The Hong Kong dollar has steadily weakened this year. Yet there is no threat at all to the peg, which we see being maintained for the foreseeable future.
On July 1, China and Hong Kong commemorated the 20th anniversary of the handover from the UK. It came at a time when Hong Kong is pushing for greater autonomy even as the mainland tries to exert greater control. In President Xi’s anniversary speech, he warned that any threat to China’s central government rule was “absolutely impermissible.”
Tensions with the mainland remain high. Even after quashing the Occupy (or Umbrella) protests in 2014, the mainland is still struggling with the so-called “radicalists” or “localists” that want greater autonomy for Hong Kong, if not outright independence. Two Hong Kong men were just sentenced to three years in prison for their role in the February 2016 so-called “fishball” protests.
In the September 2016 elections for the 70-seat Legislative Council (Legco), pro-Beijing seats fell to 40 from 43 in 2012. Traditional pro-democracy seats also fell, to 23 from 27 in 2012. Filling these 7 lost seats were the so-called “radicalists.” However, 6 of those 7 have since been ejected from the Legislative Council for promoting separatism.
Whatever happens, the opposition remains basically toothless. Yet we expect sporadic protests to continue regarding the signature issues of greater democracy and self-determination for Hong Kong.
Hong Kong still enjoys a reputation for being very pro-business. It always scores very well in the World Bank’s Ease of Doing Business rankings (4 out of 190 and up from 5 in 2016). Hong Kong does slightly less well in Transparency International’s Corruption Perceptions Index (15 out of 176 and tied with Belgium).
The economy is picking up, helped by an improving mainland outlook. GDP growth is forecast by the IMF to accelerate to 2.4% in 2017 and 2.5% in 2018 from 2.0% in 2016. GDP rose 4.3% y/y in Q1, the strongest since Q2 2011. Monthly data for Q2 suggest continued strength, while 2016 provides a low base effect. As such, we see some upside risks to the growth forecasts.
Price pressures have stabilized, with CPI rising 1.9% y/y in June. This is down from the 4.3% y/y peak back in August 2016. The Hong Kong Monetary Authority (HKMA) does not have an explicit inflation target nor does it run an independent monetary policy due to the HKD peg to USD. Indeed, it has raised the base rate four times since December 2015, in lockstep with the Fed.
However, Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Bank Rate. Indeed, the Prime rate has still been kept at 5% despite the 100 bp of Fed tightening seen since December 2015. Loans and advances are rebounding, up 14.9% y/y in June. This is the cycle high and still accelerating. M3 growth also accelerated to a cycle high 13% y/y in March. Macro-prudential measures have been used to contain potential risks from the property boom.
Fiscal policy has remained prudent. Indeed, accumulated budget surpluses will likely boost the Fiscal Reserves to an estimated HKD952 bln ($122.5 bln) by March 2018. This is enough to cover over two years of expenditures. The budget surplus came in at an estimated 3.3% of GDP in 2016, up from about 2% in 2015. Bloomberg consensus expects the surplus to fall back to 1.4% in 2017 and 1.0% in 2018.
The external accounts remain in solid shape. Hong Kong has run a current account surplus since 1998. The IMF expects that surplus to come in around 3% of GDP in both 2017 and 2018. Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP. HKMA foreign reserves stood at a record high $413.3 bln at the end of July. Clearly, Hong Kong has very low external vulnerability across virtually all metrics.
HKD PEG OUTLOOK
We can’t put it any better than the IMF did in its annual Article IV consultation from January: “The Linked Exchange Rate System (LERS) remains the best arrangement for Hong Kong SAR, backed by the credibility built up over three decades and tested through crises. The LERS is underpinned by the flexible economy, ample reserves buffers, and strong financial regulation and supervision. Wage and price flexibility allows the economy to adapt quickly to cyclical conditions and structural change. The external position is broadly in line with medium-term fundamentals and desirable policies.”
The HKD peg to the USD was put in place in October 1983. The negotiations for the 1997 handover from the UK unsettled markets. With HKD freely floating then, it weakened from less than 5 per USD in 1980 to almost 9 per USD in September 1983 before the peg was introduced.
Under the initial peg arrangement, HKD could not trade on the weak side (above) the 7.8 peg rate, but could appreciate without limit to the strong side (below 7.8). A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate that prevented appreciation beyond 7.75. The Hong Kong Monetary Authority (HKMA) is obliged to buy and sell USD to prevent the HKD from breaching either side of the band.
Since the peg was put in place, it has really been tested only once, during the Asian Crisis that started in 1997. Interbank rates soared in 1998, as foreign reserves fell and the domestic money supply shrank. The HKMA also took some unorthodox steps then, such as buying Hong Kong stocks as the Hang Seng plunged. Ultimately, the HKMA prevailed then and we would expect similar success if the HKD were to come under greater pressure now.
The HKMA runs a strict currency board. In essence, this means that every HKD in circulation is backed by an equivalent amount (at the official exchange rate) of USD. When run correctly, such a peg cannot be broken. Argentina’s peg was broken because it violated several of the basic tenets of a currency board, including central bank financing of the budget deficit.
We continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future (perhaps in 10+ years?). It seems that if conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan.
This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware. China authorities will manage market expectations in order to minimize potential turmoil and disruptions from such a game-changing move. For now, we see no change to the HKD peg.
USD/HKD traded today at its highest level since January 2016. It appears to be on track to rest the January 2016 high near 7.83, which also happens to be the high from August 2007. As local interest rates spiked then, the pair quickly moved back below the 7.8 area. This would likely happen again if pressures on HKD intensify.
Hong Kong equities have done better after a poor 2016. In 2016, MSCI Hong Kong was -2% vs. +7% for MSCI EM. So far this year, MSCI Hong Kong is up 27% YTD and compares to up 25% YTD for MSCI EM. This outperformance should continue, as our EM Equity model has Hong Kong at a VERY OVERWEIGHT position.
Hong Kong bonds have outperformed. The yield on 10-year local currency government bonds is about -44 bp YTD. This compares favorably to the best performers Brazil (-191 bp), Indonesia (-107 bp), Peru (-90 bp), Turkey (-65 bp), and Russia (-66 bp bp). Inflation is likely to remain under control, but the HKMA will follow the Fed in tightening. As such, we think Hong Kong bonds could start underperforming.
Our latest sovereign ratings model update had Hong Kong’s implied rating rising a notch to AA/Aa2/AA. Moody’s one-notch downgrade in May brings it into line with our model now. However, S&P’s AAA and Fitch’s AA+ are more optimistic.