Two countries share the same monetary policies but have absolutely different problems and solutions to them. I refer to USA and Hong Kong and their currencies, the USD and HKD.

Hong Kong shares U.S. monetary policy because of it’s currency. The HKD is pegged to the USD. Hong Kong import the U.S.’s ultra accommodative monetary policy. All factors for which HK decided to peg to the USD are no longer active. Now we are left only with the negative impact of the peg on Hong Kong. Consumer price inflation in Hong Kong is accelerating. The weak currency is intensifying the inflation problem.

Prices in Hong Kong’s residential real estate market are soaring. The Hong Kong real estate is a bubble. Residential valuations are approaching Pre-Asian Financial Crisis levels. HK residential Price/Income ratio is 9.2x in q1 2011, up from 5.5x just 3 years ago.

The USD peg and the vastly divergent US and HK economies impact the HK economy through various channels:

Rapid Expansion of the monetary base – as a result of strong side intervention to protect the HKDUSD peg, HK’s monetary base increased HKD $671 billion or approx 200% over two years. HK has effectively no control over the size of its monetary base., which means that when USA announces new QEs, HK’s inflation will increase even more and the real estate bubble will grow even more creating risky social issues. Hong Kong is on 2nd place for the fastest credit growth in the world.
Imported low short-term rates – interest-rate parity with the US means Hong Kong suffers frequently from
inappropriately high and low real interest rates. High negative interest rates have contributed Hong Kong’s current and previous asset bubbles 1993-1996, 2008-2011.
Diminished Purchasing Power – rising cost of imports. Unable to revalue, Hong Kong’s weak currency has led to a large
increase in the cost of imports, particularly in the critical food sector. Hong Kong imports 90% of its food, mainly from China. There is a direct correlation between weak HKD and HK inflation.

Source: Bloomberg

If Hong Kong doesn’t depeg it’s currency from the USD, all these problems will likely get worse because: US short term interest rates for two years near zero. HKD is still undervalued by 30% despite high inflation. HKD’s undervaluation will only worsen as the Yuan appreciates. Broad moneysupply (M2) has not yet grown to reflect the full impact of the massive 2008 and 2009 monetary base expansion. The HKMA estimates that HK has no spare resource capacity to absorb further demand growth¹

¹Source: “Half – Yearly Monetary and Financial Stability Report” – Hong Kong Monetary Authority, March 2010, p.33

According to a rank by The Economist, Hong Kong is on 3rd place among the countries with highest risk of overheating.

Inflation is one of the biggest social unrest contributing factors and it’s increasing in Hong Kong. More people are going on the streets and joining protests. This year 218,000 people, the most since the massive 2003 civil liberty protests, marched in Hong Kong’s on 1-st July.

“They aren’t happy with the fact that they do not see an improvement in living standards, despite the good economic statistics.” – Bloomberg July 1st , 2011

The HKD call options are very cheap right now:

The only effective way to mitigate inflation and a potential real estate bubble is to allow the HKD to appreciate. A 30% revaluation would bring the HKD to it’s fair value. I believe that there is a high chance that the government will act and revalue the HKD within the next 2 years. I have decided to risk a small part of my portfolio – 1% to purchase OTM call on HKDUSD for 2 years.