(Reprinted from HKCER Letters, Vol. 30, January 1995)
Is the Current Hong Kong Dollar Overvalued or Undervalued?
After over a decade of the linked exchange rate system in Hong Kong, one wonders how the Hong Kong dollar has been doing on the average, vis-a-vis other currencies. In particular, does the current nominal effective exchange rate (NEER) of the Hong Kong dollar reflect its long-run trend? This is particularly interesting in light of the wide fluctuations in the exchange values of the major currencies in the world.
We can make use of relative purchasing power parity (PPP) to better understand the above queries. A long-run path for the Hong Kong dollar for the period 1984(I) to 1993(IV) is fit according to relative PPP and shown in figure 1, along with the current NEER. This figure can be used as a basis for addressing the following questions:
Did the linked exchange rate announced in October 1983 reflect market fundamentals at that time? If the rate announced in October 1983 did not reflect market fundamentals, did prices adjust over the subsequent decade to offset the initial deviation from market fundamentals? Given the relatively stable nominal effective exchange rate of the Hong Kong dollar in 1988-93, does the current high inflation rate measured in terms of the consumer price index (9.7 percent per annum in the period 1988-93) imply that the competitiveness of Hong Kong has deteriorated a lot? Is the current Hong Kong dollar overvalued or undervalued?
With the help of figure 1, the answer to the last question is obvious: As the current exchange rate is fairly close to the long-run path in 1988-93, it follows that the Hong Kong dollar has been at more or less the right value since 1988. This, however, was not the case in October 1983.
Was the linked rate announced in October 1983 undervalued?
The Hong Kong dollar had depreciated by 57 percent against the U.S. dollar between 1980 and 1984. Yet, figure 1 suggests that, in comparison with the long-run path as defined by relative PPP, the Hong Kong dollar was still overvalued by 4 percent in 1984(I). It was overvalued by an even much larger margin of 14.3 percent in 1984(IV). This was so because (i) the effect of the 1980-84 nominal depreciation on the real exchange rate was partially offset by a relatively faster rise in the ratio of Hong Kong export prices to foreign wholesale prices (by 22.9 percent between 1980 and 1984), and (ii) the Hong Kong dollar was pegged to a currency which was overvalued in October 1983. It is well known that the U.S. dollar was in a bubble period between 1980 and 1985: It appreciated by 46 percent over those five years, and then depreciated back to the pre-1980 level by 1988.
Did prices adjust to clear the initial deviation from market fundamentals?
This is an important question since if there were any force driving prices further away from market fundamentals, or stopping prices from adjusting, as was the case in the breakdown of the Bretton Woods System, the linked exchange rate system may not be sustainable.
As mentioned above, despite the overvaluation in 1984 and 1985, the Hong Kong dollar was no longer overvalued in 1988-93. However, the initial overvaluation was eliminated by the depreciation of the U.S. dollar (and hence that of the Hong Kong dollar) instead of a reduction in the ratio of Hong Kong export prices to foreign wholesale prices. As a matter of fact, this price ratio rose by 6.9 percent between 1984 and 1988. Thus, on one hand, there is not yet any evidence that Hong Kong export prices would adjust to eliminate any overvaluation and undervaluation of the Hong Kong dollar. On the other hand, there is also no evidence that Hong Kong export prices would not adjust, were there no correction in the U.S. dollar in 1985-88.
In other words, should the U.S. dollar enter another period of sustained overvaluation or undervaluation, it is not clear whether our export prices will adjust to neutralize the change. Pegging the Hong Kong dollar to a basket of currencies, instead of just the U.S. dollar, will by definition remove this potential problem and hence avoid unnecessary disturbances to our exports. However, given that the chance for the U.S. dollar to enter another sustained period of overvaluation and undervaluation is not that high, credibility problems and administrative consideration may suggest that the current peg should be maintained before 1997.
Did our export competitiveness deteriorate with the current high domestic inflation?
Finally, the current episode of high inflation in Hong Kong, with an annual rate of 9.7 percent in terms of the consumer price index (CPI) in 1988-93, might indicate a significant deterioration in our competitiveness. Table 1 reports the CPI, the export price index, and a measure of export competitiveness of Hong Kong. Unlike the case of the CPI, the Hong Kong export price index shows only very little increase between 1988 and 1993 (2.1 percent per annum). One possible reason for this difference is that the shifting of Hong Kong production to China has reduced export prices through cost reduction, while the earnings from China have raised liquidity and therefore domestic prices in Hong Kong. As a result, despite a 59 percent rise in the CPI in the same period, the export competitiveness based on the ratio of Hong Kong export prices to foreign wholesale prices is more or less unchanged in 1988-93. Hence, the current high domestic inflation has not caused any notable deterioration in our export competitiveness, although this may not be true in the future.
Dr. Paul Yip is a lecturer in the School of Business and Accountancy at the Nanyang Technological University. This short article was written before the current episode of sharp depreciation of the U.S. dollar.
CPI, export price index and export competitiveness of Hong Kong (1984-93)
Year Export Price Index CPI Export Competitiveness
1984 84.50 68.80 90.09 1985 84.91 71.20 88.45 1986 86.65 73.50 92.92 1987 89.90 77.40 96.49 1988 92.69 83.10 99.78 1989 97.43 91.10 96.51 1990 100.00 100.00 100.00 1991 102.55 111.00 98.58 1992 103.54 121.70 99.14 1993 103.08 132.30 98.52