the yuan in Hong Kong – a process that will eventually cement the decline of the U.S. dollar as the primary international settlement currency:

The Good: On October 29, 2010, the Hong Kong Monetary Authority said yuan deposits at the city’s banks more than doubled to a record 149 billion yuan ($22 billion) in the last six months; and the Hong Kong Hang Seng Index is up 31% over the same period. Hong Kong enjoys one of the lowest unemployment rates in the world – at 4.2%; has a current account surplus of $28.34 billion (2009); and has posted five straight quarters of economic growth. The government’s forecast was raised from a range of 4 to 5% GDP growth back in May to a range of 5 to 6% expansion.

The Bad: Over the past six months, the Hong Kong dollar is down 9% against the Singapore dollar; down 14% against the Japanese yen; down 14% against the Euro; down 16% against the Swiss franc; and down 19% Australian dollar. Home prices have surged 47% since the beginning of 2009. Hong Kong has no agriculture industry or natural resources to speak of, so its imports make up just over half of GDP – HK$2.7 trillion ($348 billion). Domestic exports represent a mere 1% of total trade. The Hong Kong services sector accounts for 92% of GDP, and industry 7.9% (2009).

And the Ugly: “Hong Kong has a growth rate that is linked to the fastest-growing economy in the world, which is China, and because of its fixed currency link, a monetary policy that is linked to the weakest [the U.S.]”, said Goetz Eggelhoefer, a Singapore-based partner with Rohatyn Group. “[Hong Kong] can’t have strong growth, loose monetary policy, a weak currency and no asset inflation. Something has to give.”

Due to the combination of high growth and easy monetary policy, Hong Kong’s economy is ripe for some serious turbulence, namely, inflation. Assuming the decline in the value of the Hong Kong dollar will cause import prices to rise – slowing economic growth – calls will intensify for the Hong Kong dollar to be decoupled from the U.S. dollar – with the Hong Kong dollar rising at a gradual pace, and trading within a 0.5% daily band.

Consequently, as the Hong Kong dollar rises, the need for Hong Kong to buy U.S. Treasuries in order to maintain its peg falls (now, 1 USD = 7.75 HKD), which would force the Treasury to find replacement buyers, or would increase pressure on the U.S. government to lower spending. And as yuan availability increases, the significance of the Hong Kong dollar would decrease, laying the foundation for its eventual retirement in favor of the yuan (1 USD = 6.66 RMB).

Furthermore, China 1) is allowing use of the yuan as a trade settlement currency in provinces throughout China. Just last month, the Hong Kong Monetary Authority arranged a yuan-swap facility with the People’s Bank of China (PBC) on increasing demand for trade settlement using the yuan. Total trade settlement using the Chinese currency was 126.5 billion yuan ($19 billion) in the July-to-September period, up from 48.7 billion yuan the previous three months; and 2) the PBC initiated a pilot program in August allowing foreign central banks to clear cross-boarder yuan settlements in Hong Kong and Macau.

Despite these impressive achievements, it would be decades before the Chinese yuan replaced the U.S. dollar as a global settlement currency for international trade for the following reasons: 1) the Chinese government limits yuan availability; 2) China’s bond market, which central banks and international companies would access to borrow yuan for payment transactions, is too small to facilitate global trade, compared to the U.S. $5.7 trillion bond market; 3) the Chinese banking system is not yet sophisticated enough to effectively manage the fund stream of a bond market of a depth, breadth and scale required for international trade; 4) the Chinese markets are, on the whole, closed to outside investors; and 5) the flow of imports into China is restricted. Open markets are of paramount importance to international currency acceptance.

If indeed the Hong Kong dollar were allowed to appreciate against the U.S. dollar, how should investors play the change? One clear way is to buy the Hong Kong dollar. You can get exposure to it through E*TRADE’s Global Stock Trading (please see the site for details). You can also buy the iShares MSCI Hong Kong Index Fund ETF, symbol EWH. According to ING Groep NV (February 2010), China-based companies trading on the Hong Kong Hang Seng exchange are priced at a 38% discount to the same companies listed on Chinese exchanges. A rise in the value of the Hong Kong dollar would lift the Index. As things are, the flood of Chinese yuan into Hong Kong, coupled with easy monetary policy, have lifted the Hang Seng Index by the 31% from its May 2010 lows – and this with no change in Hong Kong-dollar value against the U.S. dollar.

Maybe the Hong Kong Monetary Authority will manage inflation risk well; maybe it won’t. But unless the U.S. takes swift, forceful action on three fundamental economic issues: a minimum wage that is comparatively too high; artificially high home prices; and artificially low interest rates, a move to decouple the Hong Kong dollar from the U.S. dollar would solidify the notion in the hearts and minds of the international community that use of the U.S. dollar as a global settlement currency is diminishing. And just as General Macarthur said in a speech before Congress on April 19, 1951, so it may be said of the U.S. dollar: “Old soldiers never die, they just fade away”.

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