China must keep US link

One problem in post-colonial Hong Kong which no one likes to dwell on is what would happen if the Hong Kong dollar's peg to the US currency breaks, writes Margaret Soares.

"One country, two systems is one notion," said Rupert Byng, head of equity sales in the London office of Sassoon Securities, a Singapore-based stockbroker. He was referring to the 1984 agreement, called the Joint Declaration, in which China agreed to let Hong Kong keep its economic and political systems separate for 50 years. "But one country, two currencies? It's a key crucial question."

The Hong Kong dollar has been pegged at 7.8 to the US dollar since 1984, meaning that for every HK$7.8 in circulation there is US$1 in reserve to support it. Hong Kong's monetary authority keeps the reserves in a war chest called the Exchange Fund - a kitty with $63bn at the end of February.

With that size cushion, Hong Kong can easily defend its currency against a major depreciation, such as it did in early 1995 when speculators tried to break the peg. But, asks Mr Byng, would the territory's new masters do the same?

"One of the most attractive things about taking Hong Kong is inheriting those reserves. Will they want to spend the dollars to defend a currency that is not their own?" he said. If the Hong Kong-US dollar link broke, the territory's currency's value would plummet "and you would see the market really collapse".

If the Hong Kong dollar's value plummeted, the monetary authority would raise interest rates to support the currency. This would depress property prices and in turn devastate the stock market because companies invest heavily in real estate.

Ashok Shah, fund manager at Old Mutual Asset Management, said China's promise to keep the Hong Kong dollar in place is "too daunting a political commitment" to even think about breaking.

The mainland needs billions of development dollars in the coming years, a good chunk of which could be raised in Hong Kong dollars.

"Why should China make it difficult to borrow in a currency it needs? It's to its advantage to exploit the link," he said.