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Web-only Exclusives
November 30, 2000

From Our Correspondent: Hirohito and the War
A conversation with biographer Herbert Bix

From Our Correspondent: A Rough Road Ahead
Bad news for the Philippines - and some others

From Our Correspondent: Making Enemies
Indonesia needs friends. So why is it picking fights?

Asiaweek Time Asia Now Asiaweek story

The Cost of a Pegged Dollar

It will be painful, but there is a silver lining

By Jonathan Sprague / Hong Kong


MARIA TSANG ARRIVED AT the stock brokerage near her home in Causeway Bay at 10 a.m. sharp with a bottle of chilled mineral water. She knew she needed to stay cool. When trading began, her investments were worth about $142,000. By midday she had lost half of her money. "I saw the 1987 crash," she says. "But I think this time is worse." Not that Tsang is in a rush to sell. She believes official assertions that Hong Kong's fundamentals are good and that the market will eventually rebound.

Hong Kong shook the world when its stock market crashed 30% in just seven trading days. An attack on its currency, the last in Asia still linked to the U.S. dollar, raised fears that Hong Kong would follow the rest of Southeast Asia into financial meltdown. Meanwhile, interest rates jacked up to defend the Hong Kong dollar sent foreign pension fund managers rushing for the exits. Only the resilience of Wall Street and the stoicism of local punters like Maria Tsang seem to have calmed the panic -- for now. But nerves remain jangled. Moreover, the turmoil threw into sharp relief long-term problems in Hong Kong's economy and suddenly made them into potential short-term crises.

Hong Kong is different. While speculative attacks against Southeast Asian currencies revealed feet of clay, Hong Kong can point to a chunky budget surplus, rising corporate profits and a growing economy, not to mention formidable exchange-rate defenses. To be sure, land prices are dizzyingly high, and 47% of bank loans are tied to property. But at least there is healthy demand for all those apartments and offices -- unlike elsewhere in the region. Yet suddenly, none of that seems to matter.

At the heart of Hong Kong's woes is the peg, the Hong Kong dollar's 14-year-old link to the U.S. dollar at HK$7.80 to $1, now standing alone as a tempting but tough target for speculators. A continued peg will reinforce confidence in Hong Kong's economic and political stability. If it goes, confidence could evaporate, sparking capital flight. Small wonder the government has vowed to defend it at all costs. But that defense has pushed up interest rates, threatening corporate profits and property prices, and cementing Hong Kong's higher costs relative to its neighbors. Therein lies Hong Kong's dilemma.

"The priority right now is to keep the stability of the currency, which has worked very well for Hong Kong both economically and politically," says James Tien, chairman of the Hong Kong General Chamber of Commerce. "By keeping the peg, we have to address other problems, but right now we have no choice."

The peg was created in 1983 during a crisis of confidence that erupted when Hong Kongers discovered that their city was returning to China. Since then, it has assured businesses and investors that their money was safe. Its retention beyond the handover with Beijing's blessing underpinned confidence in Hong Kong's continued role as an international business hub. But the peg also has side-effects. It means Hong Kong follows U.S. interest rates even though Hong Kong's higher growth rate might merit tighter credit. That situation produced chronic inflation and low, even negative, real interest rates that sent property prices into the stratosphere.

"The major problem in Hong Kong is labor cost, and the major problem about labor cost is rent, or mortgage rates," says David Roche of investment group Independent Strategy. "And as these things get more and more expensive, as other places get relatively cheaper, the growth rate in Hong Kong becomes unsustainable."

Chief Executive Tung Chee-hwa has made strengthening Hong Kong's competitiveness his key task. He has promised to curb home prices by building 85,000 new flats a year, as well as boost education and nurture more high-tech industries. But the recent round of devaluations and the peg's resilience has suddenly turned long-term problems into short-term ones. After all, the $1 that bought 2,451 Indonesian rupiah worth of labor or rent in July now buys 3,660 rupiah worth. But that same $1 still buys only 7.8 Hong Kong dollars.

"If you look out five years, we can gain back all the competitiveness Thailand or Indonesia or the Philippines had when their currencies devalued," says the General Chamber's Tien. "But if we are talking about the immediate impact on business, no one can argue that we can gain 40% in competitiveness in three months." In the short term, he adds, there is nothing Hong Kong business can do but tighten belts.

Tien says some exporters are already reporting canceled orders, while the tourist industry remains mired in a slump. At the same time, the high interest rates defending the peg are threatening to erode corporate profits and the property market. Profits are no longer expected to grow an average 10%-15%. Property prices are expected to drop 10%-30% in the next year, hurting not only the profits of property developers but the net worth of home owners. Economists now figure the economy will grow some 4% next year rather than more than 5%, as previously forecast.

All that will weigh heavily on the bourse, and, current bargains aside, no one expects the blue-chip Hang Seng Index to recover its August record closing high of 16,673 any time soon. Credit Lyonnais Securities says that even assuming lower profit growth of 7.3% and interest rates that are 125 basis points above U.S. rates, the Hang Seng's fair value is a respectable 12,000 or so.

It's not all bad. High costs do not always translate into uncompetitiveness. Hong Kong companies are still earning hefty returns on capital, says Credit Lyonnais strategist Russell Napier, something Southeast Asia has failed to do. And, he adds, Hong Kong can tap mainland Chinese labor at half the cost of Thai labor. Hongkong Bank points out that the special administrative region's product mix does not overlap much with Southeast Asia's, limiting competition. And mainland growth is boosting demand for Hong Kong services.

Nor are lower property prices entirely bad. After all, that is precisely what Tung has promised, though in less dramatic fashion. But not only will homeowners face falling values, higher interest rates will mean higher mortgage payments just when slowing economic and profit growth may cut into wages. Eric Tam, an electronics engineer, bought a flat for $516,000 early this year before getting married in March. "Life was okay before the rate increase," Tam says. "[Now] we either cut our savings or our entertainment expenditure. Worst of all, we have to postpone our plan to have a baby for I don't know how long." The medicine may be good for the long run, but it will be hard to swallow.


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