All eyes on the strengthening yuan

Apr.13, 2008 in Market Outlook

HONG KONG (MarketWatch) — That the yuan broke the symbolic seven-to-the-dollar
mark last week should bring cheer to U.S. senators looking for China’s trade
surplus to shrink.

But for those in Hong Kong caught in the middle between these two giants of world
trade, it’s a painful reminder that the only thing getting smaller is their
spending power.

And if the yuan reaches a six-to-one ratio by the end of the year, as some
predict, the future of the Hong Kong dollar peg, now 25 years old, looks set to
come under yet more scrutiny. Indeed, investors and hedge funds are already
beginning to circle.

Earlier in the week, investment guru Jim Rogers was in town to launch a new fund
and warned that weakness in the greenback isn’t over and that future prospects
for the local currency are uncertain.

If anything, the U.S. dollar’s slide is gathering pace as it falls out of favor
as the world’s medium of exchange, he said. It’s already done a lousy job as a
store of value, and now it is being shunned even for settling bills.

But if the mighty U.S. dollar is having problems, where does that leave the Hong
Kong dollar — now worth only 9/10ths of a yuan?

Rogers’ comments left much to chew on. “The yuan is one of the safest investments
in the world right now against the U.S. dollar, and therefore against the Hong
Kong dollar,” he said.

Shifting fortunes

It seems he was already talking to the converted.

Since the end of last year, yuan savings in Hong Kong banks have reached 47.8
billion yuan in February, up from 33.4 billion in January. And that doesn’t count
the increasing numbers making the day trip to neighboring Shenzhen to open yuan
bank accounts.

It’s a far cry from only a few months ago, when we heard of the underground
investment dollars being funneled into Hong Kong illegally from Shenzhen. That it
seems to be going in the reverse direction now is simple to understand: Yuan
saving rates are close to 4%, and Hong Kong banks are lucky to give you a few
basis points on your dollar.

Not only is the interest hardly worth counting, inflation ensures that real
returns are worse still.

With the yuan in the limelight, more investment banks have been issuing reports
that turn the spotlight on the Hong Kong dollar peg. It’s been a scared cow for
so long in this town, even to question its existence invited ridicule.

But people certainly listen when Jim Rogers speaks. He alluded to the inevitable:
“You have a gigantic neighbor who’s becoming the most incredible economy in the
world. “It [the Hong Kong dollar] would be like having a special currency for
Mississippi when the rest of the U.S. uses the U.S. dollar.”

This captures the core flaw in the peg — namely, that the U.S. dictates Hong
Kong’s monetary policy when the majority of its trade is now with China. This
means the peg effectively turbocharges China’s tide of rising prices when they
arrive in Hong Kong.

That’s conventional wisdom, although the Hong Kong Monetary Authority chief
Joseph Yam recently tried to defend the peg by arguing that it was rising wages
and not the peg to blame for inflation. Few seem to believe him.

Beijing to set any timetable

Of course, no central banker would publicly flag any change in a pegged currency
regime. More likely than not, any decision will be taken ultimately by Beijing.

That would depend on when a change in the status quo suits China, so Hong Kong
can best serve a function as its domestic financial market.

We heard last week that mainland authorities signed a deal to expand the QFII
program, short for qualified foreign institutional investors, to allow more
trading of U.S. stocks.

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