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Monetary Authority Chief Executive Joseph Yam says the exchange rate is one factor in inflation, but not the biggest, adding effective remedies should focus on improving and sustaining labour productivity growth.
In his weekly Viewpoint column published today Mr Yam said a weak US dollar, a strong renminbi and higher inflation recently may have led some to question again the appropriateness of retaining the link between the Hong Kong dollar and the US dollar.
"It is true currency weakness contributes to domestic inflation to a greater degree in Hong Kong, with its highly externally oriented economy which imports almost all its daily necessities, than in the less externally oriented economies. But it is important to understand how sensitive to exchange-rate changes our domestic inflation rate actually is."
Labour cost
The authority's research found unit labour cost is a more important determinant of inflation in Hong Kong than import prices, which are influenced by the exchange rate and, of course, domestic inflation in the city's import markets.
"In other words, even for a very externally oriented economy like Hong Kong, domestic factors still dominate inflation dynamics in the medium run."
Mr Yam said it is necessary to put the significance of the exchange rate in its proper context, supported by empirical research, when commenting on the subject, particularly when discussing possible remedies.
Effective remedies
Given unit labour cost is the more important contributor, effective remedies should focus on improving and sustaining growth of labour productivity, he added.
There has been remarkable growth in labour productivity in recent years, perhaps as a result of advances in information technology, leading to a decline in unit labour cost and exerting a strong dampening effect on domestic inflation.
But the strong and sustained economic recovery since 2003, which has led to a persistent decline in the unemployment rate to near 10-year lows, has in the past year or so reversed the downward trend in unit labour cost.
"I believe this is an important reason for the upturn of domestic inflation in recent months, as we have seen fairly large increases in pay in many sectors. This coincided with significantly higher inflation in our import markets. The weaker US dollar, while undoubtedly a factor, has perhaps attracted much greater attention than other factors."
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