And that, surely, is what the technocrats of the Hong Kong Monetary Authority want.
Let’s be clear: The peg isn’t going anywhere, at least in the short term. But it has been a popular speculative target of hedge fund traders in the past, from George Soros to Bill Ackman to Crispin Odey, so today’s quiet is remarkable. Apart from some low-level chatter, there has been no sign of a high-profile name bet or a bearish wave against the pegged exchange rate mechanism.
Implied Volatility in Hong Kong Dollar Options-U.S. – a measure of how expensive it is to bet on these derivatives – has risen somewhat this year, but remains below its pre-pandemic levels in 2019 and 2016.
This is somewhat surprising given that conditions look potentially less favorable for the bond than at any time since the Asian crisis of 1997-1998. After a long period following the global financial meltdown of 2008, during which Hong Kong was the beneficiary of near-zero US interest rates, the cycle has turned decisively. The financial pain is already here. More seems almost certain to be on the way.
Any economy that has a peg linking the value of its currency to the other country’s currency is effectively outsourcing its monetary policy. In exchange for the currency’s anchor of stability, the pledge provider relinquishes control over domestic interest rates and the money supply by following the policy decisions of the respective central bank. In the case of dollar pegs, this is the Federal Reserve (the Saudi riyal and the United Arab Emirates dirham are among other currencies pegged to the US unit). For a small, open trading economy and financial center like Hong Kong, this arrangement can make a lot of sense. However, it comes at a price.
Unless economic cycles are perfectly aligned, there is always the risk of introducing policies that are either too loose or too tight. For example, if the US is growing strongly and Hong Kong is in recession, then the level of interest rates is likely to be higher than what the city would prefer. and vice versa if the Fed cuts interest rates to stimulate the economy while Hong Kong is already expanding rapidly.
When it’s too loose, things (all else being equal) tend to be hot and asset prices will appreciate. The other side is less fun. When policy is too tight, funds run out and asset prices fall. This is where Hong Kong is now. The city’s foreign exchange reserves have fallen 13.6% since November last year (though they remain plenty to cover the monetary base), property prices are retreating after a long boom and the benchmark Hang Seng share index has fallen in 11- low year.
The system is strongly pro-cyclical, removing liquidity just when needed and adding it when things are already frothy. In effect, the volatility normally absorbed by a floating exchange rate is transferred to the domestic economy. Because the value of the currency cannot be changed, real estate and stock prices must adjust.
The best way to see how extreme Hong Kong compares to the US right now is to look at relative inflation rates. The chart below uses moving averages to smooth the highs and lows. Even so, it is immediately clear how radically the US has drifted away:
Hong Kong hardly needs higher interest rates, yet it has no choice but to continue following the Fed’s tightening if it wants to maintain the peg. Meanwhile, the territory’s economy has shrunk 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 at its weakest since 2008, adding to devaluation pressure.
The Fed is also far from done. In July, futures markets expected the Fed Funds rate to rise to 3.3% and decline by mid-2023. After a shock from the August inflation report, they now forecast a peak near 4.5 %. If US inflation continues to disappoint upwards, the pain will worsen for Hong Kong. Hong Kong’s one-month interbank offered rate, against which many mortgages are priced, has risen 2.4 percentage points since late May. It seems certain to go higher, judging by the corresponding Libor.
So why not lose the peg? There are many reasons. The yuan, because it is not fully convertible, is not a viable alternative. China may be trying to tie the former British colony closer to the mainland, but having Hong Kong as an offshore fundraising center still suits the country’s economic interests. Above all, there is hard-earned institutional and market credibility – notably during and after the Asian financial crisis, when the territory suffered five years of deflation and a nearly 70% drop in property prices, while maintaining the currency line. The city will not give up this reputation easily.
Hong Kong dollar bears have long discounted these arguments. But why take on a tough and clever adversary like the HKMA when UK government ministers are so accommodating? Speculators will no doubt return at some point when the easier options have dried up. Meanwhile, Hong Kong’s monetary chiefs can raise a glass to Liz Truss and Kwasi Kwarteng.
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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matthew Brooker is a Bloomberg Opinion columnist covering economics and politics in Asia. A former editor and bureau chief of Bloomberg News and deputy business editor for the South China Morning Post, he holds a CFA charter.
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