A hedge fund bets against Hong Kong’s link to the dollar

Posted: September 27, 2011 in World Economy
Tags: ,

The Economist

THE fruit-and-vegetable market on Reclamation Street in Hong Kong attracts residents who still prefer to shop at open stalls rather than cloistered malls. Under the awnings that flank the road, traders offer dragon fruit, rose apples and the flowering stems of Chinese cabbage. The prices are scrawled on cardboard tabs, which makes them easy to change.

That is just as well, because prices change quickly in Hong Kong. In the year to July they rose by 7.9%, the fastest rate in almost 16 years. In other economies, the central bank would respond by raising interest rates. But Hong Kong has little control over its monetary policy. For the past 28 years it has pegged its currency at about 7.8 to the American dollar. In so doing, it has placed its monetary fate in the hands of the Federal Reserve, which has floored rates and promised not to raise them any time soon. That has left Hong Kong with a brisk economy, low unemployment, a worrying property boom—and real interest rates of -7.7% (see chart).

That is likely to prove unsustainable, argues Bill Ackman of Pershing Square Capital Management, a hedge fund. In a 140-slide presentation this month, he explained his high-profile bet against Hong Kong’s peg. He has bought call options, which give him the right to buy Hong Kong dollars at a price of, say, 7.5 to the dollar. If the peg persists, such an option is worthless. But if Hong Kong’s currency strengthens significantly before the option expires, Pershing will make a bomb.

By abandoning its peg the Hong Kong Monetary Authority could set interest rates high enough to contain inflation and curb the property market. But in such an open economy, exchange-rate flexibility is no guarantee of economic stability. Hong Kong tried floating the currency between 1974 and 1983, but it was not a happy experience. Inflation ranged between 2.7% and 15.5%; growth lurched between 16.2% and 0.3%. In September 1983, a month before it was pegged, the Hong Kong dollar fell by 13% in two days.

The currency does not have to float for Mr Ackman’s bet to pay off. He will make money even if it is merely repegged at a stronger rate. That would help realign Hong Kong’s exchange rate, which Pershing thinks is too competitive. Yet such a realignment is already taking place, as rising prices help to offset the depreciation of Hong Kong’s dollar and America’s against other currencies.

Although Hong Kong’s exchange rate is fixed, its wages and prices are famously flexible—in both directions. That allows it to adjust to the dollar’s ups and downs without changing its nominal peg. For example, consumer prices fell for 68 months from November 1998 to June 2004, a bout of deflation shorter but deeper than Japan’s. In a 2009 paper, James Yetman, now at the Bank for International Settlements, found that prices in Hong Kong display little of the inertia seen elsewhere. Some goods, like English newspapers, keep the same price for years, but flowering Chinese cabbage can double and then halve in price in months. Hong Kong’s street markets may be dying out, but such flexible pricing may save the link to the dollar.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s