The foundations of the Hong Kong dollar (HKD) peg include the internal and external balances, productivity growth and economic flexibility.
In my view, these fundamental factors mean that the HKD peg would not break as easily as other currency pegs have.
- The political will to maintain the HKD peg is still very strong after 36 years of existence. Any speculation about Beijing abandoning the HKD peg due to Hong Kong’s diminishing role in China is misplaced, at least in the absence of a major change in the economic/political environment.
- Speculative attacks on the HKD peg, especially since late 2018, appear to reveal some ignorance about the working of the peg’s mechanism and the basics of Hong Kong’s finances, i.e. its foreign reserves and monetary framework.
Speculators have been selling the HKD since last year, pushing the HKD-USD exchange rate to the weak side of the convertibility range (Exhibit 1). Such situations have occurred many times over the peg’s 36-year life and have always ended the same way – the HKD peg holds firm and the speculators get burned.
The temptation to attack the HKD peg arises from this observation: History suggests that every currency peg ends up imploding, so why should the HKD peg be any different?
Exhibit 1: Selling of the Hong Kong dollar relative to the US dollar has pushed the exchange rate to the weak side of the peg's convertibility range
(Changes in the exchange rate between the Hong Kong and US Dollar during the period from January 2015 to May 2019)
They just don't get it..
Well, the HKD peg is indeed different. Fundamentally, some investors fail to distinguish between the Linked Exchange Rate System (the official name for the HKD peg) run by the Hong Kong Monetary Authority (HKMA), a currency board, and the fixed exchange rate system that some other central banks run.
A currency board links a currency (here the HKD) to an anchor currency (USD in Hong Kong’s case) by law, this being written in the country’s constitution (in Hong Kong, this is the Basic Law which is the constitution of the HK Special Administrative Region).
A currency board does not conduct discretionary monetary policy to accommodate economic shocks, but central banks do. In other words, a currency board must give up monetary autonomy and follow the policy of the anchor-currency country (i.e. Hong Kong's monetary policy is effectively set by the US Federal Reserve through the peg to the US dollar).
The HKMA sticks to its sole objective of sustaining the currency peg, thus steering clear of self-inflicted policy errors that might result in forced devaluation. A normal fixed exchange rate system has none of these characteristics.
As a currency board, the HKD peg is much more robust in withstanding currency attacks than a normal fixed-exchange rate system. Since a currency board must hold anchor-currency reserves at least equal to or exceeding the value of domestic currency it issues (or the monetary base), it always has sufficient reserves to back its obligation to exchange local currency for the anchor currency (and vice versa) on demand at the official exchange rate.
Speculators' ignorance ?
Thus the HKMA always has enough reserves to cover 100% of the HKD issued and to meet any demand for USD. It is required to buy USD at the strong side of the convertibility range (between HKD7.75 and 7.85 per USD) and sell USD at the weak side. These are autopilot transactions under the currency board rules.
So when the HKD weakens, the peg mechanism requires the HKMA to sell USD/buy HKD to keep the exchange rate constant. Contrary to popular belief, this is not an intervention to support the HKD. The HKMA does not trigger the transactions; it only reacts passively under its currency board mandate. As a result selling the HKD against the USD could be considered to be eqivalent to selling the USD against itself - the HKD just being a clone of the USD. The HKMA will not cede in the face of selling pressure but speculators seem to have no clue about this.
Some speculators have argued that Hong Kong is burning through its foreign reserves so quickly that it would soon run out of reserves soon and would have to abandon the peg. This suggests to me that they are confusing the aggregate balance, which has been declining, with the foreign reserves, which have been rising (see Exhibit 2).
The HKMA's reserves have grown from 50% of GDP in the 1998 (Asian crisis) to 70% in 2008 (US subprime crisis) to 117% today.
Exhibit 2: Changes in Hong Kong’s aggregate balance and foreign exchange reserves, January 1999 through April 2019
The aggregate balance refers to the sum of all deposit balances by the banks at the HKMA for settling interbank payments and payments between banks and the HKMA. It is a measure of interbank liquidity and is only one part of HKMA’s monetary base (Exhibit 3).
Exhibit 3: Changes in the size and composition of Hong Kong’s monetary base during the period from January 1999 through May 2019Hong Kong’s monetary base includes: i) notes and coins, these are backed by certificates of indebtedness issued by the Financial Secretary under the Exchange Fund Ordinance and held by the note-issuing banks to cover the bank notes they issue; ii) aggregate balance, and; iii) Exchange Fund bills and notes.
Hong Kong's currency board continues to function as it should
Hong Kong banks have lagged behind the US in raising interest rates since the US Fed started raising rates in late 2015. This process has opened up an interest rate differential between US and Hong Kong short-term interest rates and created arbitrage opportunities, leading to capital outflow from Hong Kong and draining interbank liquidity. Hence, the aggregate balance has declined, not the foreign reserves.
With speculators entering short HKD positions, the capital outflows have pushed the HKD towards the weak side of the convertibility range, triggering the HKMA’s autopilot mechanism of passively selling USD/buying HKD to keep the exchange rate constant. This has, in turn, tightened the local money market, forcing up HIBOR and closing the US-Hong Kong interest rate differential thus restoring market equilibrium. This illustrates a proper working of the currency board but not a burning up of reserves by the HKMA.
Does Hong Kong have sufficient foreign exchange reserves?
At the time of writing, Hong Kong’s USD430 bn foreign reserves are more than twice its monetary base. This means that the HKMA could literally replace every 7.8 HKDs of base money in circulation with one USD twice over.
In the event of a full blown crisis, one could argue that Hong Kong’s broad money supply, M3, could implode if depositors/investors decided to convert all their HKD deposits into USD. The resultant selling pressure would break the peg. But Hong Kong’s buffer seems sufficient to cushion any potential blow to the banking system because its foreign reserves amount to 46% of M3.
Having 46% of broad money converted into USD would be unheard of. Experience shows that in the most severe banking crises, about 10-15% of total bank deposit might flee and trigger a bank run and a currency crisis. Hong Kong’s foreign reserves are easily high enough to deal with a 10-15% deposit loss.
Of course, the robustness of the currency board system has to be backed by economic and political fundamentals. The HKD peg has shown marked differences from the other failed currency pegs. This is another area where the speculators appear to be getting it wrong again.
Where is the twin deficit?
A major economic fault line that can break a currency peg is an underlying twin (fiscal and current account) deficit which convinces currency speculators that a country has been living beyond its means by relying on too much foreign savings and is thus vulnerable to capital flight.
A twin deficit also hurts market confidence by raising the likelihood of massive central bank monetisation to fund the deficit. On this measure, the HKD peg is underpinned by a twin surplus since 2003. It’s a mystery to me why speculators would want to pick a fight with a currency backed by persistent capital inflows.
And there is a strong political will to maintain the peg
Even a currency board cannot survive without strong political support and strict adherence to the currency board rules. Argentina’s currency board (1991-2001) failed in 2002 because its government violated all the currency board rules while trying to maintain a fixed exchange rate. Massive devaluation was the choice of most Asian countries during the 1997-98 Asian crisis; but note that these countries all ran fixed exchange rate regimes, not currency boards.
Back then, the HKD peg was also under severe speculative attack. But it stood like a cliff in the storm because Hong Kong chose to keep the currency peg and let the economy adjust at the price of considerable economic pain, as borne out by a 70% drop in property prices and very significant wage deflation between 1997 and 2003. What was amazing was that not one single commercial bank failed during that period.
Few economies, and central banks, would be willing to accept that sort of deflation. But the highly flexible Hong Kong economy took the painful adjustment in its stride. Rather than a sign of weakness as seen by the speculators, this painful adjustment demonstrates:
- A strong political will by Hong Kong to keep the peg and;
- A highly flexible Hong Kong economy allowing the currency board mechanism to function properly – when the nominal exchange value is fixed, domestic economic and financial variables adjust to absorb the economic shocks.
Hong Kong emerged from the Asian crisis with faster productivity growth than the US. With the US running an unsustainable twin deficit while Hong Kong ran a persistent surplus, and with US productivity consistently lagging that of Hong Kong’s, it is doubtful if de-pegging the HKD would result in a massive devaluation as the speculators seem to expect.
Even today, the HKD peg has strong political backing, which differentiates it from the other currency pegs that failed due to wavering political support.
The US dollar peg continues to shield Hong Kong from political turmoil
- Firstly, Beijing is keen on keeping the HKD peg at least until the renminbi becomes a global currency some time in the future. The increase in volatility in the renminbi exchange rate has already given Beijing enough foreign exchange management challenges as the ''Impossible Trinity' approaches (when Beijing opens its capital account the 'Impossible Trinity' will force Beijing to choose between controlling either interest rates or the exchange rate. Controlling both (which is what Beijing would like) is not possible). Why would Beijing ask for more by abandoning the HKD peg?
- Secondly, the peg has been a stability anchor for Hong Kong. This aligns with Beijing’s interest in maintaining stability. Hong Kong’s real importance to China always lies in its role as a credible financial and legal centre, something China cannot easily build from scratch despite its rapid growth in the past four decades. Readers may recall that some 20 years ago, there was speculation that Shanghai would overtakeHong Kong as a major financial centre. Today, Hong Kong remains Asia’s number one financial centre, number three in the world after New York City and London and ahead of Singapore and Shanghai.
- Thirdly, the majority of the Hong Kong’s local interest groups, to whom the local government is also answerable, do not want to see the peg go. All businesses benefit from zero exchange rate risk under the HKD peg, which allows them to match HKD liabilities with USD revenues.
Long live the peg!
Hong Kong’s small open economy is affected by many international forces, so it has a high growth-volatility tendency. Monetary autonomy can do little to counter external shocks to such an economy.
Thus, anchoring its exchange rate to the currency of a large, flexible and relatively creditable economy remains emminently sensible and practical in preserving confidence and reducing foreign exchange risk.
I have argued for years that the endgame for the HKD is already in sight – it will disappear when the renminbi become a global currency. But it will take many years to get there.
My research leads me to believe that there are no better alternatives to the current monetary regime for Hong Kong – the HKD peg is still the best option for maintaining systemic stability.
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