July 28, 2014

Kharkiv, Ukraine

It was a different world in 1983.

Michael Jackson invented the Moonwalk. Return of the Jedi opened in theaters across the world. IBM released its most advanced personal computer yet– the XT, with a standard 10 megabyte hard drive.

And after nearly a decade of eratic swings and collapses, the Hong Kong government pegged its currency (the Hong Kong dollar) to the US dollar at a rate of 7.80 HKD per USD.

This was a big move for Hong Kong. The Hong Kong dollar had originally been backed by silver until 1935 when, facing a shortage of precious metals, they pegged it to the British pound.

This made sense in 1935 as the British pound sterling was still (barely) the world’s top reserve currency.

But things changed. In 1972, Hong Kong broke from the pound and adopted a new peg to the US dollar.

This didn’t last either. After just two years, the US government’s rising debt and inflation forced Hong Kong to abandon the US dollar peg.

At that point Hong Kong was well-known and stable… so why bother pegging the currency at all? The HKD floated freely in the marketplace, just like any other currency.

It went well for them at first. But by the early 1980s, the Hong Kong dollar had become much weaker due to jitters over the island’s reunification with China.

Finally, in 1983, they re-established a peg with the US dollar. And at the time, this probably made a lot of sense.

In 1983, Fed Chairman Paul Volker had established tremendous international credibility, both for the US dollar as well as the Federal Reserve. And most of all, Hong Kong was in need of a strong anchor.

But 31 years later the world is entirely different.

Michael Jackson is no longer with us. The world has sat through three completely lame Star Wars prequel movies. Even the cheapest mobile phone has more storage capacity than the IBM XT.

And both the Fed’s and America’s credibility have waned.

Today Hong Kong is one of the world’s richest economies. When compared with the US, nearly every objective fundamental about Hong Kong’s economy is stronger.

Its fiscal balances are higher. The government runs a budget surplus. Government debt is a rounding error. It’s a night and day difference. There’s no reason why these two currencies should be linked.

Theoretically, Hong Kong’s currency should be much stronger than the peg allows. But its purchasing power is being artificially supressed.

This means that residents of Hong Kong pay more for products and services than they should, including basic staples like food (90% of which is imported).

But after three decades, things are starting to get interesting.

Just recently the Hong Kong dollar hit the upper limit of its allowable range– exactly 7.7500. And the Hong Kong Monetary Authority has had to spend billions of dollars to defend the peg.

The reasons are unclear, though it’s entirely possible that investors are attacking the peg, similar to what happened to the pound back in the 1990s. We could be in the early stages of such an assault.

Even if not, it’s time for a change.

These currency pegs are not set in stone; Hong Kong has changed its own peg several times. And the basic fundamentals which led them to the US dollar in 1983 have changed completely.

The US is no longer the undisputed superpower it once was. The US dollar is dragging them down. Hong Kong is easily strong enough to stand on its own.

Bottom line, there’s no longer any benefit in maintaining the peg. Yet the costs (inflation, asset bubbles) are too high. This will eventually right itself.

For the last several years, we’ve been recommending that our readers hold Hong Kong dollars– especially if you normally hold US dollars.

The currency is still pegged to a very narrow band, so the most it would fluctuate is 1.27%.

But if the Hong Kong government revalues the Hong Kong dollar, the gain could easily be 30% or more if they simply revalue to the level of the renminbi.

Given the limited downside risk, this is a very safe bet to make.

The best way to do it? Open a bank account in Asia.