Beijing and the Almighty Dollar

When British Prime Minister Margaret Thatcher negotiated the transfer of Hong Kong’s sovereignty from the United Kingdom to China in 1984, there was no shortage of predictions as to what form the Communist rule over the freewheeling former British colony might take.

Few could have foreseen that in 2002, almost five years after Hong Kong had been reunited with the mainland on July 1, 1997, Beijing still doggedly defends the Hong Kong dollar peg to the U.S. dollar. And yet, that is precisely what’s happening these days.

The Hong Kong dollar has been governed by a currency board since 1983. The currency board manages the Hong Kong SAR’s money supply in order to keep the Hong Kong dollar’s value stable at 7.8 Hong Kong dollars to the U.S. dollar. When Argentina’s peso — another currency pegged to the U.S. dollar by a currency board — was devalued in January 2002, Chinese authorities moved quickly to quash all speculation that the Hong Kong dollar would meet a similar fate.

To be sure, there is no love lost between China and the United States. Afterall, the first military standoff of the George W. Bush presidency was not with the Taliban or al-Queda, but with China. The Chinese held a U.S. spy plane that had crash-landed on its territory for over two months, after first detaining its crew as well.

Since the September 11 terrorist strikes in the United States and the subsequent hunt for the Muslim extremists who sponsored that horrific act, this once-deepening conflict between the Bush administration in the United States and China has been largely forgotten.

In fact, China has been one of the sharpest critics of the “unipolar” world. By that, it means the global dominance by the United States in the post-Cold War era. In the late 1990s, Chinese leaders even presented a united front with the Russians. These two traditional rivals were united in their dislike of the United States and complained about its heavy hand.

But Chinese authorities’ staunch defense of the Hong Kong dollar peg has been constant. Mainland China put its foot down back in 1998, when the Hong Kong dollar came under speculative pressure during Asian financial market turmoil.

Back then, Beijing leaders refused to allow the Hong Kong dollar to be devalued. On the contrary, they used pressure and political threats against Western financial institutions and currency traders who dared to speculate against the wobbling Hong Kong currency.

This pattern has been repeated in 2002, following the devaluation of the Argentine peso. But Chinese leaders are no altruists. They support the Hong Kong dollar because its stability benefits mainland China as well. It is the first line of defense to the renminbi yuan, China’s own currency, which is also pegged to the greenback — at a rate of 8.28 yuan per dollar.

China has no plans to alter its exchange rate regime either. Why? Because over 20% of China’s exports go to the United States, and another 18% go to Hong Kong, where they are typically re-exported to North America, Taiwan or other dollar bloc countries.

But this is only part of the overall reason. Chinese leaders respect force and admire strength. For all its faults, the Almighty Dollar remains the strongest of the world’s currencies — and China is content to keep riding on its coat-tails.

Despite their commitment to the dollar peg, the Chinese are never inclined to put their strategic eggs just in one basket. China’s opposition to things American has even extended to strong support for the fledgling euro.

Chinese economic and monetary officials have been early supporters of the new single European currency ever since its introduction as a notional unit of account in 1999. The Chinese were clearly hoping to build up the euro as another reserve currency and an alternative to the greenback.

So it came as no surprise when early in 2002, as euro notes and coins finally arrived, China’s Finance Minister Xiang Huaicheng was encouraged sufficiently by the smooth transition to call for a portion of China’s hard currency reserves to be converted into euros.

After Japan, China has the world’s second largest hard currency reserves in the world, estimated at nearly $210 billion. Such a large-scale shift by Chinese authorities from dollars to euros could provide a much-needed boost to the flagging single currency.

Indeed, there is little doubt that the People’s Bank of China, the country’s central bank, will heed Mr. Xiang’s call. Among the reasons, however, is that some 15% of China’s reserves are denominated in German marks. Those funds would necessarily have to be converted to euros anyway, since the deutschmark has already ceased to exist. It’s a move that certainly will do nothing to boost the euro.

The exact composition of China’s reserves is a state secret, and a central banker can be jailed, or even shot, for disclosing it. But over 60% of these reserves are still believed to be denominated in dollars. Despite a desire for a new reserve alternative, there is absolutely no chance that China’s dollar-denominated reserves will be reduced to make room for euros.