The Hong Kong dollar peg will survive the Stern test of the Rampant Greenback

HONG KONG DOLLAR, PEG-PEG USD/HKD, CHINA – Talking Points:

• USD/HKD worked his way to the top of his authorized trade group
• Hong Kong authorities are forced to defend this level
• For this, they store a lot of ammunition. Beijing can bring more

The Hong Kong dollar is among many currencies that have fallen sharply against its US rival as mounting global crises have eroded the greenback’s popularity. With the US Federal Reserve in the midst of its strongest interest rate hike program in a generation – well ahead of anyone else – it’s not hard to see why its currency is winning the popular vote.

After an admittedly shaky start, the Fed appears willing and able to act more aggressively against rising inflation than any other major central bank. The US also enjoys the prowess of its own commodity and energy supply chains to a degree unmatched by its competitors. How Europe regrets its dependence on Russia oil and gas and looking miserable for the cold winter, this trump card of the US further increases the attractiveness of the dollar. However, the Hong Kong dollar is of course pegged to the US unit, which adds an exciting twist to this currency pair. We examine the peg, its history and future in light of this year’s trade promotion.

The chart is created using TradingView

What is the USD/HKD peg?

The peg was originally a device to restore confidence in the Hong Kong dollar after a period of devaluation back in 1983. The Hong Kong Monetary Authority (HKMA) has noted that its currency has fallen to the point that US dollar bought more than nine of its peers in Hong Kong, up from about six at the start of the year. Faced with shaky confidence in local banks and public unrest, USD/HKD was pegged at 7.80, since 2005 the pair has been allowed to trade between 7.75 and 7.85.

With the “linked exchange system”, if USD/HKD rises to 7.86, the HKMA will buy Hong Kong dollars from local bank reserves. This, in turn, leads to lower bank liquidity and higher interest rates, which attracts capital back to Hong Kong, strengthening the USD/HKD exchange rate.

Conversely, when the US dollar weakens, the HKMA sells Hong Kong dollars to local banks. Liquidity then rises, interest rates fall, and the local unit’s appeal fades.

The design of the peg means that it is the primary tool for controlling the exchange rate. The HKMA changes local interest rates in step with the US Federal Reserve, effectively giving up its discretion to adjust monetary policy in response to changing economic conditions.

Lack of independence is the problem now

That the current peg protection means that local interest rates are rising at a time when, other things being equal, the economy would be crying out for the stimulus of lower borrowing costs.

Hong Kong has been hit hard by China’s “zero-Covid” quarantine policy, as well as Beijing’s crackdown on freedoms supposedly guaranteed to Hong Kong after it was returned to Chinese rule in 1997.

The city has long been a tourist magnet, but the prospect of a long, tightly enforced Covid quarantine and the reality of a decidedly more repressive local regime have understandably led to a drop in visitor numbers.

Indeed, the Hong Kong Tourism Board reported a 97.4% drop in visitors last year, with little improvement expected in 2022 despite some easing of quarantine rules.

With numbers like these, it’s no surprise that overall economic growth should explode. The economy shrank by 1.3% year-on-year in the second quarter of 2022 after falling 3.9% in the first.

Obviously, these are not the conditions under which lending rates should rise. However, according to the territory’s currency rules, they must rise.

There is some relief for borrowers that local retail banks have so far not significantly increased their own rates, but it seems almost certain that they will if base rates continue to rise. And that will be a problem. In July, Hong Kong Finance Minister Paul Chan was reported to have said that “continuous rate hikes are not conducive to economic recovery.”

However, Hong Kong will have to endure it

They are certainly not profitable, but there is little that can be done about them now. Hong Kong is hardly the only jurisdiction that has seen unwelcome interest rate hikes. The surge in global inflation has put more or less all major economies in a similar position.

The Hong Kong dollar peg is the basis of financial stability in the territory. A stable currency is vital for an open economy like Hong Kong, where international trade and maritime logistics are key drivers of business. The currency is seen as safe and convertible (in fact, it is usually in the top ten globally traded units) and is the basis of Hong Kong’s status as a financial center.

Those concerns are likely to trump short-term economic pain, as they have throughout the 40-year history of the peg.

Peg is still trustworthy

Pegging enjoys a huge amount of trust in the foreign exchange market. Back in July, Chan said the city’s “huge” foreign exchange reserves would be enough to protect it. They amount to about $440 billion and are believed to be backed by Beijing’s multi-trillion dollar reserves.

Which brings us to China’s attitude, which is probably very important.

Beijing seems content that Hong Kong will retain its place as China’s “window” to international capital markets. This means keeping the Hong Kong dollar pegged to the US dollar. The latter is freely convertible, which the yuan is still not. As a result, it plays a role in world trade that Chinese currency advocates can only dream of. The greenback is also the world’s main reserve currency and will remain so. China is simply not going to cede sufficient control over its own currency to the whims of the world market.

This means that Hong Kong will be better off with the US dollar on the other side of the currency regime. As long as Beijing agrees, the peg will endure.

Written by David Cottle for DailyFX