If there’s one city in the world that has reason to welcome the latest wave of global monetary turmoil, it’s Hong Kong. With Britain dumping the pound, Japan intervening to support the yen for the first time in almost a quarter-century and Europe’s single currency hitting a two-decade low, less attention is being paid to China’s territory’s 39-year-old dollar peg.
And that’s certainly what the technocrats at the Hong Kong Monetary Authority want.
Let’s be clear: the bracket isn’t going anywhere, at least in the short term. But it’s been a favorite speculative target for hedge fund traders from George Soros to Bill Ackman to Crispin Odey in the past, so the current calm is notable. Aside from some low-level chatter, there was no sign of a high-profile name marquee bet or a building wave of downward movement versus the linked exchange rate mechanism.
Implied volatility in Hong Kong-US dollar options – a measure of how costly it is to bet against the peg using these derivatives – has risen somewhat this year but remains below pre-pandemic levels in 2019 and 2016.
That’s a little surprising, given that the terms of the bond appear potentially less favorable than at any point since the 1997-1998 Asian crisis. After a long period following the global financial crisis of 2008, in which Hong Kong benefited from near-zero US interest rates, the cycle has turned decisively. Economic pain is already here. It looks almost certain that more are on the way.
Any economy that pegs the value of its currency to the value of another country is effectively outsourcing its monetary policy. In exchange for the anchor of currency stability, the peg operator relinquishes control of domestic interest rates and the money supply, and tracks its central bank’s policy decisions. In the case of dollar pegs, this is the Federal Reserve (the Saudi riyal and the United Arab Emirates dirham, among other currencies, are pegged to the US unit). For a small, open trade economy and financial center like Hong Kong, this rule can make a lot of sense. However, it comes at a price.
Unless economic cycles are perfectly aligned, there is always a risk of importing policies that are either too loose or too restrictive. For example, if the US is growing strongly and Hong Kong is in recession, interest rates are likely to be higher than the city would like; and vice versa if the Fed cuts rates to stimulate the economy while Hong Kong is already expanding rapidly.
If it’s too loose, things (all others being equal) will tend to run hot and asset prices will rise. The downside is less fun. If policies are too restrictive, funds will flow out and asset prices will fall. This is where Hong Kong is now. The city’s foreign exchange reserves are down 13.6% since last November (although still sufficient to support the monetary base), house prices are down after a long boom and the benchmark Hang Seng stock index is down at an 11-year low.
The system is extremely pro-cyclical, withdrawing liquidity exactly when it’s needed and adding it when things are already frothy. In fact, the volatility that is normally absorbed by a floating exchange rate is instead transmitted to the domestic economy. Since the value of the currency cannot change, real estate and stock prices have to adjust instead.
The best way to see how out of control Hong Kong is compared to the US is to look at relative inflation rates. The chart below uses moving averages to smooth out the peaks and valleys. Nevertheless, it is immediately clear how radically the USA has moved apart:
Hong Kong hardly needs higher rates, but it has no choice but to pursue Fed tightening if it wants to maintain the peg. Meanwhile, the territory’s economy has contracted over the past two quarters; Covid-19 restrictions have devastated local businesses; Home prices have fallen for 11 straight weeks; and a record exodus of residents left the city in the 12 months to June amid political changes imposed by the Communist Party. In addition, China’s economy is also struggling and the yuan is the weakest since 2008, increasing depreciation pressures.
Even the Fed is far from finished. Back in July, futures markets were expecting the fed funds rate to peak at 3.3% and fall by mid-2023. After a shocking August inflation report, they are now forecasting a top of almost 4.5%. If US inflation continues to disappoint on the upside, Hong Kong’s pain will intensify. Hong Kong’s one-month interbank rate, at which many mortgages are priced, has risen 2.4 percentage points since late May. Judging by its Libor equivalent, it seems certain that it will head higher.
So why not just throw the hook away? There are several reasons. Because the yuan is not fully convertible, it is not a viable alternative. While China is trying to tie the former British colony closer to the mainland, having Hong Kong as an offshore fundraising center still serves the country’s economic interests. Above all, there’s hard-won institutional and market credibility — especially during and after the Asian financial crisis, when the region endured five years of deflation and a nearly 70% drop in property prices while holding the currency line. The city will not give up this reputation anytime soon.
Hong Kong dollar bears have long ignored these arguments. But why take on a tough and smart opponent like the HKMA when UK Government ministers are so accommodating? Speculators will no doubt return at some point when the easier loot has dried up. Meanwhile, Hong Kong’s chief financial officers can raise a toast to Liz Truss and Kwasi Kwarteng.
More from the Bloomberg Opinion:
Kyle Bass takes on a widowmaker currency trade: Mark Gilbert
Don’t fret over Hong Kong’s dollar peg just yet: Matthew Brooker
Hong Kong dollar peg has become unsustainable: Richard Cookson
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Matthew Brooker is a Bloomberg Opinion columnist covering finance and politics in Asia. A former editor and bureau chief of Bloomberg News and deputy business editor of the South China Morning Post, he is a CFA charterholder.
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