Should Hong Kong Keep Its Currency Pegged to the US Dollar?

For the past 30 years Hong Kong has maintained the tradition of pegging its official currency, the Hong Kong Dollar, to the US Dollar. This linked exchanged rate system has provided economic stability and credibility to this export-oriented region. However with China abandoning it US dollar peg in 2005, plus the fact that Hong Kong and the US are in different positions in the economic cycle, people are starting to question the validity and the effectiveness of this peg. Dr. Joseph Yam, the previous HKMA chief executive have stated, “there is a need to address the question as to whether the monetary system … can continue to serve the public interest of Hong Kong.” 

I believe it is a necessary measure to abandon the currency peg with the US dollar, because it doesn’t work when you try to fit one set of monetary controls on two totally out of sync economies. Whilst the US is currently in a deflationary gap, Hong Kong has been suffering from uncomfortably high inflation and asset bubbles. What US is doing to eliminate to gap, by lowering interest rates, can only push Hong Kong into more inflation. Right now, Hong Kong needs to regain its autonomy in monetary policy, so that it has the freedom to restrict money supply to reduce inflation. 

Another problem with the dollar peg is China. China is Hong Kong’s major trading partner, so China influences strongly on Hong Kong’s economy. Now that the Chinese Renminbi is pegged to a basket of currencies, and not the US dollar, Renminbi has been appreciating over the last couple of years in respect to HKD. The increase in value of renminbi means Chinese exports is more expensive in Hong Kong. Businesses relying on such exports may increase their prices leading to cost push inflation. What Hong Kong should do, however, is to take advantage of China’s strong and growing economy, and instead of pegging to the US dollar, should peg to the Renminbi when it becomes a fully convertible currency.

So to summarise, I think Hong Kong should break away from the US dollar straight away and become a free-floating currency (this should work- look at the Singaporean dollar). When the Renminbi is fully recognized internationally, it should be pegged to the Renminbi.

Despite Hong Kong officials’ open opposition to removing the peg with US dollar, I believe the transition is just a matter of time. Of course, this is not a solely economic issue – politics has a lot to do with this. Nevertheless, the Hong Kong dollar should not be pegged to the US dollar as it is a hindrance to Hong Kong’s economic performance.

China Slowing Down?

Source: http://pbl-eyetter-bowman.blogspot.jp/2008/11/cartoon-mccain-and-obama-to-work-n.html

China's economy has hit an all time low as the lastest statistics showed that the gross domestic product only rose by 7.6% in the second quarter, first time below the 8% mark after the financial crisis in 2008. This, of course, comes to be a surprise to many of us as we still vividly remember the double digit growth that China experienced before the financial crisis and again in 2010. 

A reason for the slowing growth has to do with the massive fiscal package that the government had injected into the economy four years ago. Much of the investment in order to save the economy were directed towards infrastructure. As I mentioned in a previous post, this was proven to be very effective and produced many positive outcomes (at first), such as the impressive short term economic growth during 2009 - 2010 period. However, what I did not mention was that the increased capacity caused a significant surge in prices, especially in the property market, which led the economy into high inflation. In order to deal the overheating economy, the government implemented a set of policies to reduce spending, which in effect, is reflected through the declining economic growth in China.

The important question right now, I think, what effect it has on other economies. Broadly speaking, China had been the support that struggling economies around the world needed, especially when US and Europe's economy is still in bad shape. China's slowdown can only cause hindrance and negative impact on other economies. Tai Hui From Standard Charted Bank in Singapore stated that "China has been a big factor for the slowdown in Asia this year" and that if China's growth continues to be like this then "that's going to mean very difficult (for) manufacturers in this region".

Declining level of confidence within consumer and business groups may further lower consumer and business spendings, which is already showing signs of weakening in China. The central bank has lowered the interest rate two times since June and the government has tried to boost aggregate demand by further injecting money into the economy - these market based approaches seems to not be effective at all in this situations, which urges the government to start thinking of new ways to tackle the problem.

Money Leaving China: A Problem?

Source: http://www.bearishbull.com/?p=36

This is a section of an article from the Economist on China’s recent balance of payment deficit.

“MAINLAND China can now boast over 1m wealthy citizens (qianwan fuweng) each with over 10m yuan ($1.6m), says the latest edition of the “Hurun Report”, which keeps track of China’s capitalist high-roaders. But the mainland seems to be having trouble keeping them. According to the report, published on July 31st, more than 16% of China’s rich have already emigrated, or handed in immigration papers for another country, while 44% intend to do so soon. Over 85% are planning to send their children abroad for their education, and one-third own assets overseas.

The affluent 1m have profited handsomely from China's economic boom. But only 28% of those asked expressed great confidence in the prospects over the next two years, down from 54% in last year's report. That unease may also be visible in a more obscure report released on the same day, by China's State Administration of Foreign Exchange (SAFE). It showed that China's balance of payments had recorded a deficit in the second quarter, for the first time since 1998. Put simply, more money was leaving China than arriving.

The same phenomenon can be described less simply. The balance of payments records two different kinds of transactions: cross-border payments for goods and services (ie, exports and imports), which are recorded in the “current account”, and cross-border payments for assets. China’s current account is still in surplus, largely because its exports exceed its imports. China is also attracting plenty of direct investment from foreigners eager to buy or build companies on the mainland. But both these inflows of foreign exchange were outdone by a record outflow of other kinds of capital, amounting to a net $110 billion. This left China’s overall balance of payments in deficit, diminishing China’s international reserves by $11.8 billion (or just under 0.4%)”

Source: http://www.economist.com/node/21559949

Looking at the situation with rising exchange rate and overall balance deficit, the chief China economist at Nomura Zhiwei Zhang thinks, “the capital outflow is not an alarming sign in itself, but just reflects economic worries that are already well-known”. People are moving their assets from China abroad because they sense a kind of structural weakness and instability in China’s markets and thinks it is much better, and safer to place capital somewhere else.

Victor Shih from Northwestern University pointed out China’s three structural weaknesses. Below is taken from his 2011 paper, I have emboldened the key points.

"China has three structural causes of capital flight.  First, wealth in China is highly concentrated.  Using three different methodologies based on survey data, data on large share holders of listed company, and data on the total financial and real estate assets in China, the wealthiest 1% urban households command between 2 and 5 trillion USD in wealth.

·     A 20% reallocation of this wealth overseas would cause a substantial but likely controllable drainage of China’s foreign exchange reserve. 

·     A 30-40% reallocation of this wealth overseas would see the depletion of China’s foreign exchange reserve by close to 1 trillion USD or more.  

·     Second, underground banks, false trade invoicing, and now an experimental scheme to allow individual investors to invest overseas provide multiple channels for capital to circumvent China’s exchange control.

·     Third, real deposit interest rates are negative and will remain so in the foreseeable future, thus prompting wealthy households to speculate overseas on a large scale if relative returns suddenly decrease in China.

·     If the top 1% of households in China reallocates 1 trillion USD of their wealth overseas, the central bank then will be faced with a choice between large scale quantitative easing and an illiquid banking system. 

·     In the short term, China’s only recourse to reduce the volatile state of its foreign exchange reserve is to bring real interest rates back to positive territory."

Source: http://ineteconomics.org/sites/inet.civicactions.net/files/BWpaper_SHIH_040811.pdf

So is this going to be a problem for China? Right now, no; but in the long run, without proper government control, yes.

"Economyths"

Recently I read a book called “Economyths” by David Orrell that talked about the limitations of orthodox economic theory. Here I’d like to share a section that he wrote in the introduction.

“Economics is a mathematical representation of human behaviour, and like any mathematical model it is based on certain assumptions. I will argue, however, that in the case of economics the assumptions are so completely out of touch with reality, and with the needs and behavior of most people, that the result is a highly misleading caricature. The theory is less a science than an ideology. The reason why so many people are so conned into thinking the assumptions are reasonable is that they are based on ideas from areas like physics or engineering that are part of our 2,500-year scientific heritage dating back to the ancient Greeks. Superficially they have the look and feel of real science, but they are counterfeit coin.

To make progress, it’s not enough to adjust or revise these assumptions. Much work has already been done in exploring minor variations. Instead, as a Nature article entitled ‘Economics Needs a Scientific Revolution’ put it: ‘We need to break away from classical economics and develop completely different tools.’ While economics has traditionally modeled itself after physics and mechanics, the economy has more in common with a living organism than it does with a machine.”

What is Quantitative Easing?

Source: http://danielpryorr.wordpress.com/2012/05/30/quantitative-easing-or-government-stealing/

Normally a central bank uses the official interest rate to regulate the money supply. The idea behind it is simple: if the interest rate is high, it makes borrowing more expensive and thus encourages people to save. This will reduce the money supply in the economy (contractionary monetary policy). Conversely a low interest rate makes borrowing more attractive than saving, thus increasing the money supply in the economy (expansionary monetary policy).

This is an important consideration since the supply of money directly correlates to the amount of spending in an economy. An increase in money supply (a decrease in the interest rate) will increase consumption spending and increase investment spending – which is particularly useful when the economy is in recession because it boosts the aggregate demand, which, in turn, creates the economic growth needed to get out of the recession.

But a question arises: what if an economy is in recession (low supply of money) and the interest rate is close to zero? It is illogical for the central bank to lower interest rate below zero. So what should it do? In terms of monetary policy, this is where quantitative easing steps in.

Quantitative easing is another way that a central bank increases the money supply of an economy. It is the process of injecting money into the economy that is created out of nothing. A colloquial term used here is “printing money”, but a central bank hardly does that. Instead it is done electronically by increasing the value in its credit account.

The central bank then use this newly created money to invest in financial assets that is usually owned by commercial banks or similar financial institutions. Therefore the money created is “transferred” to them. This encourages financial institutions to lend more to firms and individuals, which therefore (in theory) increases the overall economic activity, stimulating economic growth.

This sounds very good for the economy, but there are also consequences. Increasing the money supply excessively by “printing money” will cause the currency to devalue greatly, which might lead to unfavourable results like inflation or hyperinflation.  On the other hand, too little money injected into the economy will yield no results. It is very hard, if not impossible, to find out how much money is needed to produce the optimum result. 

In the year 2009, the Bank of England injected 200 billion pounds into the economy. It is said that it “helped to increase gross domestic product by between 1.5% to 2%, indicating that the effects of the programme had been ‘economically significant’” (BBC)

There are many analysts that disagree with this claim, and the thing is, and I quote from BBC:

" The simple fact is, on one knows how bad things would have been without QE (quantitative easing).

As BBC economics editor Stephanie Flanders says: ‘ Quantitative easing may well have saved the economy from a credit-led depression. We will never know.’ "

So is quantitative easing effective and useful? It is hard to say.

Boosting Aggregate Demand - The Way Forward for the Eurozone

Instead of adopting a conservative way of reducing debt by cutting back on spending, European governments should take on a more aggressive approach by doing exactly the opposite.

The Keynesian model shows that a country can be “stuck” in a recessionary (or deflationary) gap for a very long time due to downward nominal wage rigidity and insufficient aggregate demand. Keynesian economists therefore think a country must “grow” its way out of a recession, and considering the case of the Eurozone I cannot agree more. Countries in the Eurozone must boost its aggregate demand so that AD can shift to the right from AD to AD₂ and produce at the potential GDP (Figure 1). In other words, the Eurozone should make high economic growth one of their main priorities in the upcoming years.

Figure 1. Source: www.economicshelp.org

In order to achieve growth expansionary demand side policies must be in place. Firstly, the interest rates should be kept low.This way in encourages more borrowing from consumers and businesses, which therefore increases spending. Secondly, governments should increase spending in areas where there is an almost-guaranteed positive return. This is what we call fiscal stimulus packages. Such packages trigger a multiplier effect where the GDP return (or national income) exceeds the government spending that causes it and can in effect stimulate aggregate demand in an economy. An example of such investment is investment on infrastructure. This is actually what China did back in 2009, when it spent 1.5 trillion RMB on railways, roads and airport. By doing so, even in a time of global financial crisis, China maintained an impressive 9% real GDP growth rate.

Is Debt Always Bad?

We have seen from last week's discussion how Greece is suffering from its massive debt, and from that it is very easy to assume that debt, both public and private, is alway bad... but is it?

The answer is no. Borrowing money and being in debt in the short run increases your capital and gives you the opportunity to invest in something you may not be able to afford at that moment. This is important for decision makers so that they don't have to wait until they have sufficient money and delay their investment plans. It also increases their responsiveness to the changes in the economy so that they can make their investments in a period of time where the economy is doing well.

To determine whether a debt is good or bad we must consider the balance between the risk and the return of the investment. If the risk (reflected through the interest rate) is high and the return (or net gain from the investment) is low, then overall the investment is not worthwhile and the debt is considered bad. In other words, there is no point to be in debt. On the contrary, if the risk is low and the return is high, then this is a good investment and it makes sense to be in debt in the short term. The balance between risk and return shows how easily is the debt repayable and thus is a good indication whether the investment is worthy or not.

This is why a student loan is usually considered a good debt. Education provides a valuable asset that is very useful in the future, therefore high return. The interest rate for student loans are usually very low, therefore low risk.  The same goes to real estate loans.

The key is to not to borrow excessively and be in more debt than you can afford to. Governments and individuals must evaluate and judge whether their decisions to be in debt will bring long term benefits and whether the debt will be repayable. If it is a "yes", go ahead and borrow; if it is a "no", don't bother because it is not worth your while.