700B BAILOUT AND SHOULD HONG KONG GET OFF THE PEG

Someone asked the other day since the Fed is printing so much money which would fuel inflation, devalue the US$, then should Hong Kong de-peg and float their currency?

1.I would first like to touch on the misnomer which is "printing". It's a difficult statement to respond to because there is just too much media hype around. These days there is no physical printing of money needed to increase the money suply because extension of credit is also money, i.e. credit = money. The recent bailout is simply that. An electronic transfer that simply says the recipient bank has "x" amount of dollars in a "ledger" balance and thats it!

2. It doesnt matter how much money is created. If very little makes it's way to the economy i.e. if there is no one borrowing to spend it then its still a case of "little money chasing too many goods" which results in deflation. This is happening now. The Fed has literally pumped billions into banks but there is no inter-bank lending (no one borrowing) because of a lack of trust. Credit is not being extended to commercial enterprises so businesses have no credit to make simple transactions such as payroll, purchases e.t.c. Hence no matter how much money is created, if there is no borrowing/lending which means prices do not go up, there is no effective debasement of the currency!

3. Inflation/debasement only happens if there is too much money chasing too few goods or when easy credit is available , such as the buildup of the housing bubble a few yeasr ago, where even a jobless vagrant could get a no-money-down load to buy a house! But now the reverse is happening no matter how much money is made available, because at the end of it borrowed money still has to be paid (which was not for a period of time, until this disaster).

HK could float the currency. Although I still think a free-float is too risky for an economy so small. It is easily open to a currency attack/manipulation if say a few hedge funds decide that the free-floated Hong Kong dollar is ripe for attack.This is basically what happened in 1998:

1. Hedge Funds shorts the HK dollar (i.e. borrow the HK dollar and sells it. a few days later they have to buy it back to cover their positions.). They then buy it back a lower level . They could not make much out of shorting the HK dollar because it is pegged (only allowed to fluctuate within a defined band)!

2. However this action (selling the HK dollar means USD is leaving HK) caused the inter-bank rate to sky-rocket because the HK dollar was being oversold.

3. When the interest rate shot up, guess what? the Stock market went down. Then the Hedge fund shorts the Hang Seng Index (most of the blue chips). Here is where they thought they could make a killing! http://www.hkbu.edu.hk/~econ/web988.html

4. Enter Donald Tsang, who spent something like 120B HK to buy back the stocks. This resulted in the creation of the TRACKER FUND. This caused a lot of hedge funds to loose money because they had to "unwind" their trades at higher prices than their sell price. http://en.wikipedia.org/wiki/Tracker_Fund_of_Hong_Kong

Hence I believe HK has 2 practical choices:

a. peg to CNY in the future

b. peg to a basket of currencies like Singapore.