Hong Kong’s US dollar peg could be a weak link if protests drag on, China scholar warns

Karen Yeung

The 36-year-old peg between the Hong Kong and US dollars, a major pillar of financial investor confidence in the city, could turn into a weak link if financial markets were to turn sour, causing a “double hit” to the city’s economy, a Chinese scholar has warned.

Hong Kong’s unique linked exchange rate regime has helped the city maintain economic prosperity over the past decades, said Zhou Luohua, vice-president of the Chongyang Finance Research Institute at the Renmin University of China.

But, he said, the system is now too rigid, becoming the “Achilles’ heel” of the Hong Kong economy, making the city extremely vulnerable to large declines in its stock market or property prices.

“If property and stock prices start to fall, the Hong Kong Monetary Authority can’t provide sufficient liquidity like the [US] Federal Reserve or other central banks as its money supply capacity is determined by the size of its US dollar reserves,” Zhou said in a statement on the Chongyang Finance Research Institute website. “If asset prices are plunging, it would trigger an exodus of funds at the same time, translating into a ‘double hit’ for the Hong Kong economy.”

Zhou’s warning was the latest questioning the sustainability of the peg, which has kept the exchange rate at 7.8 per US dollar since 1983, although the Hong Kong Monetary Authority (HKMA) has repeatedly defied speculation that it has any plan to change it. The exchange rate is now allowed to move within a trading band of between 7.7500 and 7.8500.

The Hong Kong dollar peg system has sustained the economy during a number of major economic crises including the Asian financial crisis and severe acute respiratory syndrome epidemic in 2003. It also remained intact even with the change in the city’s sovereignty from Britain to China in 1997.

When the exchange rate breaches either the upper or lower limits of the trading band, the city’s de facto central bank, the HKMA, is mandated to either buy or sell the local currency to bring the exchange rate back within the limit.

Having intervened in the foreign exchange market several times in the past year, and given that it is still sitting on foreign exchange reserves of US$449 billion which can cover the monetary base around two times over, the HKMA is unlikely to abandon the currency peg, analysts said.

The peg to the US dollar is the cornerstone of Hong Kong as an international financial centre. Despite there being repeated discussions, the mainstream view is that the city still needs such a regime

Liang Haiming

“The peg to the US dollar is the cornerstone of Hong Kong as an international financial centre. Despite there being repeated discussions, the mainstream view is that the city still needs such a regime,” said Liang Haiming, president of Silk Road Valley Research Institute.

But worries are emerging that, given the deteriorating global economic environment, the HKMA will be forced to use up most of its firepower in the period ahead to defend the city’s unique currency arrangement, leaving Hong Kong’s economy vulnerable, analysts said.

The chance of a sharp deterioration in the business environment accompanied by massive capital flight has risen, which could precipitate a severe correction in the property market and threaten to undermine the city’s financial stability, they said.

There is a clear risk that the HKMA could be called upon to actively defend the Hong Kong dollar through sustained intervention in the currency markets, resulting in a negative net economic impact on the city, analysts said. For much of the year, the Hong Kong dollar has been pressed down against the 7.85 weak end of the trading band.

Alicia Garcia-Herrero, chief economist at Natixis Bank, said the city’s lack of capital controls implies that capital flows can be very volatile. Bank deposits in Hong Kong are massive, at US$1.7 trillion, equivalent to 469 per cent of gross domestic product (GDP), meaning foreign exchange reserves might not be sufficient if they need to cover the monetary base in a situation of large deposit withdrawals.

Indeed, Hong Kong is on the verge of its first recession in a decade, with anti-government protests affecting tourism and biting into retail sales. The government last week downgraded its GDP growth forecast for 2019 from 2 to 3 per cent to 0 to 1 per cent, which would be weakest economic position since 2009.

In addition, China’s trade war with the United States continues to unleash damage, with US President Donald Trump now tying the largely stalled trade talks with a “humane” resolution of Hong Kong’s deepening political crisis.

“If the US could remove recognition of Hong Kong’s special status, Hong Kong would no longer be able to trade freely with the US. And how does the [Hong Kong dollar] peg to [the US dollar] hold if there is no way for the city to earn [US dollars]?,” said Michael Every, senior Asia-Pacific strategist at Rabobank.

Natixis’ Garcia-Herrero said the stability of the current Hong Kong dollar regime has helped the city develop into an international financial centre, which has become an important “financial firewall” for mainland China.

How does the [Hong Kong dollar] peg to [the US dollar] hold if there is no way for the city to earn [US dollars]?

Alicia Garcia-Herrero

The city’s economic foundations are based on free capital movement, while mainland China still maintains a relatively closed capital account, she noted.

Hong Kong’s financial sector can insulate China from the negative consequences of global economic and financial turmoil so that Beijing can limit access to mainland financial markets or make access to global assets for Chinese citizens difficult.

But this becomes a problem for Hong Kong if it experiences capital outflows as a consequence of recent events, Garcia-Herrero warned. While shocks to the economy are likely to come from mainland China, Hong Kong cannot count on any exchange rate or monetary policy help from China due to its dependence of and linkages to US Federal Reserve monetary policy.

“There is no doubt that the current [Hong Kong dollar] regime has helped Hong Kong build a massive offshore financial centre, but it does not offer any respite if a negative shock affects the economy, which is exactly where we are today,” Garcia-Herrero said.

“Beyond Hong Kong’s financial institutions, those who will be the most affected by the arising risks are the mainland Chinese banks in town.”

Henry Chan Chi-sheung from Caitong International Securities said that Hong Kong’s debt and property prices have risen to very high levels, meaning any sharp decline could cause much more economic harm than it did during previous downturns. A decline in corporate earnings would have knock-on effects on property demand and banks’ non-performing loans, especially when private sector credit stands at 300 per cent of GDP, he said.

“This Hong Kong dollar peg regime is ‘no good’ at all, especially if the Hong Kong protests accelerate the declines in Hong Kong corporate earnings and the economy,” Chan said.

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