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06HONGKONG1383 2006-04-03 10:39:00 CONFIDENTIAL Consulate Hong Kong
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1. (C) The Chinese renminbi (RMB, 8.02=1 USD) and Hong Kong
dollar (HKD, 7.76=1 USD) are likely to reach parity by
year-end, assuming the RMB continues its gradual appreciation
in line with most forecasts. Looking at the evolution of the
two currencies, such parity would merely be an accident of
history. However, considering Hong Kong's increasing
economic integration with the mainland, the RMB becoming a
dearer currency than the HKD is likely to spark widespread
discussion here of scrapping the HKD-USD peg, not to mention
much speculative activity against the HKD. One financial
contact told us that the conversation about the future of the
peg has already begun within a Hong Kong Government (HKG)
advisory committee that he sits on. Local analysts with two
of Hong Kong's paper currency-issuing banks, HSBC and
Standard Chartered, doubt that change is coming within the
next three years, but our HSBC contact said that there is a
growing view within his organization that the HKD-USD peg
should be re-examined in light of Hong Kong's growing role as
a financial intermediary for mainland China. Given the
emphasis that Hong Kong places on maintaining its reputation
as a stable and well-run international finance center, we
anticipate that any move off the peg would occur only after a
minimum of several years of discussion and debate. During
the ensuing period, however, neutralizing speculative
activity could very well become an ongoing headache for the



2. (SBU) Hong Kong has currency autonomy under "one country,
two systems." The link between the HKD and USD dates to
October 1983. At that time, the British colonial government
responded to currency instability associated with uncertainty
over Hong Kong's future under Chinese rule by instituting a
link -- not technically a "peg" but generally referred to as
such -- between the HKD and the USD. The value of the fully
convertible HKD is maintained through a currency board, i.e.,
a system that ensures all issued currency is fully backed by
reserves of USD. (See Ref A)

3. (C) DBS Bank Managing Director Andrew Fung is among 153
members of the HKG's Commission on Strategic Development, an
entity that advises the Chief Executive (CE) on Hong Kong's
long-term needs and goals. Fung told us that commission
members are actively discussing and submitting papers on the
future of the HKD-USD peg. Numerous commission members who,
in Fung's words, "have the ear of senior officials" are
arguing that the HKD-USD peg should be floated shortly after
the Chinese renminbi (RMB) surpasses the HKD in value. The
RMB presently trades at 8.02 to the USD; the HKD is
maintained within a small band centered at 7.80 to the USD.
Conventional wisdom among currency watchers is that the RMB
will appreciate at least 3 percent during the remainder of
2006, thus putting it at or beyond parity with the HKD within
the next nine months.

4. (C) Fung asserted that once the RMB appreciated beyond
parity, speculators would assume the HKD would rise along
with it, creating overwhelming market pressure. If the Hong
Kong Monetary Authority (HKMA) then maintained the HKD-USD
peg, the result would be stock market and property bubbles as
speculators chased assets denominated in HKD, hoping to make
a profit once the peg was broken. The speculative inflows
would also create unwelcome interest rate volatility for
property-focused Hong Kong, in Fung's view.



5. (C) Fung predicted that CE Donald Tsang would not go along
with breaking the peg before the next CE election in 2007.
The prospect of a float would be highly unsettling to Hong
Kong savings account holders who often out of habit hold USD,
Australian dollar, or New Zealand dollar accounts as a hedge
against what for many years has been a fear of a HKD

HONG KONG 00001383 002 OF 002

devaluation (currently unwarranted). It would also hurt
leading businesses whose holdings tend to be invested in USD
instruments on the assumption of a stable USD-HKD peg.

6. (C) Fung said that Hong Kong's economy is now much more
closely tied to that of the mainland rather than the U.S.
Although it is not technically feasible to peg to the RMB (a
non-convertible currency), any floating of the HKD would lead
to its closely tracking the RMB's value. Speculators know
this and would start to get very excited about the prospect
of the peg being broken once the RMB hit 7.5 to the USD, Fung



7. (C) Standard Chartered Bank Global Research Economist Tai
Hui predicted no change in the HKD-USD peg for at least three
years. He assessed HKMA as very capable of fighting
speculators through reserves and sterilization measures. Any
float would create confidence issues for the HKD. HSBC
Senior China Economist Hongbin Qu said the HKD-USD peg would
likely hold for at least several years. He said that HSBC --
like Standard Chartered, an issuer of HKD paper currency --
does not publicly discuss the peg; however, there is a
growing internal view that Hong Kong should rethink its
currency tie to the USD. Qu explained that if Hong Kong is
to build upon its growing role as China's center for
financial intermediation, it needs a currency more closely
linked to the mainland, not to the U.S.



8. (SBU) On May 18, 2005, the HKMA tweaked its currency
policy for the first time since the 1998 Asian Financial
Crisis, hoping to prompt speculators to reduce reliance on
the Hong Kong dollar (HKD) as a proxy currency for
anticipated Chinese renminbi (RMB) revaluation. The
introduction of a 0.6 percent trading band around a linked
rate of 7.80 to the USD -- replacing what was a one-way
depreciation floor -- suggested that HKMA viewed distortions
to Hong Kong's financial system caused by RMB speculation as
a significant and enduring economic challenge that could
potentially worsen as China took steps to introduce RMB
flexibility. The change made it riskier for speculators to
maintain positions using the HKD and seems to have worked.
However, our contacts all pointed out that any significant
and growing variance between the HKD and a stronger RMB would
still likely invite speculation against the USD-HKD peg. (See
Ref B)