Peter T Treadway, PhD
Historical Analytics LLC
pttreadway -at-

February18, 2011


Nobody’s Leaving the Euro

Frequently I have been asked how would Greece leave the euro if it so chose. My answer, which I have alluded to in The Dismal Optimist, has been look at what Argentina did in January 2002 when in a process dubbed pesificacion it forced the conversion of dollar deposits back into pesos which almost immediately lost the bulk of their value against the dollar.

Taking Argentina as a guide, here’s what Greece would have to do. To begin, the Greek finance and prime ministers would adamantly declare that Greece was staying in the euro. Then one fine night when everyone was asleep they would issue an order converting all euro deposits back into a resuscitated drachma. Henceforth, only drachmas would be available at Greek banks and only drachmas would be usable as legal tender in Greece. The drachma in international markets would immediately go to a huge discount against the euro. Of course, when the Greek people woke up and realized their euro deposits had been transmogrified into a devalued substitute and they had in fact been cheated, the country would go up in flames.

I recited this scenario to a Greek professor friend in Hong Kong who quickly pointed out the naiveté and incompleteness of my model. Assume Greece did that, he rejoined. Then the very day Greece was going up in flames every Italian, Portuguese, Spaniard and Irishman would pull his or her euros out of their banks. What would be launched would be the MOTHER OF ALL BANK RUNS. Europe’s banking system would go up in flames.

It won’t be allowed to happen.

I do not want to underemphasize the yet unresolved banking and sovereign debt problems that afflict the euro area. Probable sovereign defaults lie ahead particularly with Greece and probably Ireland. But in the end the euro will survive just as the US did after eight states and the territory of Florida defaulted in the 1840s. The member countries can threaten to check out but as the song says they can never leave. Yes there is no central European government and common fiscal policy. But history, technology, geography and overwhelming financial convenience are powerful forces behind the euro. If necessary the hard working Germans will pay and pay. Post World War II Germany has been determined to comport itself as a model citizen. This, combined with still lingering nightmares from the hyperinflation after the first World War, make Germany the ideal core engine for the euro. And the profligate south will slowly have to give up its wanton ways. Euro Uber Alles.

Looking over to the other side of the Atlantic, can we be even cautiously optimistic about the US whose president in the midst of a cyclical and structural fiscal crisis, dreams of massive railroad and alternative energy expenditures? (sorry “investments”) How long can the US government stay in this fiscally irresponsible dream world when the rest of the world including US states are biting the bullet of contracting government? The respected financial historian, Barry Eichengreen, in several of his books has pointed out how in the interwar period the dollar and the British pound shared the limelight as the world’s reserve currency. Competition among reserve assets is not unhealthy. The headless euro, powered by its German locomotive and disciplined by the bond markets, may give the dollar significant competition. As will gold.

Hong Kong –The Great Mall of China

Average citizens don’t always realize how invisible monetary and macro forces play dominant roles their economic decisions. And investors often suffer from the same ignorance. Nowhere better is this illustrated than in today’s Hong Kong. Hong Kong is a place investors should keep an eye on, if only because of its currency US dollar currency peg puts it at the intersection of the US and Chinese economies.

Hordes of newly rich Mainland tourists are continuously descending on the city like the northern tribes that overran the Great Wall of China a thousand years ago. But unlike the invaders of old, the Mainlanders haven’t come to pillage. They are happy to buy. And buy. And buy. (And gamble in nearby Macau) Condominiums, LV and Prada bags, Cartier and Bulgari jewelry, Gucci clothes, Rolex watches, baby’s milk – everything. The Mainlanders wear Prada. Every day the newspapers tell of the closing of another venerable Hong Kong retail establishment, often a restaurant or food store, to be replaced by an upscale store selling some chic European brand.

All this is great for landlords renting to the European brands, apartment owners selling to the Mainlanders and merchants running the upscale stores. Or operating a Macau casino. (Macau gambling revenues are now approaching four times that of Los Vegas and the Macau gambling stocks have soared.) But this is also sparking a populist reaction in Hong Kong whose citizens feel like they are being priced out of their own city especially with regard to non-tradable goods like apartments. Their ire is directed at the Hong Kong government which is supposed to do something about this. And the government in Hong Kong has duly responded with a variety of punitive measures against so-called speculators in high end apartments. But these measures attack symptoms and ignore underlying causes which are monetary and macro in nature.

I will offer two causes and one so-so solution:

First as I have been arguing the Peoples Republic of China is a very protectionist place and one where the newly rich Chinese consumers get a bad deal. Tariff and non-tariff barriers drive up the cost of imported luxury goods in China and restrict their availability. Gambling in China is forbidden. Interest rates on bank deposits are held down below inflation. Restrictions on the free flow of information contribute to shoddiness of locally produced goods and whistle blowers on subjects like poisoned baby’s milk are treated as troublemakers.

So what are the new rich and middle classes of Chinese cities supposed to do with their money? Travel restrictions have now been relaxed. Across the border lie Hong Kong and Macau, with totally wide open tax free non-protectionist free market economies. Just like residents of U S states with high cigarette taxes buy their smokes in neighboring states with lower taxes, Mainlanders head for Hong Kong and Macau.

Second, the Hong Kong dollar has now become undervalued relative to the renminbi. Six years ago the Chinese currency was trading at 8.27 to the US dollar. Now the ratio is 6.57. The Hong Kong dollar is pegged to the US dollar at a central target rate of 7.80. (The Macau pataca is pegged one to one to the Hong Kong dollar. Therefore the pataca is also pegged 7.80 to the US dollar.) As the renminbi has risen against the US dollar, the Hong Kong dollar has become cheaper for the Mainlanders even as the Hong Kong and Chinese economies become more integrated. Actually, as Treasury Secretary Geitner has finally figured out, in real terms the renminbi has been revalued even more than the change in nominal exchange rate because of the acceleration of inflation in China. For the Mainlanders, Hong Kong and Macau are huge bargains just because of the currency misalignment alone. For the Mainland-oriented Hong Kong vendors and the Macau casino operators, the price signals say “keep expanding.” Just like in 2002 when the Greenspan low interest rate policy signaled “leverage up and buy a house.”

Unless the renminbi suddenly becomes overvalued against the dollar, sooner or later the Hong Kong authorities are going to have to do something. The authorities of course know what is going on. But their options are limited. The simple solution – repeg the Hong Kong dollar to the renminbi – is not a solution because any such peg is not workable because the Chinese currency is not freely convertible on capital account. Meanwhile as the US irresponsibly continues with QEII, high powered money is flowing into Hong Kong. The December CPI for Hong Kong was up 3.1% yoy. Expect that to rise if the current monetary structure is not changed.

One solution might be to repeg the HK dollar (sometimes called the HONKY) at a higher rate to the US dollar. There is nothing eternal or sacrosanct about the Hong Kong US dollar peg. Certainly in the past at various times the Hong Kong dollar had floated, been pegged to sterling and earlier to silver. But do this once and the markets may start anticipating further changes encouraging all kinds of speculative flows.

And the political problems with this could be formidable. At the time of the 1997 Handover back to China, many worried that PRC troops would come marching into Central (Hong Kong’s financial district) and kill the golden goose that was and is Hong Kong. But they were wrong. The PRC troops did march into Central. But then they disappeared into what used to be called the Prince of Whales building and only come out for the rare ceremonial occasion.(As opposed to the British troops who would regularly emerge on Friday nights for some manly brawling in Wan Chai’s bars.)

Rather an army of populists, one of which was the last British Governor, has invaded Hong Kong. They are quite visible. They have brought with them such things as more generous welfare payments and minimum wage laws. Fiddle with the peg and they will start poking their noses into managing the currency.


Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong

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