Eye on China: Hong Kong peg to volatile yuan 'years away'

Opinion

Almost exactly one year after the one-off 2.1 revaluation of the yuan against the United States dollar, the Chinese currency is bamboozling observers as much as ever.

Despite the Chinese authorities introducing a system which would have permitted a limited daily strengthening, the yuan has appreciated much less than many observers believed it would.

It has been a clever exercise of raising expectations, attracting lots of liquidity but never giving investors the big one-off gain they wanted - since liquidity would be drained from the country as investors repatriated their profits in the event of a significant revaluation.

There is now a new twist to the story, involving the Hong Kong dollar. The idea is being mooted that the Hong Kong dollar could be linked to the yuan instead of the US dollar. The current exchange rate is 7.8 Hong Kong dollars to a US dollar.

To me, this is a ludicrous story which profoundly underestimates the problem the yuan has as a currency. It is also a reflection of the way people are moving too fast in regarding China as an economic superpower.

The point about a peg is that it normally involves a weaker currency and a strong currency. A small economy with an undeveloped economic and political infrastructure will try to reassure investors by informing them that the value of the domestic currency will remain constant in terms of, say, the US dollar.

This is precisely what happened to Hong Kong in 1984. The currency had been dropping rapidly as the terms of the Sino-British Joint Declaration (the agreement which eventually led to the handing of the colony back to China) were being hammered out. Investors were naturally extremely nervous with this scenario and were selling off the Hong Kong dollar.

The Government then came up with the plan to link the currency to the US dollar at a certain level. Stability returned and, a quarter of a century later, the system is still in place.

But linking to the US dollar was a natural choice. The US dollar is the world's reserve currency; it is extremely liquid and it is backed by the most powerful country on Earth.

In Hong Kong, investors have the comfort of knowing that every piece of local currency they have is backed by the equivalent in US dollars.

Should investors want to convert into US dollars they can do it instantly and send their money out of Hong Kong immediately - there are no capital controls. These factors make Hong Kong an attractive place to international investors.

But imagine having the Hong Kong dollar linked to the yuan. For a start, there are a slew of practical problems. Hong Kong's financial system would have to be insulated from the mainland's capital controls, since the yuan may not be shipped overseas and back again at will (the Government has established a closed capital account to prevent foreign funds pouring in or any major sell-off of the Chinese currency).

A cumbersome system of exceptions would have to be introduced involving granting the yuan freedom of movement in Hong Kong but not on the rest of the mainland. The possibility of leakage, and instability, would multiply.

In fact, you might end up with two exchange rates for the same currency - the market-driven rate prevalent in Hong Kong and the rate prevalent in China. If the rate in Hong Kong is much weaker, it could spook domestic holders of yuan and cause a run on the banks.

If the rate overseas is much stronger, it would attract a great deal of foreign funding betting on a revaluation. This would provide liquidity to China's financial system.

But this liquidity is not necessarily needed, given the trillions of US dollars in domestic savings and China's policy of exporting capital.

Smart international investors would not be happy. The knowledge that in times of crisis they would have the option of converting Hong Kong dollars back into yuan at a guaranteed rate would hardly reassure them.

In times of crisis, people send money to the country they feel can best protect the value of that currency and that is the US. The long-term weakening of the US dollar is Washington's policy to help shrink the current account deficit. It's not being forced on the US by outsiders.

Having yuan assets would also expose investors to the full capriciousness of China's legal and financial system. Given how impenetrable China's policy-making system is, investors would be taking on a great deal of risk compared with the relatively clear signalling policy of the US Federal Reserve.

Essentially, the yuan is a weak currency. The Chinese Government recognises this. The yuan may have the potential to become a major international currency but that's a long way away.

Even if the yuan becomes less policy-driven and more market-oriented and transparent, it will not avoid the huge volatilities that developing country currencies are exposed to.

That volatility is precisely why a place like Hong Kong, seeking stability, will not peg to the yuan until China's legal, financial and political systems have caught up. And that is a decade away at least.

* Dan Slater is a journalist based in Beijing.