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2020 Observations to Hong Kong Dollar Exchange Rate System

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2020 Observations to Hong Kong Dollar Exchange Rate System 2020 Observations to Hong Kong Dollar Exchange Rate System 2020.7.20 Stone Tan Financial Chief Economist: Dr. Kuo Yuseng Analyst: Chang Hua Chia Disclaimer • This document is for general reference only and should not be used as a basis for entering into a particular transaction. You should not rely on the data and opinions in this document, nor should the information presented here be used to replace any of your decisions or seeking independent professional advice (be it in finance, law, accounting or tax or other advice). • Although the information and opinions provided in this document may be considered as taken from/derived from published/unpublished sources deemed reliable, and all reasonable and prudent measures have been taken in preparing this document, there is no expressed or implied statement or guarantee to the accuracy or completeness of the information hereof, and will not assume any responsibility for any incorrect information, errors or omissions. The opinions expressed can be changed at any time without notice. • The information in this document is only for specific recipients to circulate, and is not a recommendation or investment opinion to the recipient of this document. This document does not consider particular investment objectives, financial situations, and/or special needs of any individual recipient ("Specific requirements") Hypotheses of this Qualitative Research This research assumes that after observing certain signs, the HK government and Hong Kong Monetary Authority decides to delink proactively, instead of being pressured into decoupling (contrary to the current market talk, which is mostly that HKMA will be forced to defend the linked exchange rate system) • This research does not deep-dive or discuss the rationality, necessity, and/or possibility for proactive decoupling, but is based on the premise that although US dollar remains the reserve currency for the short term, significant changes in the international financial environment have risen, and the benefits of active decoupling are greater than not decoupling • This research presents the conclusion first, and shows the logic deduction process also graphs in attachments Agenda • Executive Summary • Analyses of Timing and Conditions Hong Kong Actively Decouples the Currency • Attachment 1: Hong Kong Exchange Rate • Attachment 2: Hong Kong Interest Rate • Attachment 3: Hong Kong Economy • Attachment 4: Will Hong Kong Decouple or Not • Attachment 5: Optioins after Hong Kong Decouples Executive Summary Given recent political, social, and economic changes, the international community and financial market are bound to hold discussions and form opinions about the HK dollar regime, which has been linked to the U.S. dollar since 1983. • This report feels that under non-extreme conditions, the HKSAR and the HKMA have absolute capabilities and willingness to keep the current LERS; supports from the Chinese government and the People’s Bank of China will further strengthen market confidence. Hong Kong's status as a financial center is unlikely to change in the near future. Odds that a raft of pressure to decouple are not high, as extraordinary circumstances will decline the role of US dollar as the reserve currency • This report assumes that under certain hypotheses and premises, after the HKSAR carefully weighed all interests and determined that time is right, should proactively look into the possibility and feasibility of actively reforming the LERS, as well as to initiate inspections and observation points to facilitate follow-up market analyses. • Hypothesis 1) Financial market volatility caused by a sharp depreciation of the US dollar; 2) Rapid outflow of foreign currency deposits from Hong Kong’s banking system; 3) The central government's perception of Hong Kong as a financial center has fundamentally changed; 4) United States applied extreme measures sanctioning Hong Kong’s financial sector; 5) Rising USD/HKD trading pressure. In the event the above hypothetical scenarios occur, advantages of changing or limiting the linked exchange rate policy will be greater than the disadvantages. Hong Kong should proactively make modifications to respond to changes in the international finance environment. Agenda • Executive Summary • Analyses of Timing and Conditions Hong Kong Actively Decouples the Currency • Attachment 1: Hong Kong Exchange Rate • Attachment 2: Hong Kong Interest Rate • Attachment 3: Hong Kong Economy • Attachment 4: Will Hong Kong Decouple or Not • Attachment 5: Optioins after Hong Kong Decouples What conditions Hong Kong dollar will actively decouple? • Given the rapid increases in government debts, double deficits, unlimited easing by the Federal Reserve, and substantial expansion of the Fed’s balance sheet, US dollar has depreciated in value sharply. Hong Kong to maintain the linked exchange rate will lead to inflation and assets to bubble, which in turn will bring turmoil to the local society and impair social stability - observation points — US dollar index, Fed policy, 10-year treasury bond rate, and US dollar capital outflow • Liquidity problem with US dollar in the Hong Kong banking system: Hong Kong (Mainland) has a significantly different economic cycle from the US dollar-denominated world. Huge amounts of capital flow into the HK dollar system driven by higher returns and lower risks. Observation point — the quantity and frequency HKMA buys when the currency is strong • A rapid loss of Hong Kong's US dollar position - institutions and individuals transfer foreign currency deposits to other countries— observation points —foreign deposit figures in Hong Kong banks, and policies governing remittances • For China, Hong Kong’s status as an international financial center is no longer important—it loses its function as an intermediary and buffer, transitioning from controlled currencies to freely traded currencies — observation point — induction of digital currencies • US sanctions and policies erode the fundamentals of Hong Kong LERS — such as restricting Hong Kong banks’ ability to remit and purchase US dollars • Pressure builds on the conversion of HK dollar to US dollar — significant changes in inter-bank balances—raising interest rates — require banks to surrender Certificate of Indebtedness to the HKMA; the liquidity of foreign exchange assets is fundamentally restricted —observation point — HK dollar interest rate Options of Impossible Trinity • Thinking 1: Trade off of Impossible Trinity — Maintaining free flow of funds is the cornerstone to Hong Kong as a financial center, and must remain so after LERS reforms • Thinking 2: When advantages of the LERS are no longer advantages due to circumstantial changes, or when disadvantages of the LERS no longer suit the Hong Kong government, or are beyond its ability to support • Thinking 3: The LERS strips away Hong Kong’s independent monetary policy to revitalize the economy, or its ability to rein-in inflation LERS Advantages are no longer advantages • LERS was created to attract capital inflow — it can still exist after the reform but is different from before → the internaonal financial center status can sll be maintained • After the reform: the currency is no longer fixed at an agreed exchange rate in return for an independent monetary policy – so as to solve Hong Kong's monetary policy’s inability to be in the same cycle as the Hong Kong economy • Can Hong Kong support a floating exchange rate? There might be volatility and instability initially Advantages of LERS Conducive to maintaining long-term economic stability, also aids Hong Kong becoming a commercial and financial center Simple, transparent, and the market can clearly grasp its operating mechanism Enables Hong Kong to deal with external impacts and to avoid a sudden collapse of the currency, such as guarding and supporting the stability of the HK dollar during multiple international political and economic crises Changes on the marketU.S. dollar pressured to depreciateHK dollar falls Depreciation may cause Hong Kong assets to bubble HKMA cannot modify economy via monetary policy HKMA actively removes LERS Raises HK dollar interest rates of to People’s Bank of China injects supports and liquidity; rein-in bubblization Hong Kong dollar rallies Foreign investors flow to asset holdings denominated in HK dollar → Hong Kong and China’s foreign reserves stabilize Reform shifts peg to against a basket of rates HK dollar exchange rate returns to market mechanism and and also an independent monetary policy foreign exchange reserves Hong Kong's status as a financial center and a dollar- denominated market Source: The Economist 2/3 of currency trades involve neither the Hong Kong dollar nor the yuan Source: The Economist Historical fact: Singapore dollar actively decoupled • From 1973 to 1985, Singapore began to peg its currency against a fixed and trade-weighted basket of currencies • From 1985 onwards, the Singapore Dollar floated within a bandwidth system, with the Monetary Authority of Singapore (MAS) stepping-in the currency market from time to time, to ensure the domestic economy remained stable • Reason: the pegged currency, the pound sterling, sharply devaluated (similar to when HK dollar ended its peg from the British pound last time) Historical fact: Switzerland actively decoupled • During the Eurozone debt crisis, foreign investors moved heavily into Swiss francs from the sinking euro and drove up the value in a very short period of time, causing the Swiss National Bank to imposed a ceiling in September 2011, capping
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