There may be some psychological effects on the market as the renminbi exchange rate passes through certain levels. But Hong Kong has no intention to change its exchange rate policy.
I understand that there are levels in the exchange rate of the renminbi that the market is particularly sensitive about - for example, if the renminbi strengthens to beyond 8 against the US dollar and even more so if it strengthens further to 7.80. From a purely economic point of view, it is difficult to understand why the market should be particularly sensitive to these specific levels and not, even if less so, to levels nearby. Market psychology is, of course, sometimes difficult to explain and may not be supported by rational economic arguments. I am not a psychologist, but I do feel that if market participants spent more time on the economics of exchange rates, then they would find it less worthwhile or meaningful to focus on these psychological exchange rate levels.
As the pace of reform and liberalisation on the Mainland picks up, and the Mainland's economy becomes increasingly integrated with the global economy - with considerably greater freedom of trade in goods and services and flow of capital between them - there will be a certain degree of convergence between price levels on the Mainland and in the rest of the world. This convergence will not be absolute; the price levels of many open economies still differ, given the different degrees of specialisation in production and trade, and the immobility of production factors such as land and labour. But there is likely to be significant convergence as the Mainland's economy becomes more open. This convergence will be reflected in some appreciation in what economists call "the real effective exchange rate" of the renminbi against other currencies. This will take the form of appreciation in the nominal exchange rate observed in the spot market, most notably the one against the US dollar, currently the main reserve currency of the world. If the exchange rate is fixed against a particular currency, the domestic inflation rate will be higher than that of the anchor currency. Depending on the monetary policy stance, some combination of nominal appreciation and higher domestic inflation may be observed.
The Mainland has chosen to introduce flexibility to the nominal exchange rate to facilitate the important, but not necessarily smooth, process of integrating its economy with that of the rest of the world. This is an obvious choice because the alternative of high domestic inflation, notwithstanding the current benign global inflation environment (itself partly the result of the integration of the Mainland's economy with that of the rest of the world), may result in much greater dislocation in the economy than the temporary overshooting in the exchange rate that would inevitably occur in any flexible exchange rate system. Exchange rate flexibility also increases the room for independent monetary policy to deal with shocks to the economy, including those arising from the integration process. This consideration is increasingly important as the size of the Mainland economy (which was already the fourth largest in the world in 2005) grows rapidly and capital account liberalisation proceeds steadily. But somewhat regrettably, sound and rational economic arguments have been clouded by politically motivated commentary.
Politics aside, it is obvious that the Mainland authorities are steering the process skilfully. The macroeconomic numbers, notably the sustained high economic growth and low inflation, prove the point. The introduction of flexibility to the exchange rate has been accompanied by bold and well structured steps of capital account liberalisation, such as the recent measures generally described as QDII (Qualified Domestic Institutional Investors), which may ease some of the very one-sided pressure on the exchange rate. As domestic savings are presented with opportunities to earn higher investment returns overseas, there may be less need to save, causing the savings rate to fall (and consumption to rise), the savings-investment gap to narrow and the current account surplus to decline. This seems to be a sensible strategy for reforming and liberalising the financial system, not only in terms of prudently managing the associated risks of financial instability, but also contributing to resolving the global imbalance, as opposed to the highly risky alternative of allowing the renminbi exchange rate to appreciate sharply, as some have called for.
In observing or even predicting the movements of the renminbi exchange rate, one should therefore consider these economic arguments. One should also note that, as long as the renminbi is not a freely convertible currency, the authorities are quite capable of steering the path for the exchange rate, and therefore the views of State leaders that there would not be unexpected step changes in the exchange rate are highly credible.
I understand, however, that the psychological levels of the renminbi exchange rate affect the Hong Kong dollar, leading to the questions about the long-term relationship between the renminbi and the Hong Kong dollar. Apart from reiterating that the Government has no intention to change the Linked Exchange Rate system, I would like to point out that the price convergence between the Mainland and the rest of the world, involving the appreciation of the renminbi against other currencies, applies to Hong Kong as well. Given the proximity of Hong Kong to the Mainland and the extensiveness of the relationship between them, both the degree and pace of the convergence may be greater than for economies in other parts of the world. This convergence was one of the reasons for the period of deflation in Hong Kong (and benign inflation rates elsewhere) a few years ago. It will obviously be to our benefit if this continued convergence is facilitated by a gradual appreciation of the renminbi against the Hong Kong dollar. In other words, the psychological levels of the renminbi exchange rate are merely psychological; they do not indicate any increase in the probability of change in the exchange rate policy of Hong Kong.
Joseph Yam
4 May 2006
Click here for previous articles in this column.
Document in Word format
