The View

Hong Kong’s currency peg is likely to come under attack amid Fed tightening, weaker yuan

Currency speculators can be expected to set up anti-peg trades

PUBLISHED : Monday, 21 December, 2015, 10:49am
UPDATED : Monday, 27 June, 2016, 11:51am

As a small, open economy hitched to monetary policy settings of the world’s largest economy, Hong Kong is accustomed to magnified business cycles.

Interest rate cuts in the United States tend to have much greater impact here, sparking inflation or bubbles, while hikes in rates can hit like a hammer.

With last week’s move by the Federal Reserve, Hong Kong for the first time faces a double-tightening effect: the yuan is likely to weaken, acting as an additional squeeze on the local economy. This is a new dynamic – and one that could revive speculative trades on the demise of Hong Kong’s currency peg.

China previously was also pegged to the US dollar, though unofficially. Then in 2005 Beijing switched to a de facto crawling peg, and for nearly a decade the renminbi strengthened against the US dollar at a steady and predictable pace, no matter what gyrations took place elsewhere in global currency markets.

The peg question will become more pressing as the yuan and the Hong Kong dollar move in opposite directions in any prolonged Fed tightening cycle

In the past year the yuan has no longer been a one-way bet, however, and more volatility is on the way. Just ahead of the Fed’s decision to raise policy rates on December 16, the People’s Bank of China issued an attention-getting decision of its own: it will manage the yuan against a “basket of currencies.”

“By referencing a basket of currencies, we believe the PBOC is leaving more room for further [yuan] depreciation against the dollar in the future,” Bank of America Merrill Lynch said in a report. “This would be particularly important if the Fed rate hike and the expectation of further hikes trigger significant dollar strengthening against [developed market] and [emerging market] currencies.”

China’s currency has fallen only slightly against the greenback in the past year, even as other global and regional currencies plunged. That makes the yuan less competitive against trade partners. By moving to a “basket system” including the currencies of Japan and Europe – places still in easing mode - Beijing is preparing to protect itself against further dollar strength.

Under the strictures of the currency board system, Hong Kong has no such protection: it will follow the dollar up. Thus the double tightening ahead, coming not just from rising financing costs, but from a depreciating yuan - which creates a further challenge by undermining Chinese purchasing power in Hong Kong. China is a crucial source of retail, tourist and investment funds.

The weaker Chinese currency adds a new element to the perennial question: is it time to scrap the peg? Concerns about the currency board system’s declining appropriateness have been rising in recent years, amid an increasingly stark mismatch between the Hong Kong and US economies.

These days, Hong Kong is more closely tied to still-developing China, which is expected to see average gross domestic product growth of 5 per cent a year over the next decade. That is down from the current 7 per cent, but still a much bouncier pace can be expected from the mature US economy.

Inappropriately low interest rates in Hong Kong – imported through the peg - have been blamed for the surge in property values and somewhat high inflation in recent years. After the boom comes the bust, with some warning of a 20 per cent decline in property prices next year.

Former Hong Kong Monetary Authority chief Joseph Yam Chi-kwong has suggested that Hong Kong would do better to either widen the Hong Kong dollar’s trading band, or switch to a Singapore-style system, in which the currency is managed against a basket of currencies rather than just the US dollar.

Now that China seems to have made this move to a basket system itself, the pressure on Hong Kong to follow suit is even greater.

“The peg has served Hong Kong well as a small economy,” current HKMA chief executive Norman Chan Tak-lam said defensively after the Fed’s hike last week, adding that there was “no intention” of changing the peg. If imperfect, the risks of a change to the peg might not be worth the potential rewards.

But the peg question will become more pressing as the yuan and the Hong Kong dollar move in opposite directions in any prolonged Fed tightening cycle. Expect to see a revival of trades betting on the peg’s demise.

Cathy Holcombe is a Hong Kong-based financial writer