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
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.”