Some Thoughts on the HKD Peg

The Hong Kong dollar weakened sharply this week, with the US dollar trading at its highest level since late 2011. Yet HKD remains in the strong half of the 7.75-7.85 trading band and below the midpoint peg rate of 7.80. We do not think it is a speculative attack, as some in the press are suggesting. Rather, we think it reflects another leg in capital outflows from the mainland. Either way, we see the peg remaining in place for the foreseeable future. BRIEF HISTORY OF THE PEG

The HKD peg to the USD was put in place in 1983, when prospects for the 1997 handover of Hong Kong from the UK to mainland China disrupted Hong Kong markets. The Sino-British Joint Declaration was signed in December 1984 and set forth the conditions for the turnover of Hong Kong back to mainland rule at the expiry of its 99 year lease. However, the negotiations leading up to it unsettled markets. With HKD freely floating then, it weakened from less than 5 per USD in 1980 to almost 9 per USD in 1983 before the peg was introduced.

Under the initial 1983 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, such as buying Hong Kong stocks as the Hang Seng plunged. Ultimately, the HKMA prevailed then and we would expect the same now if the HKD comes under greater pressure. HKMA foreign reserves stood at a record high $358.8 bln at the end of December.

HOW IT WORKS

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. Under a currency board, countries running balance of payments (BOP) imbalances would see an automatic adjustment under what classical economist David Hume called the “Price-Specie Flow Mechanism.” Hume focused on trade instead of BOP, as capital flows during his time were not as important as they are now. Then, gold was the internationally accepted currency, not the US dollar.

Under Hume’s framework, countries running trade deficits would see gold flow out, causing the domestic money supply to shrink. This would slow economic activity until the trade balance is in equilibrium (largely through recession and less imports). Conversely, surplus countries would see gold inflows, expanding money supply, and faster growth until the trade balance is in equilibrium. In today’s world, the HKMA sees inflows and outflows of USD (not gold) that would lead to changes in the money supply, interest rates, and economic activity that would ultimately lead to equilibrium.

It’s worth noting that when the HKD peg was introduced, Hong Kong lost the ability to run monetary policy that was independent of the Federal Reserve. Instead, the HKMA adjusts its Base Rate in lockstep with the Fed funds rate targeted by 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 been kept at 5%, despite the Fed’s 25 bp hike in December that led to a similar increase in the Bank Rate to 0.75%. There was also a period back in 2006 when the base rate rose from 6.0% to 6.75% while Prime Lending rates were kept at 8% due to excessive liquidity in the Hong Kong financial system.

PEG OUTLOOK

The main rationale for shifting the peg is that the Hong Kong economy is not as closely tied to the US as it once was. Instead, economic ties with mainland China have deepened even as Hong Kong became a Special Administrative Region (SAR). Now that Hong Kong is part of mainland China, the argument goes that Hong Kong monetary policy should not be tied to the Fed, but rather to the People’s Bank of China.

What this argument for delinking from the US dollar ignores, however, is the fact that the Chinese yuan is not yet freely convertible. While China has certainly stepped up its efforts at liberalizing China’s financial system, the yuan cannot play the same role as the US dollar yet. The mainland banking system, for instance, is underdeveloped and ill-equipped to take on full convertibility at this juncture. As one of the premier financial centers in the world, we believe it is virtually impossible for Hong Kong to peg its dollar to a non-convertible currency such as CNY.

However, we continue to believe that it is realistic scenario to expect a repegging of the HKD to the Chinese yuan at some time in the future (perhaps in 10+ years?). The “One Country, Two Systems” arrangement agreed to in Hong Kong’s 1997 handover is supposed to hold for 50 years, but this can only be regarded as a transitional arrangement that can be adjusted as needed. It seems that if conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China), then the Chinese authorities are likely to eventually link or perhaps even unify the Hong Kong dollar with the yuan.

Again, 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. And as we saw during the various financial crises in recent decades, Chinese policymakers usually do not make policy shifts during periods of market turmoil. To repeat, we see no changes to the HKD peg during this current period of instability.

CONCLUSIONS

We can’t put it any better than the IMF did in its annual Article IV consultation from November: “The Linked Exchange Rate System (LERS) remains the best arrangement for Hong Kong SAR and serves as an anchor of stability for this small open economy with a globally integrated financial services industry. The smooth functioning of the LERS derives from the robust institutional, legal and policy framework in place in Hong Kong SAR; the ample fiscal reserves available to cushion the economy from adverse shocks; the healthy financial system that can accommodate large portfolio adjustments; and, more generally, flexible asset, goods, and labor markets that can adjust quickly to ensure misalignments in the real effective exchange rate (REER) do not persist.”