The Hong Kong economy is booming but its currency is chocked and kept undervalued. It is a problem to have a purposefully weak currency when the economy is strong, particularly during the era of QE which has debaed the anchor. Hong Kong pegs its currency to the US dollar within a very narrow band, currently between HK$7.85 and HK$7.75 per one US dollar. The HK dollar has been lingering around the strong end of the band which is HK$7.75 for some time, partly due to strong exports and leaks from the U.S. QE in the form of capital inflows. This currency wants to appreciate but it’s strained and cannot get stronger because it’s managed by its currency board. Hong Kong must pursue currency controls to keep its dollar from appreciating. Interest rate has to stay low to follow the interest rate of the American anchor. In sequel, inflation cannot be kept in check unless interest rate is raised to keep inflationary expectations stable. Therefore, this upper lid on the currency leads to distortions and economic inefficiencies, impacts monetary stability and hinders the development of the financial sector.
Does all this ring a bell? Yes, it reminds us of the upward pressure that GCC currencies came under in 2007-2008. Most of their currencies are pegged to the U.S. dollar and the GCC interest rates had to follow the American rates. Inflation accelerated in the booming GCC countries and reached more than 13% in Qatar and Dubai. Monetary authorities should have increased interest rates regardless whether inflation was caused by foreign or domestic sources. But those authorities’ hands were tied up by the peg and could not let go.
In the current era of QE, the GCC countries should not be affected by QE as Hong Kong has been. The GCC economies are not currently booming, their stock markets are not sizzling and their interest rates follow the anchor's rate. So no one should expect huge dollar leaks from QE going to the GCC markets. Moreover, the GCC countries depend heavily on oil exports and oil is priced in the dollar. Thus, the GCC countries are not under a serious threat of accelerating domestic inflation as a result of capital inflows. However, the GCC can be affected by imports from non dollar countries whose currencies will experience an appreciation against the US dollar.
Now there are strong indications that Hong Kong wishes to reset its currency against the dollar. It wants to appreciate it significantly. This means the change entails shifting the entire band around a stronger HK dollar instead of just expanding it. The small country band is a problem. Moreover, there are also those who believe that the single peg is not working well for Hong Kong and should be abolished altogether.
This new situation in Hong Kong brings us back to the GCC currency peg in the next few years. Oil prices are ascending despite their weak fundamentals. It will not be long before OPEC’s five or six million barrels-per -day of excess capacity diminishes to two million barrels a day, which should bring us back to the summer 2008. The GCC economies will start booming like Hong Kong’s today and may be more. But the GCC’s economic situation is different from that of Hong Kong. As mentioned above, most of the GCC countries are major oil exporters, oil is priced in the US dollars and most of the GCC foreign assets are held in dollars. The GCC countries have also been embarking on a monetary plan that should create the desired GCC monetary union in the next few years. Politically, the GCC countries have allegiance to the U.S.
Thus, the GCC cannot abolish the dollar peg soon despite the fallouts of QE. The best recourse for them now is to be ready to expand the band around the central parity when their economies have rebounded. A small band will not be on the good side of the GCC in the foreseeable future. They will need a much wider band that Hong Kong wishes to have now. When the GCC has a common currency, the single peg should be abolished for a more flexible exchange rate arrangement. It will not be long before Hong Kong and the GCC find themselves sailing in the same currency boat.
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