by Henry C.K. Liu *

C h i n e s e C o m m u n i t y F o r u m Saturday, June 13, 1997

Recent press reports have speculated that China is opposed to de-linking the Hong Kong dollar to the U.S. dollar at the fixed rate of 7.8 to 1. The underlying logic attributed to the alleged Chinese position is that decision makers in Beijing are apprehensive of possible resultant instabilities from de-linking and the adverse economic impact on Hong Kong's and China's economies which are closely linked. Regardless of the reliability of these reports, the validity of such apprehensions can be challenged by sound analysis.

Hong Kong prides itself on being a free-market economy. Yet with regard to its currency, Hong Kong strangely clings to an obsolete exchange rate that has become markedly unresponsive to market forces. A free-floating Hong Kong dollar will have a number of positive effects on the Hong Kong economy with minimum disturbance in the local price structure. It will improve the price competitiveness of Hong Kong goods and services in world markets, lower the cost of doing business in Hong Kong and attract new international capital to Hong Kong because of its increased local purchasing power. A free-floating currency will reduce interest rates on local currency loans, thereby stimulating the stagnant local economy. It will moderate the real inflation rate in Hong Kong in global terms without requiring drastic reductions in local prices. It will revive the depressed Hong Kong tourist industry without subjecting it to de-stabilizing price cuts. It will encourage localized savings by eliminating the surrealistic phenome

non of negative real interest rates. It will encourage localized corporate and personal expenditures through the increased cost of foreign goods and services. The hefty Hong Kong foreign exchange reserve will also increase in local currency terms while suffering no decline in real value.

To be sure, despite all the benefits, there are transient detriments in de-linking the Hong Kong dollar. Existing US$-denominated debt would experience an increase in the cost of debt service and amortization. But Hong Kong has no public debt, except infrastructure debt held by quasi-public authorities. Indebtedness from infrastructure improvements is serviced by user fees which can be increased in local currency terms without fatal pain to the public and without altering Hong Kong's price competitiveness in world markets, since this debt has been structured on a fixed exchange rate tied to the U.S. dollar. Hong Kong's foreign exchange surplus will moderate temporarily, but if the Hong Kong dollar reflects its true market value, there will not be any compelling need for a large foreign exchange reserve to support a monetary policy that ignores market forces. Property values will drop in real terms but an asset value

deflation through exchange rate fluctuations is less damaging than a direct decline in local prices. In any event, most analysts agree, including those in government, that Hong Kong property values have been over-inflated.

The confidence factor is a red-herring. International confidence will increase in a Hong Kong flexible enough to deal intelligently with new realities rather than being incapacitated by blind adherence to obsolete policies.

Private debts are worrisome. There does not appear to be a painless way out. Some 40% (over US$50 billion) of the outstanding bank debt is issued to companies purchasing or developing property. Much of this debt (US$7 billion, highest in Asia except for Japan) is in the form of convertible bonds which do not appear on the borrower companies' balance sheets. Convertible bonds require the debtor to repay the investor if the shares of the issuing company fall below a pre-fixed level while they give the investor the right to convert the debt into company shares if the price increases to a level the investor finds attractive. Persistently high local interest rates will force these companies into financial difficulties if not eventual bankruptcy. Banks and the property sector account for half of Hong Kong's stock market capitalization. Still, the prospect for a soft landing may be better with a currency de-linking than a drastic collapse in local prices, because with currency de-linking, the economy receives compe

nsatory stimulation through lower interest rates and lower costs, which in turn may provide borrowers with sufficient cash flow to service foreign currency debt at higher exchange rates.

As for China, the Chinese economy requires the continuation of a high growth rate. It is now burdened with industrial over-capacity, similar to the rest of Asia, but the size of China's domestic economy gives it the ability to absorb the over-capacity, provided rapid growth continues. Such growth depends directly on a rising in-flow of foreign direct investment, now accounting for 12% of China's gross domestic product (GDP). The global capital market, beset with deflationary ills, may have trouble supplying China's foreign capital needs in the next few years. Foreign banks are already tightening credit lines or raising the cost of loans to China. Chinese sovereign debt prices have fallen in world markets. New debt and equity deals by Chinese and Hong Kong companies have been forced to postpone indefinitely. The good news is that 88% of China's external debt is medium term or long term and most of the foreign investment in China is for direct investment projects which locked equity in for 35 years or more. In

ternally, China has an estimated US$200 billion in accumulated non-performing bank loans, which amounts to 5 times the equity capital of all Chinese banks, making the banking system technically insolvent. More than half of the state-owned enterprises (SOE) are money losers, desperately needing restructuring. Despite a top leader's recent declaration of the government's determination to solve the SOE problem within 3 years, no specific plan has been released detailing publicly how that ambitious goal can be accomplished. Foreign debt has reached nearly US$120 billion, albeit China's foreign exchange reserve stands at a healthy US$135 billion. It has been clear for some years that the only real option for China is the rapid development of its huge domestic economy through domestic inter-regional trade, accelerated capital investments and a steady rise in personal consumption. Given problematic global political-economic conditions, Chinese exports will not grow at rates that can adequately meet China's intern

al economic needs. With the "take-off " phase of Chinese economic development through export coming to an end, the next phase has to be the development of the domestic market through the upgrade of the standard of living of the mainland population. This will require a continuing rise in foreign direct investment, some 66% of which came from Hong Kong last year. If the Hong Kong economy falters because of an over-valued Hong Kong dollar, this flow of capital will dry up. A free-floating Hong Kong dollar, in addition to making Hong Kong goods and services less costly to mainland buyers, will keep the Hong Kong economy vibrant and allow it to continue to play the important role of supplying needed external capital to China.

November 10, 1997

Henry C.K. Liu, Chairman,

Liu Investment Group

New York, NY, USA

"mailto:hliu@mindspring.com"

*(Educated as an architect/urban planner (Havard - M.Arch, 1960), Mr. Liu was the founding Chairman of the Graduate Urban Design Department at ULCA 1964-1970. He also served as an adjunct professor in several universities, including Harvard and Columbia. Mr. Liu practiced consulting in urban development as President of Liu Urban Design Associates from 1970 to 1978, listing among his clients Governor Winthrop Rockefeller. Beginning 1974, Mr. Liu acted as developer for his own account for major urban projects in New York and Washington D.C. He was development advisors to governmental agencies of several developing countries. For the last decade, Mr. Liu has been primarily focusing as a principal on investment and finance for projects in the U.S., Asia and the Middle East. Mr. Liu was born in Hong Kong and came to the U.S as a student in 1951.)