Hong Kong monetary system returns to balance after a double whammy

The Hong Kong dollar ended Friday having suffered its worst week of declines in 12 years as investors yanked massive sums out of Hong Kong stocks, while analysts believe further outflows will add to borrowing costs, further weighing on the local economy.

SCMP, January 16

Scary stuff and I am certainly prepared to believe that there is more bad news to come. But what is happening to the Hong Kong dollar just now is actually a welcome relief from a long bout of one way pressure.

First, however, an excuse. I do not believe that a picture is always worth a thousand words. Television, for instance, does more to subtract than to add to the sum of human knowledge. But words are not worth much in economics compared to what a chart can tell you. Hence ...

My first chart sets out the story of the HK dollar to US dollar exchange rate in recent years. The two black lines mark the intervention levels. For more than ten years now the HK Monetary Authority has been obliged to stop the HK dollar from going stronger than HK$7.75 or weaker than HK$7.85.

The jagged line in between gives you the actual market rate and it clearly shows that only rarely over the last ten years has the HK dollar been weaker than the official HK$7.80 peg. For the last four years in particular it has regularly butted up against that permissible strongest rate of HK$7.75.

Bear in mind here that not only has the HK dollar been strong against the US dollar but since mid-2014 the US dollar has also risen by some 20 per cent against the average of its trading partners. We have a case here of the proverbial double whammy.

The second chart sets out what it costs us to keep the HK dollar within its intervention bands. For those technically minded it consists of the aggregate balance of the HKMA settlement account and the outstanding issuance of Exchange Fund bills and notes. Let’s call it the HKDDF for HK Dollar Defence Fund.

Out government is at this point carrying about HK$1.2 trillion of foreign assets acquired only for the purpose of keeping the peg in place. This is more than 50 per cent of our gross domestic product and it doesn’t contribute to GDP at all, except indirectly.

It hasn’t hurt us, at least not so far. The HKMA could easily build up the HKDDF to a higher figure and is quite ready to do so.

It is still a very big sum, however, and it carries the risk of a horrible foreign exchange loss should circumstances conspire to break the peg and force the HK dollar to a much stronger level. This is admittedly only a slight risk but it does exist.

Fortunately, the pressure has now suddenly come off and we may be looking at a period in which the HK dollar trades on the weak side of its peg. If so, we can unwind some of that HK$1.2 trillion in keeping it from going too weak, a double benefit to match a previous double whammy.

I call that a monetary system coming back into balance. Where is the threat?