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Although the information and opinions provided in this document may be considered as taken from/derived from published/unpublished sources deemed reliable, and all reasonable and prudent measures have been taken in preparing this document, there is no expressed or implied statement or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 marketU.S. dollar pressured to depreciateHK 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 the Swiss francs at 1.2 against 1 euro • Before delinking, the SNB bought a whopping amount of the pegged currency (Euro) to maintain its exchange rate • January 15, 2015, the SNB suddenly announced that it would no longer hold the currency at the 1.20 cap against the euro, an exchange rate it had maintained since September 2011. On that day, the Swiss franc rallied nearly 28% against the euro • It’s possible for the pegged currency to weaken significantly by the QE in the Eurozone—the price to pay—exports of goods and tourism

Swiss franc soared in value after decoupling, and only returned to the exchange rate before scrapping the peg three years later in 2018

Changes in HK dollar exchange rate arrangements

Source: HKMA

Historical fact: the exchange rate arrangement of the Hong Kong dollar is mostly related to changes in the value of the pegged currency • With the Chinese government removing the silver standard in 1935 and linked HK dollar to the pound sterling, negative impacts of the global economic recession were delayed in Hong Kong • In 1972, the free floating and depreciation of the British pound, caused HK dollar to decoupled from the British currency, and briefly linked to the US dollar with an intervention band instead. • It was allowed to float freely after the oil crisis in 1973, due to US dollar devaluation in its purchasing power caused by inflation in America • In 1983, due to the escalating crises of confidence over the future of Hong Kong dollar after 1997 and HK dollar devalued precipitiously, the currency was linked to the US dollar again Shortcomings of the LERS have always existed, but is Hong

Kong's tolerability the same as before?

• Balance of payments cannot be adjusted by exchange rates，Due to the linked exchange rate arrangement, the appreciation or depreciation of the Hong Kong dollar against other currencies is entirely subject to the exchange rate of the US dollar against that currency. Nonetheless, Hong Kong’s economic environment is not completely the same as that of the United States. If Hong Kong is faced with economic impacts of its competitors, be it locally or abroad, in the form of currency devaluation or export market recession, it cannot use exchange rate depreciation as an influencer to changes in the environment, as this would affect foreign trades and international balance of payments, etc. • Unlike the floating exchange rate regime, market fluctuations cannot be adjusted in real time through a freely floated exchange rate. That is, under the LERS, there may be imbalances in the balance of payments • Same as other fixed exchange rate regimes, if the market exchange rate is higher than the linked exchange rate, there will be excess demand for foreign currencies, causing Hong Kong to have a balance of payment deficit. If the market exchange rate is lower than the linked exchange rate, this means that Hong Kong will have a balance of payment surplus. Huge deficits are not good for the economy. Current account deficits generally equate to an increase in external debts, and a heavy debt burden is more likely to deter investors. On the flip side, a huge current account surplus could fall under trade protectionism and be hurt by it

Imported inflation

• Under the LERS and other fixed exchange rate regimes, inflation that spreads internationally is called imported inflation (or cost inflation). The economic scale of Hong Kong relative to the United States is very small, and is easily affected by the policies of the United States • Getting the expected capital flow is a tool to stabilize the exchange rate at the linked exchange rate level. When foreign countries have inflations, prices of Hong Kong goods denominated in foreign currencies will fall, therefore driving up Hong Kong’s exports. This will give Hong Kong a balance of payment surplus, and put the exchange rate under pressure to appreciate. Under the automatic adjustment mechanism, banks purchase Certificates of Indebtedness in US dollar and issue Hong Kong dollars. The money supply to the Hong Kong currency market increases, and inflation worthens

Conflicting goals, internally and externally • Inflation gap and balance of payment surplus – Inflation gap is the difference between the current level of real GDP and GDP, if the economy was operating at full employment; this is generally described as an overheated economy. When surplus exists in the balance of payments (that is, when there is excess demand for the Hong Kong dollar, the currency comes under pressure to appreciate), the money supply in the LERS increases and interest rates fall, so as to block the inflow of funds. This will stimulate aggregate demand and increase inflationary pressure • Tightening the gap and balance of payment deficit –Tightening the gap means that national income is below the level of full employment, and unemployment occurs. When there is a deficit in the balance of payments, interest rates will be raised to prevent the loss of funds, so that the linked exchange rate can be maintained. However, doing so will reduce investments and make the unemployment problem worse • These two conditions show the shortcomings of the linked exchange rate regime, as it requires monetary policies to manage external events When internal and external objectives conflict, the floating exchange rate regime can resolve external events by modifying exchange rates, while the monetary policy (interest rates + money supplies) can deal with internal issues. Maintaining the linked exchange rate not only sacrifices monetary policy autonomy, but is also at risk of creating a monetary policy that is in conflict with internal issues

Active decoupling scenario (1) US dollar depreciates in value sharply

US dollar index (DXY) remains high

10-year treasury bond yield 0.62%2020.7.16

10 years treasury

Fed’s main assets are treasury bills and asset-backed securities

After achieving three months of significant gains, US dollar debts showed momentum of steady growth since mid-June 2020

2020 US dollar monetary base increased significantly

Speed and frequency of US dollar assets flowing into emerging markets during various crises in history

Source: Financial Time

2020 Most of government debts issued by the United States and Europe are bought by central banks

Changes in the size of swap lines between the Fed and other central banks

Maturities of central bank liquidity swaps

Source: Alhambra Investment

Negative correlation between the ratio of foreign holding US-debts and US dollar index

Source: Financial Time

Strength of monetary and fiscal policies of different countries

Active decoupling scenario (1) Its increasingly hard for Hong Kong banks to access US dollars

US financial sector holds tremendous interests in Hong Kong?

• 2018, accounted for about 5% of the banking sector in Hong Kong, American banks with US$148 billion in total assets and US$ 79 billion in customer deposits, clearly were not the driving force in Hong Kong’s financial sector • The only American bank on Hong Kong’s top 10 bank list, was Citibank HK at 10th place. With US$ 39.1 billion assets and annual income of US $527 million, it’s a far cry compared with top-ranked HSBC, who’s total income was US$59,836 million and total assets were US$2,375 billion • In 2nd place was Bank of China (Hong Kong), 3rd Hang Seng Bank, 4th Standard Chartered Bank (Hong Kong), 5th The Bank of East Asia, 6th Industrial and Commercial Bank of China, 7th DBS Bank (Hong Kong), 8th OCBC Wing Hang Bank, and 9th Nanyang Commercial Bank. They each belongs to the United Kingdom, China, Hong Kong, and Singapore respectively

SWIFT- the extreme weapon • Restricting Hong Kong financial institutions from making cross-border transfers from HK dollar to US dollar through SWIFT, will not only severely affecting the free-profits America makes from Hong Kong, but also impact the global dollar hegemony, forcing other countries to diversify currency risks by switching to multi-currency reserves • Ronick Chan Chun-ying, the legislative councilman elected representing Hong Kong’s banking sector, said: "US sanctions on Hong Kong will not affect the LERS, as this peg was chosen by the Hong Kong government. If the United States insists on delinking from Hong Kong dollar, Hong Kong can easily switch to a basket of currencies, to reduce currency risks.” • It is not necessary to convert US dollars through US financial institutions or big offshore markets such as Europe and London. America is not the only source of US dollar, as many exchange methods exist on the market. Deliberate decoupling will affect the circulation status of the US dollar in the world and its trading status, causing the market to demand other currencies for trading, and impacting residents’ confidence in the US dollar." • Hong Kong is the world’s third largest US dollar trading center and an important source of funds for US companies. If the exchange of Hong Kong dollar is stopped, hurt to the US itself will be tremendous as well.”

SAILING THROUGH THE TURBULENCE

Active decoupling scenario (3) A rapid outflow of foreign currency deposits – local banks come under pressure Hong Kong Exchange Fund vs Monetary Base

Foreign currency positions of the Hong Kong banking system are huge

Current situation: net capitals are still flowing in to Hong

Kong

Active decoupling scenario (4) International financial center status Hong Kong has traditionally acted as an intermediary and buffer of funds from Mainland China

Top-performing globalstock exchanges

Statistics of Shenzhen-Hong Kong Stock Connect and Shanghai-Hong Kong Stock Connect

HKMA Agenda • Executive Summary • Analyses of Timing and Conditions Hong Kong to Proactively Decouple 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: Options after Hong Kong Decouples History of Hong Kong LERS

HKMA

Hong Kong LERS in Financial Crises

USD/HKD – upper limit

HK dollar 12M forwards briefly touched the lower limit in early June 2020

Financial Time

Current determinants affecting the direction of HK dollar

• Interest rate: when Hong Kong interest rates are out of sync with the United States. When the Fed cut interest rates but the Hong Kong Interbank Offered Rate (Hibor) remained relatively high, it became attractive for investors to sell US dollars to buy Hong Kong dollars, and capital flows in • Since 3-6, 2020, the gap between Hibor and the US Libor rate was near the widest since 1999, and pushed the HKD/USD exchange rate to $7.75 HK dollars for the first time since the beginning of 2016. The HKMA sold HK dollars from April to June to keep the exchange rate within a trading range

Hong Kong dollar monetary base is HK $1.7 trillion

Hong Kong - Changes in Exchange Fund of Hong Kong

Mechansim of LERS

Source: HKMA

Relationship between Aggregate Balance and assets

Source: HKMA

Foreign exchange reserves reaching high levels

Source: HKMA

M3/foreign currency reserve assets

Hong Kong base rate

Hong Kong moves on interest rates

• Every time the Fed changes interest rates, the HKMA adjusts Hong Kong's base interest rate accordingly • After two cuts in March 2020, Hong Kong’s base rate, or the overnight interbank offered rate, was still higher than the short- term Hibor • When banks can turn to the interbank market for cheaper loans, changes HKMA make to the basic interest rate become irrelevant. The last time HKMA reduced its rate was by 64 basis points in March, while the Fed cut it by 100 basis points Hong Kong – Hong Kong Interbank Offered Rate

Hong Kong’s benchmark interest rate-HIBOR

• Tighten liquidity. The HKMA bought Hong Kong dollars in 2018 and again in 2019. Both times, the arbitrage transaction was shorting the HK dollar and buying the US dollar with a higher yield. These movements led to a 70% drop in the aggregate balance of the banking system—an indicator of the interbank cash pool—to the lowest level since the global financial crisis. This happened when banks’ loan-to- deposit ratio was high, and made the cash on hand of lending institutions even tighter • Reasons why HIBOR may not immediately follow US rate moves. Liquidity pressure exacerbates interest rate volatility, leading to some one-off factors such as when an IPO locks-in large-scale funds, Hong Kong's borrowing costs will soar

LIBOR minus HIBOR

Source: HKMA HKMA steps in to weaken the local dollar

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: Options after Hong Kong Decouples

Hang Seng Index

Source: Macromicro

Deposit-to-loan ratio of Hong Kong banks

Agenda

US laws and acts concerning Hong Kong

• The "U.S. Hong Kong Policy Act" was enacted by the United States Congress in 1992, allowing the United States to continue to treat Hong Kong as an autonomy separately from Mainland China after the handover, for matters other than defense and foreign affairs. This Act expresses that United States should respect Hong Kong's status as a separate customs territory, and should continue to grant the products of Hong Kong "most-favored-nation status", also should continue to allow the United States dollar to be freely exchanged with the Hong Kong dollar, and that United States businesses should be encouraged to continue to operate in Hong Kong • This Act expresses that whenever the US President determines that Hong Kong is not sufficiently autonomous to justify treatment different from that accorded China under an US law, the President may issue an Executive order suspending the application. However such an Executive order issued may be terminated by the President whenever the President determines that Hong Kong has regained sufficient autonomy to justify different treatment under the law or provision of law • This Act maintains that Hong Kong should be treated as a separate territory in economic and trade matters from China; this was the reason why high tariffs setting on Chinese goods did not impact Hong Kong. Furthermore, on commerce matters such as import quotas and certificates of origin, this Act expresses that the United States should recognize certificates of origin for manufactured goods issued by the Hong Kong Special Administrative Region, and grant the products of Hong Kong nondiscriminatory trade treatment. US should also continue to allow the United States dollar to be freely exchanged with the Hong Kong dollar • Hong Kong Human Rights and Democracy Act + Hong Kong Autonomy Act

US financial sector holds tremendous interests in Hong Kong?

• In 2018, accounted for about 5% of the banking sector in Hong Kong, American banks with US$148 billion in total assets and US$ 79 billion in customer deposits, clearly were not the driving force in Hong Kong’s financial sector • The only American bank on Hong Kong’s top 10 bank list, was Citibank HK at 10th place. With US$ 39.1 billion assets and annual income of US $527 million, it’s a far cry compared with top-ranked HSBC, who’s total income was US$59,836 million and total assets were US$2,375 billion • In 2nd place was Bank of China (Hong Kong), 3rd Hang Seng Bank, 4th Standard Chartered Bank (Hong Kong), 5th The Bank of East Asia, 6th Industrial and Commercial Bank of China, 7th DBS Bank (Hong Kong), 8th OCBC Wing Hang Bank, and 9th Nanyang Commercial Bank. These banks belong to the United Kingdom, China, Hong Kong, and Singapore, respectively. It is unlikely for these non-US banks to follow up on Trump’s "USD-HKD Decoupling"; conversely, they might be delighted to see American banks withdraw from Hong Kong, so as to make a move on the financial turf that’s opened up

Official response-1 • Hong Kong implemented LERS in 1983, before the "US Hong Kong Policy Act " came about. There was never the issue of needing US approval. It is always up to the local government anywhere in the world to decide for themselves which currency and which system to linked to • “LERS is not a special treatment granted by the United States, but established by Hong Kong based on our own needs for financial and currency stability instead”, said Eddie Yue Wai Man, Chief Executive of HKMA • The China Banking Regulatory Commission also stated that Hong Kong’s financial market is currently operating smoothly, LERS is holding stable, and that there is no abnormal capital outflow. Hong Kong has a sound legal system, a healthy financial system, a large number of high-quality and professional financial talents, a robust economic foundation, and a world- class business environment. With US $440 billion foreign exchange reserves and more than HK $ 1 trillion fiscal reserves Hong Kong can fully cope any risks and challenges • Financial Secretary Chen Mo-po: “I said in my interview with CCTV in May that Hong Kong has sufficient strength to support the LERS. I also pointed out that Hong Kong has a swap agreement with PBOC, if Hong Kong needs US dollars, PBOC is there to provide. At present, HKMA has US$445.9 billion in foreign exchange reserves, twice of the monetary base.”

Official response-2

• Not only is Hong Kong the favorite of non-US financial institutions, it also has a very robust and resilient fiscal structure. It’s long been third largest US dollar trading center in the world • According to statistics published by the HKMA, in April 2020, Hong Kong’s foreign exchange reserves (including monetary base, government fiscal reserves, etc.) totaled a whopping US$ 441.2 billion, most of which were US dollar assets, representing 6-times of the currency in circulation in Hong Kong • With a large scale of net capital outflow, the volume of bank deposits will inevitably decline. However, deposits in the Hong Kong banking system have remained steady in recent months. In the first ten months of 2019, Hong Kong dollar deposits increased by 3%, US dollar deposits rose by 1.8%, and the overall total deposits up by 2.6%. The slight fluctuations in monthly changes were due to large fund-raising activities in those months. More importantly, the overall deposit figures continued to increase in the past few months

Hong Kong foreign exchange reserves and monetary base

Investment banks’ responses

• ING: there won’t be any impact on Hong Kong's LERS if the United States restricts Hong Kong banks from buying US dollars. The HKMA has a huge reserve of U.S. dollars, and the authorities have reiterated that they will go to the PBOC to exchange U.S. dollars when necessary. Restrictions on banks’ conversion to U.S. dollars would only affect banks’ level of convenience and business operations. Unless the United States cuts Hong Kong from SWIFT, a move that will undermine the local banking system, but also profoundly damaged U.S. dollar’s international standing, and will prompt the local government to switch to other currencies. This proposal seems to be "more talk than action", and is unlikey to be implemented OCBC Wing Hang Bank: Since LERS was established by Hong Kong, relevant sanctions proposed by the United States will not make it disappear. Also, given that the majority of Hong Kong banks conduct large volumes of foreign exchange transactions with the US and other regional institutions, if the United States carried out these restrictions, it will weaken the market's confidence in the US dollar. As the U.S. presidential election is approaching, we cannot rule out that Trump, in order to win the re-election, will not hesitate to use sanctions to exacerbate Sino-US relations, but we do feel the possibility of carrying out the proposal is low

2020/5 Modest outflow of foreign currency deposits

• 2020/5 US dollar deposits fell sharply, decreasing by 0.9% or the equivalent of HK$ 49.1 billion during the period to approximately HK$ 5.16 trillion • Renminbi deposits in Hong Kong increased by 6.2% to RMB 694.9 billion at the end of May. The outstanding amount of Renminbi CD issued was RMB 37.7 billion, down RMB 6.2 billion for the month • Overall, the size of the offshore RMB liquidity pool rose 4.9% to RMB 732.6 billion. The total renminbi remittances for cross- border trade settlement amounted to RMB 521.5 billion in May, down 3.4% for the month

Capability to defend LERS

• Hong Kong’s foreign exchange reserves are at a high level anywhere in the world. In March 2020, this amounted to about US$ 440 billion, accounting for 130% of the GDP. Not only did it exceed major economies, it’s significantly higher than Singapore (83%), a small economy with high reserves • The foreign exchange reserves are also 6.9 times the Hong Kong dollar in circulation, more than twice the monetary base, and 25% (HK dollar) of the broad money M3 • Hong Kong should be able to defend the LERS. However, more attention should be paid to liquidity tightening and rising HKD interest rates, which may affect the underlying fundamentals such as real estate and banking sectors Summary • Given Hong Kong’s foreign exchange reserves, the monetary base (including interbank balances, debt certificates, etc.) plus supports from the central government, until the United States take extreme actions (causing instantaneous loss of confidence), LERS will remain a critical asset to both Hong Kong and China, and odds of a passive decoupling are not high • The decoupling of HK dollar and the US dollar depends on whether Hong Kong financials are valuable, and whether other cities/regions can be alternative replacements. In order to safeguard its advantage as a financial center, Hong Kong will continue the US dollar linked exchange rate system • The prerequisite for active decoupling calls for Hong Kong’s financial base and its status as an US dollar funding center, to be gradually replaced. Albeit Hong Kong’s business cycles and trades are highly synchronized with China’s, hence restricted by the globalization of the RMB, but an option similar to Singapore’s basket peg is still more likely, as funds will be protected by the Basic Law to flow in and out freely • In the initial phase of shifting to a basket of currencies, HK dollar will maintain a price similar to the current level due to the full support of the Hong Kong government and the central government. But in the intermediate phase, it will be at par with Hong Kong’s economic performance and the direction of the renminbi

Agenda

If: HKD going forward • Continues to be linked to the US dollar for a period of time • Pegs to a basket of currencies • Increases the weight of RMB in the basket • Links directly to the RMB • HK dollar trends toward the Australian dollar

Continues to peg to the US dollar

• John Greenwood, father of LERS, Norman Chan, retired chief executive of HKMA, and former Financial Secretaries John Tsang and Antony Leung, all suggest for the HK dollar to continue its peg to the US dollar, a view that is shared by Capital Economics and UBS • Jie Lau, Head of Macro Strategy of Standard Chartered China, feels that net capital inflows from continuous IPO of mainland-capital enterprises, together with HK dollar interest rate being higher than the US dollar interest rate and rising geopolitical risks, HK dollar has become the best alternative option to the US dollar. The HK dollar is a very important currency for the mainland, it can almost be said as the "Chinese version of the US dollar." In other words, for any company that cannot avoid exposures to the US dollar risk, but must hold the currency, the HK dollar is the best alternative

HK dollar gradually shifts to peg to the RMB

• Hong Kong's economic and trade dependences on mainland China are becoming deeper, and the economic cycles of the two are heavily correlated, which are conducive to the policy practices of the HKMA • This is why that Joseph Yam, the former chief executive of HKMA, financial expert Yang Wailong, and Zheng Hongtai, the associate director of the Hong Kong Institute of Asia-Pacific Studies at the Chinese University of Hong Kong, are all in support for the HK dollar to peg to the RMB. Goldman Sachs Group and Royal Bank of Scotland (Royal Bank of Scotland) also share the same view too

Main reasons to link to the RMB

• The weight of Chinese constituent stocks in Hang Seng Index • Hong Kong's import and export trading partners • Globlization of the RMB • Maintaining the dual-currency system • Integration of the Greater Bay Area • Transparency of the currency policy

To peg with a basket of currencies

• Exchange rates can be revised according to the economic conditions of individual country • The weight and composition of currencies in the basket allow policy control • Widens the HK dollar range (ex Malaysia) • Similar to Singapore’s flexible basket peg: to formulate monetary policy using an exchange rate mechanism rather than interest rate like other central banks, and only allowing the SGD to float within an undisclosed range against the hidden basket

End