Insight - Don’t fret for Hong Kong’s dollar peg just yet

Yet if there is one aspect of this special administrative region of China that looks unlikely to change anytime soon, it is the currency peg to the dollar.

HONG KONG has undergone wrenching changes that were all but unimaginable little more than two years ago.

The remaking of the city in the wake of pro-democracy protests in 2019 has touched upon areas such as freedom of speech and the legal system that are pillars of its standing as an international financial centre.

Yet if there is one aspect of this special administrative region of China that looks unlikely to change anytime soon, it is the currency peg to the dollar.

Tougher times may be coming, it’s true. The Hong Kong dollar has slid toward the weak end of its trading band against the United States currency for the first time in more than three years. The economic cycles of the territory and the US are out of alignment.

The Federal Reserve (Fed) is contemplating aggressive interest rate increases to choke off inflation that reached 8.5% in March.

Meanwhile, China’s economy is going through perhaps its most difficult period in three decades, battered by renewed Covid outbreaks, a collapsing property market and investor outflows driven by President Xi Jinping’s interventions in the private sector and support for Russia. The yuan has weakened sharply.

This mismatch, though, has always been the price of operating a currency board. The economy using such a system essentially gives up control of monetary policy, importing the interest rate decisions of its counterpart.

With a Covid-weakened business environment and inflation of less than 2%, Hong Kong needs higher borrowing costs like a hole in the head. But it has no choice.

Arbitrage relationships limit the extent to which local rates can diverge from those in the US. If the city’s rates are too low, traders can borrow Hong Kong dollars and use them to buy the greenback, making a risk-free profit. This activity will cause Hong Kong’s monetary base to shrink and local interest rates to rise, bringing the system back into balance. It’s an automatic mechanism.

The tradeoff for this anchor of currency stability is that domestic asset prices must adjust where the Hong Kong dollar cannot.

At times when, if allowed to move freely, the currency would tend to appreciate, the monetary base will expand, interest rates will fall and there will be pressure for prices to rise.

Now, the bias is downward, so that’s negative for property values, which have already been sliding. It’s a mistake to conclude that this prospect means the peg’s future is in question. The system is just doing what it is designed to do.

In fact, there’s almost zero sign of stress so far. The one-month Hong Kong interbank offered rate is at a negligible 0.2% and the Hong Kong Monetary Authority’s (HKMA) aggregate balance, another key measure of liquidity, is still heavily positive.

Bank deposits have seen no significant outflows, according to HKMA data as of March. A tight trading band of 7.75 to 7.85 to the dollar gives the monetary authority a measure of wiggle room, though this hardly amounts to a discretionary monetary policy.

How great could the pressure get? The HKMA’s base rate may have to rise to at least 3%, from 0.75% currently, if the Fed raises borrowing costs to the market’s expected range of 2.5% to 2.75% by year-end, Stephen Chiu, Bloomberg Intelligence chief Asia foreign exchange and rates strategist, wrote in a note. Chiu doesn’t see that as a problem for the Hong Kong dollar.

Fiscal and institutional credibility are central to the successful maintenance of a currency board. Hong Kong has this in spades, with HK$1 trillion (US$127bil or RM553bil) of fiscal reserves and no external debt.

Investors need to be convinced that a government has both the economic strength and the political will to take the pain of the down cycles; otherwise demise can turn into a self-fulfilling prophecy, as shown in Argentina in 2001.

Again, anyone tempted to forecast an end to Hong Kong’s peg should consider first what the city has sacrificed to establish that trust.

The peg withstood speculative attacks during the 1997-98 Asian financial crisis. The one-month Hong Kong inter-bank offered rate rose to more than 20%, property prices plunged and the stock market fell by more than half.

What followed was more than five years of grinding deflation, during which unemployment rose to a record high and the peak-to-trough slump in home prices reached close to 70%. It’s hard to imagine that any Hong Kong administration would give up such hard-won credibility easily.

China’s political and economic interests are also served by keeping the existing system. But having the city as a gateway and funding channel into the dollar world, as well as an incubator for innovations such as development of an offshore yuan market, is still very much still to Beijing’s advantage.

Nothing lasts forever. The Hong Kong dollar peg may one day be declared a colonial relic that is surplus to requirements. That won’t be for quite a while yet. — Bloomberg Matthew Brooker is a Bloomberg Opinion columnist. The views expressed here are the writer’s own.