Will China maintain both the Hong Kong dollar and the yuan after the upcoming hand over?

China has an official answer for those worried about the future of the Hong Kong dollar. Yes, China has formally committed to maintaining the Hong Kong dollar for 50 years.

But that doesn't mean keeping both currencies in their current states. Currency traders are hard to convince. Rumors of devaluation or a move toward convergence keep their appetites whetted. The Hong Kong dollar has seen several assaults in the past few years, notably in 1995 from George Soros. "The boys will have a try again," says one banker wryly. "They always do."

But many observers discount the traders' chances, even though upholding the status quo could cost the Chinese dearly-politically as well as economically. Some sort of devaluation of the Hong Kong dollar is seen as more likely than any attempt to converge the two currencies. "It simply wouldn't be technically possible," says John Ellis, senior vice president of Bank of America.

Since 1983, the Hong Kong dollar has been linked to the U.S. dollar at a rate of HK$7.80/$1. The Hong Kong Monetary Authority (HKMA) operates its version of Fort Knox-an exchange fund-into which the three banks that issue Hong Kong dollar notes must pay the equivalent in dollars. This and other substantial reserves make the HKMA a formidable force. Spot volatility in the Hong Kong dollar is negligible. The forward market is very competitive, very liquid out to six months, but not very active beyond the July 1997 handover date.

The Chinese yuan is not a convertible currency, though China has plans to make it so by 1998. In anticipation, the government is amassing dollars, an estimated $100 billion in the last two years. But the weakness of the Chinese economy, with double digit inflation-now about 17 percent per year, but more than 20 percent per year in several of the last few years-makes China's currency a very weak cousin to its Hong Kong neighbor.

Hong Kong's inflation rate was about 8 percent in 1996, but that is still high when compared to that of the United States. Because of the currency's fixed link to the dollar, the inflation differential is a pull against the Hong Kong dollar that the HKMA must constantly fight against.

Traders see three possibilities in the year ahead: total collapse of the Hong Kong dollar akin to that of the Mexican peso in 1994; a gradual widening of the band that the Hong Kong dollar trades against the U.S. dollar; or no change, with the HKMA maintaining the HK$7.80/$1 link. The first would happen only if China was unable to keep the economy of Hong Kong sufficiently separate from that of China or if it decoupled the U.S. dollar link unilaterally. "That decision could only be political," says one trader, "because it would be suicide." China, however, may find that it can no longer stomach the relationship with the United States that the currency link implies.

More likely, and much cheaper than either alternative, is the gradual widening of a currency trading band. The HKMA pays to keep the U.S. dollar link static. If that were to prove too expensive, the HKMA could simply institute a band as was done recently in Thailand. "It's a long term solution," says BofA's Ellis. "It keeps the country in control by making intentional changes to policy rather than bowing to one-off events by speculators."

The HKMA and the Chinese government have a lovely game of cat and mouse to look forward to in the months before hand over. As George Soros has written, the size of the financial reserves won't determine the strength of the Hong Kong dollar, but, rather, the people's belief in political stability. Currency traders and speculators will be testing that belief at every turn.