Should HK de-peg?

THE question of whether Hong Kong (HK) should de-peg its currency against the US dollar (USD) has been a subject of debate for a long time. The recent dollar weakness and intervention by the HK Monetary Authority (HKMA) to maintain the peg suggest that it is time for HK to de-peg.

The HK$7.80 peg and within a tight band of between 7.75 and 7.85 to the dollar was established in 1983 under a linked exchange rate system. Nevertheless, the HKMA does not actively intervene in the foreign exchange market to maintain the peg.

When demand for Hong Kong dollars (HKD) is greater than supply, the HKMA sells the currency to banks for US dollars. This will expand the aggregate balance (a component of the monetary base) and lower HKD interest rates, creating room for the currency to move away from the lower limit of the band.

However, if supply is greater than demand and the HKD exchange rate has weakened towards the upper limit, the HKMA will purchase HKD from banks. The aggregate balance will then contract to drive HKD interest rates up, pushing the currency away from the upper limit to stay within the 7.75 to 7.85 range.

No autonomy

Due to the linked exchange rate system, HKMA mirrors the US Federal Reserve’s (Fed) move when it comes to interest rates.

Any rates hike is mirrored by the HKMA, irrespective of HK’s economic conditions or inflation environment.

Hence, while the current Fed Fund Rate is set at between 4.25% and 4.50%, the HKMA has set interest rates at 4.75%. The HKMA adjusts its interest rates on the next market day after the Fed does so.

With interest rates linked to the United States, the level of inflationary pressure in the HK economy is immaterial, and hence, HKMA seems to have no autonomy in deciding the cost of funds in the economy, even if inflation is surprisingly low.

For example, based on the current inflation rate of just 1.4%, the current prime lending rate is at 5.5%. However, due to ample liquidity in the system, HK commercial banks typically offer lending rates based on HK Interbank Offer Rate (Hibor) or based on Prime Lending Rate and adjusted accordingly. The Hibor tends to be a better indicator of actual funding cost and not the benchmark interest rates.

Under attack

Since the dollar peg, the HKD has come under attack numerous times, but HKMA has always been able to defend the peg.

The obvious attack was during the 1997 Asian Financial Crisis (AFC), whereby currency speculators moved to sell the HKD heavily after the attack on other Asian currencies, including the Thai baht and our ringgit.

The HK government then used all its might to defend the currency, as well as intensify selling pressure on companies listed on the HK Stock Exchange, because the market too came under pressure as foreign investors shorted both individual stocks and the Hang Seng Index.

The HKD also came under pressure during other major crises, including the severe acute respiratory syndrome in 2003, the Global Financial Crisis of 2008, Covid-19 in 2020, and as recently as early this month when the greenback started to weaken against other Asian currencies.

Rock solid

HK has strong foreign currency reserves of US$408.7bil as at the end of last month and can withstand currency attacks from all fronts. Early this month, the HKD was again under pressure as it hit the lower band of its peg, and the HKMA had no choice but to intervene, selling the HKD to the market and limiting its appreciation against the greenback. It was reported that HKMA spent some US$7.8bil to intervene in the market.

Trouble from US tariffs

It seems certain the United States will maintain at least a 10% reciprocal tariff rate on the rest of the world, while others may be subjected to even a higher rate, especially China.

This will sustain the price pressure for goods sold to the United States while inflation expectations also rise and remain elevated.

Nevertheless, the market believes that the Fed will cut rates twice this year, followed by another two times next year. However, the rate cut expectations are driven by a slowing economy and not elevated inflation in the months or over the next year or so.

Hence, while HKMA will mirror any move by the Fed, it is time to decouple from the Fed by free-floating the HKD or re-pegging it with another currency.

Should the Fed raise rates due to the elevated inflation pressure from tariffs, HKMA would have no choice but to up its benchmark rate as well to maintain its currency peg.

This could be detrimental to both borrowers and the economy and may again push HK to de-peg. Should HK decide to de-peg, it will gain monetary policy autonomy, which is a tool any central bank should always have and not be subject to another central bank’s move on interest rates.

Managed float

HK has two options when it comes to de-pegging its currency against the US dollar. One is to re-peg against the yuan based on a fixed rate of one HKD to 1.1 yuan or based on the current exchange rate at 1.08 uuan per HKD with a tolerable allowance of between 1.05 and 1.15 yuan.

A peg against the yuan will be a big win for China, as both China and HK may enjoy some form of monetary union.

Although not fully convertible, the yuan is an excellent choice for HK given the economic and political closeness with mainland China. A HKD-yuan peg could also lead to greater convertibility of the yuan and a baby step towards making the yuan a potentially stronger candidate as the reserve currency of the world.

Another alternative for HK is to maintain a managed float system, similar to Singapore. The movement of the HKD will then be dependent on a trade-weighted basket and allowed to fluctuate within a certain band and slope.

This will allow HKMA to control the exchange rate while interest rates in the economy would then be determined by expectations on the value of the HKD as well as the interest rate spread between HK and the rest of the world.