INFOCUS MACRO COMMENT AUGUST 2020 Is the Hong Kong dollar at risk? DISCIPLINED BY NATURE. FLEXIBLE BY DESIGN. HIGHLIGHTED IN THIS PUBLICATION: The icons alongside represent our investment process. Through a disciplined provision of investment policy and security selection at GLOBAL STRATEGIC GLOBAL SECURITY ASSET ALLOCATION SELECTION the global level, regional portfolio management teams have the flexiblility to construct portfolios to meet the specific requirements REGIONAL REGIONAL PORTFOLIO of our clients. ASSET ALLOCATION CONSTRUCTION IS THE HONG KONG DOLLAR AT RISK? With tensions between the US and China rising, investors naturally wonder whether Hong Kong’s linked exchange rate regime is at risk. In this edition of Infocus, Stefan Gerlach argues that it is not. With the US presidential election approaching and President These developments gave rise to political uncertainty and Trump appearing to think that ratcheting up tensions with concerns about the future of Hong Kong and the Hong Kong China is a good election strategy, there is every reason to dollar (HKD). The outcome was a massive depreciation of the expect more political turbulence. Unsurprisingly, investors HKD, which fell from 5.29 HKD/USD in January 1981 to 8.70 HKD/ wonder whether there is any risk that the Hong Kong dollar peg USD in September 1983 or by 64%. To stop the turmoil, a (one- to the US dollar could become collateral damage. sided) peg of the HKD to the USD through a currency board was introduced in October 1983 at a rate of 7.80 HKD/USD. To assess that risk, it is understandable to ask why Hong Kong has a pegged exchange rate in the first place. While large In the intervening 37 years, the currency board has economies, such as the US, trade a lot, their traded goods experienced several episodes of extreme market pressure sectors tend to be a small part of the overall economy. The often related to political developments in Mainland China. US authorities therefore generally pay little attention to the Nevertheless, the peg – or the ‘Linked Exchange Rate System’ exchange rate and let it float. (LERS) – has remained unchanged and has continued to underpin monetary and financial stability in Hong Kong. That is For small economies, however, the exchange rate is of critical no small achievement. importance. While many prefer floating exchange rates because they help offset economic shocks, they can also move Exchange rate policy in Hong Kong is also influenced by the strongly in response to political developments. A floating fact that it is a small economy on the periphery of the much exchange rate can therefore also be a shock generator as well larger economy of Mainland China.1 Small open economies as a shock absorber. that are adjacent to a much larger economy often fix their exchange rate to their neighbour’s.2 It would therefore be Switzerland is a case in point: the Swiss franc often moves natural to peg the HKD to the Chinese Renminbi (RMB). Indeed, abruptly to political news that raises concerns about a until 1935 both Hong Kong and China were on a silver standard breakup of the eurozone. Since such developments are of and between 1983 and 2005 both fixed to the USD. But since little importance for the Swiss economy, they do not warrant the RMB is not yet fully convertible, it is not possible to peg the a change in the exchange rate. Indeed, a sharp appreciation of HKD to it. the franc could harm the Swiss economy. This is why the SNB seeks to prevent the Swiss franc from appreciating in response Could the peg be abandoned? to political uncertainty in the eurozone. It is easy to see that a With that as a background, could the LERS be abandoned? flexible Hong Kong dollar would be highly exposed to political That seems extraordinarily unlikely. First, the link is sacrosanct shocks in Asia. among policy makers in Hong Kong. No one has any experience of living under a flexible exchange rate and economic The Hong Kong dollar peg: some background considerations, as outlined above, are strongly in favour of Indeed, the early 1980s provides an instructive example. In Hong Kong having a fixed exchange rate. 1982 the British Government started to negotiate with the Chinese government about Hong Kong’s status after 1997. In Second, the Hong Kong Monetary Authority’s foreign exchange March 1983, the British Government recognised that China had reserves are massive, exceeding USD 500 bn. With such a large sovereignty over Hong Kong. war chest to defend the currency, it is difficult to envisage the currency board being overrun by speculators. 1 It is, of course, legally a part of China. 2 They at times even use the currency of the larger neighbour. For instance, Monaco and Andorra use the euro and Lichtenstein uses the Swiss franc. 2 | August 2020 IS THE HONG KONG DOLLAR AT RISK? Third, that said, the ability of policy makers to defend the Figure 2 shows, while the pegged rate was 7.80 HKD/USD, exchange rate does not depend solely or even mainly on how until 1999 the HKMA the took action to defend the peg at the large the foreign exchange reserves are but rather on the exchange rate 7.75 HKD/USD. Following the experiences of the economy’s ability to withstand higher interest rates. If the Asian financial crisis, in April 1999 that intervention rate was currency board were to sell USD to Hong Kong banks in order moved by ‘1 pip’ (0.00001) per calendar day to reach 7.80 after to sustain the exchange rate, it would debit those banks’ 500 days. accounts with the HKMA. That would reduce interbank liquidity, 2. HKD/USD exchange rate and Linked Exchange Rate System or what is known in Hong Kong as the ‘Aggregate balance’, and push up interest rates. 7.90 As Figure 1 shows, during the Russian and Asian financial 7.85 crises, pressures on the HKD pushed up interest rates to above 7.80 10%. The Hong Kong economy, being so dependent on the property market, would not be able to endure interest rates at /USD 7.75 this level for any extended period of time. HKD 1. 1-month HKD Hibor – 1-month USD Libor spread 7.70 12 7.65 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 10 HKD/USD Weak-side Convertibility Undertaking Strong-side Convertibility Undertaking 8 Source: Refinitiv and EFGAM calculations. Data as at 28 July 2020. 6 % 4 Another series of major innovations was announced in May 2 2005. The currency board had been one-sided in that the HKMA stood ready to prevent the HKD from falling below 7.80 0 HKD/USD, the so-called ‘Weak-side Convertibility Undertaking’ -2 (CU), but had not specified at what level it would step in to JFMAMJ JASONDJFMAM JJASOND 1997 1998 prevent the HKD from appreciating. The HKMA then introduced Hibor-Libor, 1-month (%) a strong-side CU to buy US dollars from licensed banks at Source: Refinitiv. Data as at 28 July 2020. 7.75. It was also announced the existing weak-side CU would be shifted from 7.80 HKD/USD to 7.85 HKD/USD to achieve However, the HKMA has an additional tool to deal with symmetry around the linked exchange rate of HK$7.80. pressures on the HKD since it also manages all the government’s reserves, which total about USD 150bn. If these Thus, while it is unlikely that the peg will succumb to reserves were sold for HKD, there would be no impact on speculative pressures, it seems likely that it may evolve further interest rates since interbank liquidity would be unaffected. in the future. Changes in the peg The future of the HKD and the peg The fact that there is a strong economic rationale for the linked How might it do so? It seems self-evident that after the 50-year exchange rate, that policy makers have no experience of other transition period ends in 2047, the HKD will be replaced by monetary policy regimes, and fact that the HMKA have plenty the RMB. There are no examples of one country having two of ability to withstand episodes of even extreme pressure on currencies. But what might happen before then? the HKD suggest that the pegged exchange is here to stay. The Basic Law specifies that the HKD shall remain legal That said, the linked exchange rate regime has undergone tender during the transition period.4 However, as the Chinese a number of improvements and changes over the years.3 As economy and financial markets continue to grow, the RMB 3 See https://www.hkma.gov.hk/eng/key-functions/money/linked-exchange-rate-system/milestones-of-monetary-reform/ 4 See Article 111. The Basic Law is available here: https://www.basiclaw.gov.hk/en/basiclawtext/images/basiclaw_full_text_en.pdf August 2020 | 3 IS THE HONG KONG DOLLAR AT RISK? will no doubt be increasingly used in Hong Kong. It is easy to Conclusions imagine a situation in a few years’ time in which RMB can be The conclusions of this analysis are clear. The HKD peg, which used at par in retail stores and, later on, that firms earning has served Hong Kong well, in our view will not succumb to a revenues and having a large part of their business in Mainland speculative attack, but will continue to evolve over time as it China start paying their workers in Hong Kong in RMB.