“Hong Kong dollar peg under threat from speculative attack” makes a suitably eye-catching headline. But despite the “massive” 1% fall in Hong Kong currency’s value against the US dollar so far this year, Hong Kongers can relax. The peg is in no danger.
It is true that by local standards, the recent move has been a big one. The Hong Kong dollar has spent much of its time since the 2008-2009 financial crisis pinned to the ceiling of its permitted HK$7.75-7.85 trading band against the US dollar by hefty capital inflows. But in the last few weeks, as sentiment in the financial markets towards China has taken a beating, hammered by Beijing’s non-existent policy communication skills, the Hong Kong dollar has fallen back from the strong side of its band.
On Wednesday it hit HK$7.8250, its weakest since August 2007. Inevitably this fall has raised questions about the peg’s future, with an increasing number of speculators betting that market pressure will force the Hong Kong government to abandon its 32-year old peg to the US dollar, and re-link its exchange rate to a declining renminbi.
They are going to be disappointed. Although the derivatives market is now pricing in favour of a fall in the Hong Kong dollar through the floor of its trading band within the next 12 months, in reality the probability that the peg will be forcibly broken in the foreseeable future is zero. Hong Kong’s exchange rate system is what is known as a currency board, which means that the territory’s entire HK$1.6trn monetary base is fully backed by deployable US dollar reserves. To preserve the peg, the Hong Kong Monetary Authority will automatically begin selling those reserves once the exchange rate reaches the floor of its band at HK$7.85, and the exchange rate will fall no further. What’s more, at the end of November, the HKMA was sitting on an additional US$150bn of excess foreign reserves. In other words, the local authorities have more than enough ammunition to defend the Hong Kong dollar against all conceivable market pressure.
That has never stopped people questioning the peg’s viability before. In 1998, in the depths of the Asian crisis, the peg attracted a concerted attack from speculators who believed that a devaluation of the Hong Kong dollar was inevitable. Their assault inflicted considerable financial pain, driving short term Hong Kong dollar interest rates up to 23% and wiping 25% off the stock market in a matter of weeks. However, the Hong Kong government retaliated vigorously, intervening massively in both the foreign exchange market and the equity market to drive out the short-sellers.
More recently, in late 2011, speculators led by US hedge fund manager Bill Ackman lodged sizable bets that Hong Kong’s incoming chief executive would revalue the Hong Kong dollar upward by some 30% in an attempt to relieve pressure on property prices and soothe social tensions caused by rising housing costs. In fact, the very first thing CY Leung did following the confirmation of his appointment in March 2012 was to pledge his commitment to keep the Hong Kong dollar peg unchanged.
The present round of speculation will prove just as inconsequential. In reality, it is hardly surprising that the Hong Kong dollar should have slipped back from the strong side of its band. At nearly five times its pre-2008 level, the local monetary base remains enormously swollen by floods of liquidity which poured into Hong Kong in search of a safe harbor during the financial crisis and never left. After local short-term interest rates started 2016 at their deepest discount to US interest rates since Ackman’s attack, it is only natural that Hong Kong should now see some outflows. Those will bring local interest rates back into line with US dollar interest rates and hit local asset prices—the benchmark Hang Seng stock index fell down 3.82% on Wednesday—but they will not endanger the peg.
As the International Monetary Fund emphasised in its 2016 health check on Hong Kong’s economy consultation published on Tuesday, the peg is “an anchor of expectations and cornerstone of stability” which remains “the best arrangement for Hong Kong”. Despite the market moves of recent days, that’s not going to change any time soon.