Hong Kong's monetary system, like China's, is based on the silver standard. When China abandons it in 1935, Hong Kong follows suit. The Hong Kong dollar (HKD) becomes the official monetary unit, and a currency board links it to the British pound sterling. HKDs are issued by Hong Kong and Shanghai Banking Corporation and Standard Chartered Bank.
Briefly linked to the U.S. dollar when the British pound is allowed to float, the HKD's exchange rate is also allowed to float the following year. Excessive money growth and uncertainty about Hong Kong's political future cause sharp devaluation of the dollar.
The Hong Kong dollar plummets further when negotiations break down between Britain and China over Hong Kong's future after 1997. To create stability, the currency board is reinstated, and the Hong Kong dollar is linked to the U.S. dollar at a rate of HKD7.8 to US$1.
The Sino-British Joint Declaration of 1984 allows Hong Kong to continue issuing its own currency until the year 2047. The currency board system appears to effectively slow inflation. Hong Kong's financial markets become jittery with the coming political transition.
The Hong Kong dollar is fixed to the United States's currency, as are its interest rates, even though Hong Kong's inflation rate is three times America's. The Hong Kong dollar is increasingly perceived as overvalued.
The HKD remains the legal currency after the hand-over. Government invests an estimated US$15 billion of Hong Kong's reserves in the market to ward off speculative attacks resulting from uncertainty about whether its currency will stay pegged to the U.S. dollar. Interest rates rise drastically. Hong Kong suffers further overvaluation of the dollar and a brief period of severe inflation.
The Hong Kong dollar slowly begins to recover as the economy stabilizes. Internal debate continues over whether the peg system should remain in place. Deflation sets in.
As deflation persists and the economy wobbles in and out of recession, government spending outpaces revenue, particularly from property taxes, and the growing deficit places pressure on the Hong Kong dollar, which remains pegged at its fixed rate to the U.S. dollar. Rumors of devaluation pick up anew; some economists argue a 20 percent devaluation would be appropriate.
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