The Chinese Union
Could China and Hong Kong create a common currency?
Over the weekend, millions of Chinese exchanged red envelopes filled with cash to celebrate the advent of the Year of the Snake. Oddly, most of those envelopes contained a currency that lumbers in the shadows of international markets, the yuan. The world’s biggest exporter and second-largest economy still lacks a currency that can be used freely around the globe. China wants this to change, but how and when?
These are questions of intense interest to investors, speculators, and corporate managers around the globe. Right now, the yuan’s value moves within a band enforced by the People’s Bank of China, and there are restrictions on how it can be used by foreigners. A convertible yuan would trade without limits on currency markets, becoming more liquid, permitting bigger transactions, and responding more quickly to changes in the demand for Chinese assets and products. Convertibility would also pave the way for the yuan’s use as a reserve currency by central banks and sovereign wealth funds, and perhaps even as the standard currency for pricing some commodities, such as copper.
These things would benefit China. When other countries use your currency for their reserves, they link their economic fortunes to yours. The stability of your currency is of material interest to them, and they can even help to defend your currency against speculative attacks or other unwanted fluctuations. And when your currency is used in trade, the private sector needs to hold more of it, lowering the cost of financing.
Naturally, China’s present regime for the yuan also has some benefits. People who do business with China can count on a fairly narrow range for exchange rates, so it’s easier to make long-term contracts. Convertibility would erase this implicit guarantee, but it would simultaneously solve the problem of volatility by opening the door to much greater hedging. Multinational companies could trade yuan and related derivatives by the billion to balance their risks. So far, China has taken only baby steps in this direction, with the first yuan futures hitting the markets just last September.
Typically, a country in China’s situation might move to convertibility once it felt comfortable opening its financial markets and relying on domestic demand to drive the economy. But China has a complication: Hong Kong. The city-state became part of the People’s Republic in 1997, but it maintains its own economic system and its own currency, the Hong Kong dollar (HKD). With a population of just 7 million, its exports amount to a quarter of the total for the rest of China.
Just as convertibility is a long-term goal, so is reincorporation of Hong Kong into the Chinese economy. Today this process would be like a snake swallowing an ostrich egg. Yet China is changing rapidly, both in terms of financial sophistication and the openness of its markets. With time, Hong Kong will be less different from the rest of China, and thus the separation will seem less necessary. If the yuan is to become convertible, it will likely be as part of a long-term plan for economic convergence.
Paradoxically, however, as China has grown more similar to Hong Kong, its currency’s value has diverged. For the past three decades, the HKD has been pegged to the U.S. dollar within a very slim band, roughly 1 percent of its value. Meanwhile, from 1995 to 2005, the yuan had its own peg to the American dollar and was reliably worth about HKD 0.93. But since 2005, the yuan has risen to HKD 1.23 as China’s trade deficit has dwindled.
Recently, there has been pressure on the HKD to appreciate as well, thanks to enormous incoming investment in real estate and other assets — driven, of course, by China’s growth. Hong Kong’s monetary authorities will not give up their peg lightly, however. Their bosses have long advertised the HKD’s rare combination of convertibility and a virtually fixed exchange rate as a godsend for companies involved in global commerce.
But the presence of a convertible yuan might force them to reconsider their currency regime. Two-way trade between Hong Kong and the rest of China is worth close to $200 billion each year and will surely continue to grow. With a convertible yuan, the exchange rate for all that trade would become completely unpredictable.
Unfortunately, the obvious solution to this problem — a currency union — is not a particularly good one at the moment. To be sure, a single Chinese currency would not keep Hong Kong from holding on to many other distinct aspects of its economy. Its legal, tax, and regulatory systems could still remain independent. Rather, the problem is that Hong Kong and China have not met enough conditions for a successful currency union; though their trade is fairly free, they don’t share fiscal policy or allow unfettered migration, and hence their economic cycles have yet to synchronize. With monetary policy set in Beijing, as it surely would be, Hong Kong’s economy would probably be in for a bumpy ride.
More likely, Beijing will use convertibility as part of a gradual program to dismantle Hong Kong’s monetary independence. Once the yuan becomes convertible, China will undoubtedly encourage its use in Hong Kong. Just as the euro is used in some European Union countries that have yet to adopt it, and the dollar is used around the world, the yuan will operate alongside the HKD until conditions are right for a changeover.
Pressure will grow on the Hong Kong authorities to allow the HKD to rise in anticipation of an eventual currency union. Hong Kong’s "high degree of autonomy" is guaranteed until 2047, but smoothing the eventual transition into China is a high priority that officials on both sides are already discussing. Though a shared fiscal policy is unlikely, free migration will become less of a political liability as China gets wealthier. In this light, and given the heroic efforts needed to protect the peg to the American dollar, Hong Kong’s leaders may eventually become willing partners in a currency union.
Xi Jinping, China’s new leader, has strong ties to the country’s entrepreneurial south and is expected to usher in the next major wave of economic reforms. He will likely have two five-year terms to bring the rest of China closer to Hong Kong, perhaps assisted by Yi Gang, a talented governor-in-waiting at the central bank. Convertibility would make a good capstone for term number one. Currency union may have to wait for his successor.