Attacking Hong Kong dollar peg would hurt those the US hopes to help

The United States is unhappy with China’s new national security law for Hong Kong and is seeking ways to express its disquiet. Some advisers to US Secretary of State Mike Pompeo have reportedly suggested taking measures that would undermine the Hong Kong dollar’s Linked Exchange Rate System (LERS), its peg to the US dollar.

Washington should file those suggestions in the rubbish bin. Such measures would hurt the very Hongkongers that Washington wants to help. It is the Hong Kong people who would primarily lose out if undermining the LERS led to a much weaker Hong Kong dollar.

First reported by Bloomberg on July 7, the notion of undermining the Hong Kong dollar peg had not apparently gained much traction in Washington and hadn’t been aired at a senior level in the White House. Presumably, though, the idea has received greater attention since the story ran.

As it stands, the Hong Kong Monetary Authority has been defending the LERS – to stop the Hong Kong dollar from strengthening rather than weakening. A succession of initial public offerings has been attracting capital inflows into the Hong Kong dollar.

From an American perspective, any decision to undermine the Hong Kong dollar’s peg to the US dollar needs to factor in the possibility that such action might fail, damaging Washington’s reputation. Even the very attempt might have consequences that US authorities would not like.

As Geoff Yu, senior EMEA market strategist at US bank BNY Mellon, noted last week, legal and institutional support for the Hong Kong dollar “remains strong” and is embedded in Article 111 of the Basic Law. That article sets the Hong Kong dollar as “the legal tender in the Hong Kong special administrative region”, that “the authority to issue Hong Kong currency shall be vested in the government of the Hong Kong special administrative region” and that crucially “the issue of Hong Kong currency must be backed by a 100 per cent reserve fund”.

Consequently, as Yu points out, undermining the LERS would require “actual depletion or devaluation of the reserve fund relative to the Hong Kong dollar monetary base”.

That would take some doing. As HKMA chief executive Eddie Yue Wai-man wrote on June 2, “the LERS is underpinned by sizeable foreign reserves of over US$440 billion, which is more than two times our monetary base”.

Washington could make sustaining the LERS harder, though not impossible. It could do so by withdrawing approval for the HKMA to use the Federal Reserve’s temporary repurchase agreement facility for foreign and international monetary authorities, known as the FIMA Repo Facility.

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This facility, as the Fed describes it, allows FIMA account holders “to temporarily raise dollars by selling US Treasuries to the Federal Reserve's System Open Market Account and agreeing to buy them back at the maturity of the repurchase agreement”.

Seeking to undermine the Hong Kong dollar peg in that way would be effectively weaponising access to US dollar liquidity, though, and is not a step Washington should take lightly. It might unnerve other sovereign entities, which like the HKMA also have vast amounts of US dollars in their foreign reserves, largely in the form of US Treasury holdings.

Washington should also bear in mind that seeking to undermine the Hong Kong dollar peg would have ripple effects. Such an action would inevitably damage Hong Kong’s position as a major hub in the global financial system.

“With Hong Kong’s financial system closely integrated with the global economic and financial systems, any move that hits our financial system would also send shock waves across the global financial markets, including the US,” Yue wrote. “Confidence of international investors in using the USD and holding US financial assets could also be undermined.”

Jack Lew, who was treasury secretary under then US president Barack Obama, made a similar point about sanctions overreach posing a risk to US interests during a speech in 2016. “If foreign jurisdictions and companies feel that [the United States] will deploy sanctions without sufficient justification or for inappropriate reasons,” he said, “we should not be surprised if they look for ways to avoid doing business in the United States or in US dollars.”

Washington clearly wishes to express its concern about developments in Hong Kong, but the it should not countenance any proposals that advocate undermining the Hong Kong dollar peg. Not only might any attempts to undermine the Hong Kong dollar peg fail, they could well backfire on the US itself.

Neal Kimberley is a commentator on macroeconomics and financial markets