In 1974, the Hong Kong dollar was floated at $HK4.97 to the US dollar. From 1981, the currency collapsed, diving 45 per cent to a record low of $HK9.60 in September 1983.

The currency’s plunge undermined confidence in the then-British colony’s banks. Amid the panic, authorities decided the only goal for monetary policy was a stable exchange rate.

So in October 1983, the currency was pegged at $HK7.80 to the US dollar. The Hong Kong dollar has stayed around that rate ever since.

The economy has mostly done well under the peg. Hong Kong, a small, open economy where exports often exceed 300 per cent of GDP (compared with, say, 22 per cent for Australia), has grown strongly in the past three decades or so as importers, exporters and international investors have enjoyed reduced exchange-rate risk.

Though the time might be coming when Hong Kong authorities need to adopt a more appropriate exchange-rate system. The giant flaw of Hong Kong’s exchange-rate regime is that authorities surrender their ability to control interest rates. Other flaws include that a falling currency can’t absorb shocks – much like the dilemma euro members face.

Under the peg, authorities adopt the interest-rate policy of the linked currency; in this case, the US. This is because, under the system, a country must back its monetary base with foreign reserves while committing to convert its currency to the reserve currency at a prescribed rate.

So, essentially, the currency becomes indistinguishable from the reserve currency, except in appearance and nominal value. Therefore, the interest rates on the two currencies must be the same.

Since the currency peg began, the US’s monetary-policy stance has periodically been problematic for Hong Kong because Hong Kong’s economic conditions have often differed from those in the US. Right now, it’s especially troublesome – the US is running its loosest-ever monetary policy (near zero rates while electronically printing money) at a time when prices in Hong Kong are rising at their fastest pace in 16 years.

Inflation in Hong Kong is running close to 8 per cent as rents, food prices and utility charges are rising. The higher food costs are mostly for staples, meaning poorer Hong Kong residents face even faster inflation than the official figure. Hong Kong’s inflation rate is likely to stay among the quickest in Asia. Import prices are rising because the value of the Hong Kong dollar is sliding as the US dollar weakens.

Chinese goods are more expensive as inflation bites there. Global inflation pressures are building as Asia’s fast growth and the Federal Reserve’s loose monetary policy boost commodity prices. Unfavourable weather is bolstering food costs while unrest in the Middle East and North Africa has lifted oil prices.

At the same time, Hong Kong’s own domestic economy is chugging along fast enough to stir inflationary pressures. While GDP fell 0.5 per cent in the June quarter and might stay negative for a few quarters because exports are struggling due to the global downturn, retail sales are growing at a 20 per cent annual pace.

Stores are reporting robust sales as more mainland Chinese visit and boost spending in all categories. Wage demands are likely to increase now that inflationary expectations have jumped and unemployment is at a 13-year low, at 3.2 per cent. What can authorities do to cool domestic spending to tame inflation? Nothing, when it comes to monetary policy. That won’t do forever.

Hong Kong authorities are well aware of the strengths and weaknesses of a peg under a currency board. They cannot hint at any concern or telegraph any changes to the exchange-rate policy because that would undermine confidence in the peg. But don’t be surprised if, one not-too-distant day, they heed the call from some lawmakers and banks and once again change Hong Kong’s exchange-rate system.

Michael Collins

Michael Collins is an investment commentator at Fidelity Worldwide Investment