Recent volatility aside, Hong Kong’s dollar peg is here to stay
Aidan Yao says Hong Kong has plenty of ammunition to defend the peg, if necessary, and there are currently no real alternatives that are compatible with its status as a financial hub
The Hong Kong dollar-US dollar exchange rate hit the weak side of its 7.75-7.85 currency band on April 13, prompting the Hong Kong Monetary Authority to intervene in the market multiple times to support the currency.
Even though market interventions by the HKMA are not uncommon historically, previous interventions, in 2008-09, 2012, and 2014-2015 were all in response to excessive currency strength, requiring the HKMA to sell Hong Kong dollars.
What we are observing now is the reverse: the Hong Kong dollar has fallen to the weak side of its trading range, forcing the central bank to intervene to support its value.
Being one of the few remaining fixed-exchange regimes in the world, these developments have created renewed chatter about the vulnerability of Hong Kong’s peg.
Before we go into regime sustainability, here’s some background on how the Hong Kong dollar peg works.
To maintain a rigid peg between the Hong Kong dollar and US dollar, Hong Kong has to give up its ability to set monetary policy while maintaining an open capital account. This means domestic interest rates are the primary shock absorbers in the Hong Kong dollar economy.
However, the interest rate adjustment mechanism has not been functioning properly in recent years. Ever since the US Federal Reserve started to hike rates in 2015, Hong Kong dollar interest rates have been reluctant to move up, creating an interest rate wedge between the Hong Kong dollar and the US that has grown to its largest state since 2007.
The key reason for this sluggish adjustment is abundant liquidity in the financial system, caused by a number of factors.
First, a flush of liquidity created by quantitative easing in developed economies has flowed to the Hong Kong dollar in search of higher returns. This has been supplemented, in recent years, by a strong inflow of money from mainland China, buying Hong Kong properties and stocks, contributing to a rampant price increase in the city’s real estate and equity markets. Finally, renminbi depreciation since 2015 has led many Hongkongers to convert their renminbi deposits back to the Hong Kong dollar, adding to local liquidity.
All these factors have kept Hong Kong’s financial system flush with liquidity, which held back the convergence between Hong Kong and US interest rates and created incentives to sell Hong Kong dollars for US dollars. This is the cause of the recent Hong Kong dollar depreciation.
To ease that pressure, the HKMA has started actively draining liquidity via foreign interventions. The new market equilibrium should be reached fairly quickly, provided the extreme expectations for the Hong Kong dollar de-peg do not become mainstream.
But if the market is serious about breaking the peg, can the HKMA defend it?
The chance of the George Soroses of the world succeeding in harming the peg is negligible. As its first line of defence, Hong Kong has US$440 billion in foreign exchange reserves, 1.4 times its GDP and almost twice its base money.
If that were not enough, Hong Kong has a big brother (Beijing) watching its back. A liquidity swap line with the People’s Bank of China, worth 400 billion yuan (US$63 billion), can be tapped straightaway. But Hong Kong ultimately has the backing of the world’s largest reserve arsenal at US$3.1 trillion. Breaking the Hong Kong dollar fortress is nearly impossible so long as Hong Kong (and Beijing) wants to defend it.
But is there any chance that Hong Kong won’t defend its currency?
The chance of an intentional de-peg is nearly as low as having it broken by external forces, because Hong Kong does not have any real alternative foreign exchange options compatible with its financial centre status.
Free-floating the currency is not an option as the Hong Kong government has always thrived so as to minimise foreign exchange risks for users of Hong Kong’s financial and trade services. Plus, floating the currency would mean the HKMA, instead of the Fed, would manage Hong Kong’s monetary policy, creating some technical and credibility issues that may not be easy to adapt to in the short term.
Pegging the Hong Kong dollar to the renminbi is another option. But that would expose Hong Kong to one fatal problem: the renminbi is not yet fully convertible, and having the Hong Kong dollar linked to a non-convertible currency would expose Hong Kong to the same degree of capital control as the mainland. A lack of free capital flows would be detrimental to Hong Kong as a financial centre.
Hence, there’s no chance that the authorities, in Hong Kong or Beijing, will let go of the currency any time soon.
Finally, will the market gyrations cause any real economic damage? That depends on how much interest rates go up from here. The prime lending rate in Hong Kong has been nailed to the ground, at 5 per cent, since 2009. It seems that the HKMA wants to see these rates move higher gradually to help it normalise monetary conditions and rein in Hong Kong’s red-hot property market. While this will put some pressure on mortgage borrowers, the overall impact of a gradual policy normalisation should be manageable for Hong Kong’s banking system and economy.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers