What the Hong Kong dollar peg is and why it matters

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Pegged to the US dollar since 1983, the Hong Kong dollar is typically a boring currency. Except when it’s not like this year. As the US Federal Reserve began raising interest rates in March to combat historically high inflation, outflows from the Hong Kong dollar market intensified as investors chased higher yields. Consequently, interbank liquidity – the pool of Hong Kong dollars in the system – dwindled rapidly as the city struggled to maintain the peg, drawing market attention and concerns about the impact on the struggling local economy.

The Hong Kong Monetary Authority, the de facto central bank, has a mandate to keep forex trading at HK$7.75 to HK$7.85 per US dollar. The current band was discontinued in 2005 and has never been broken. When it gets too close to one end or the other, the HKMA steps in by either buying or selling the city’s dollars. When HKMA uses its foreign exchange reserves to buy Hong Kong dollars from commercial banks, the overall balance of Hong Kong dollars in the banking system – interbank liquidity – decreases accordingly. From May 11 to the end of July, the HKMA bought a total of HK$172 billion ($22 billion), shrinking by more than half. This tighter liquidity is driving up local borrowing costs.

2. Why is it important to keep the bracket?

First and foremost, it is considered an anchor for financial stability. A stable currency is important for an open economy like Hong Kong, where trade and logistics are important drivers. Investors park their money in Hong Kong because the currency is relatively safe and easily convertible – one of the reasons the city became a global financial center in the first place. Breaking the parenthesis would mess up this whole equation.

3. What usually moves the Hong Kong dollar?

It’s often because local borrowing costs aren’t moving in line with the US. For example, the gap between the Hong Kong Interbank Offered Rate (Hibor) and its US counterpart (dollar Libor) widened significantly after the Fed began aggressive rate hikes as liquidity in Hong Kong was still very plentiful. (Hibor and Libor represent a daily average of what banks say they would charge to lend to each other.) This gap makes it attractive for traders to borrow in Hong Kong dollars to buy US dollars to get the higher return. This so-called carry trade can push the local currency towards its weak end of HK$7.85, prompting the HKMA to intervene.

4. What is the concern now?

Less liquidity as a result of defending the peg has resulted in increased borrowing costs for Hong Kong businesses and individuals this year, at a time when tight Covid-19 restrictions, particularly on travel, continue to weigh on the economy and hurt employment . Additionally, Hong Kong’s real estate sector is already under pressure from an exodus of Hong Kong residents, whether for pandemic or political reasons, after Beijing tightened its grip on the city in 2020. Higher mortgage costs won’t help.

5. Should people worry about the pen?

Officials in Hong Kong say no. Finance Minister Paul Chan said in July that the city’s “huge” foreign exchange reserves — about $440 billion, about 1.7 times the monetary base of the Hong Kong dollar — would be enough to maintain the currency peg. Sustained periods of outflows have already existed during previous stresses such as the global financial crisis, the SARS epidemic, and during the US-China tensions under then-President Donald Trump. At the time, Chan noted that China’s central bank can also provide US dollars through a currency swap line if Washington ever imposes sanctions on the city. China has the world’s largest foreign exchange reserves, at over $3 trillion. John Greenwood, the architect of the Hong Kong dollar peg and now an independent advisor at the International Monetary Monitor, said because the city has a currency board charged solely with maintaining the peg, rather than a central bank that conducts domestic monetary policy, “speculation contrary to the Hong Kong dollar always fails.”

6. Why not peg the Hong Kong dollar to the Chinese yuan instead?

There are several factors that support the status quo. The US Dollar is fully convertible and freely traded in bulk in the foreign exchange markets. The yuan does not fit into this calculation for the time being. The US dollar also dominates as an international reserve currency, while the yuan still has some way to go to strengthen its reserve status. Hong Kong’s de facto central bank governor Eddie Yue said the peg has worked well for nearly 40 years and there are no plans to change it. However, Hong Kong has tended over the years to adopt currency arrangements that facilitate cross-border trade with the mainland. Pegging the local dollar to the yuan “could be a long-term possibility” — if the yuan were used more widely in Hong Kong and internationally, economists at Goldman Sachs Group, including Hui Shan and Andrew Tilton, wrote in May. Politics could be another driver if Hong Kong were to lose its semi-autonomous status and be integrated into the mainland. As George Magnus, an economist and fellow at Oxford University’s China Center put it, “It is China’s choice whether to maintain the peg.”

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