Is the Hong Kong-US dollar peg – the Linked Exchange Rate System (LERS) – truly sustainable? It’s once again being stress tested: Some hedge funds are reportedly taking large positions against the peg based on a decoupling of US-China trade and a depletion of Hong Kong’s foreign exchange reserves. [1] Yet experience has shown that attacks on the LERS are all in vain. [2] We believe it will be no different this time.
Decoupling
While there is anecdotal evidence of some leading US multinational tech companies moving production out of China to the US and elsewhere, the macroeconomic trends do not yet support the thesis of a decoupling of trading links between the US and China.
Firstly, despite the trade war and the pandemic, Sino-US bilateral trade has continued to rise, defying expectations. [3]
Secondly, separate from US-China trade, decoupling is easier said than done. The world’s integrated supply chains are centred on China and many foreign direct investment (FDI) strategies target China’s domestic market. In recent years, FDI flows from Japan, South Korea and Taiwan to China have remained significant despite efforts to reduce concentration risk and spread more investment across Southeast Asia.
Southeast Asia is deeply integrated within the global supply chains that depend on China, so relocating production to the region does not deliver much diversification benefit. This reliance in Chinese inputs is why China’s shutdown during the Covid-19 outbreak hit Japan, South Korea and Taiwan’s production lines. [4]
Foreign exchange reserves depletion
The plunge in Hong Kong’s aggregate balance (see Exhibit 1) does not indicate a depletion of its foreign exchange reserves. [5] Speculators erroneously believed it did during the failed 2018-19 attack on the Hong Kong dollar peg. The aggregate balance actually reflects the pool of interbank liquidity.
Despite capital outflows since the beginning of 2022, Hong Kong’s foreign exchange reserves remain massive. They amounted to USD 420 billion in October, or 170% of base money (M0), while the aggregate balance was less than USD 13 billion (HKD 100 billion).
This means that the Hong Kong Monetary Authority (HKMA) can honour any demand for US dollars in exchange for Hong Kong dollars 1.7 times over, while the LERS only requires a minimum foreign-reserve coverage of 100% of M0 (see Exhibit 2). In other words, Hong Kong has more than enough cover for all Hong Kong dollar cash outflows.
Automatic stabiliser
The sharp rise in US interest rates in the second half of this year has pushed the London/Hong Kong Interbank Offered Rate (LIBOR-HIBOR) spread to over one percentage point, resulting in arbitrage activity that is driving the HKD-USD exchange rate to the weak side of the Convertibility Undertaking range (see Exhibit 3).
This has, in turn, triggered the LERS’s automatic adjustment mechanism. It requires the HKMA to buy Hong Kong dollars, thus reducing local liquidity (i.e. the aggregate balance), and to sell US dollars to keep the exchange rate from falling through the floor of the Convertibility Undertaking range.
The resultant liquidity squeeze has pushed up HIBOR, reducing the LIBOR-HIBOR spread and stabilising the Hong Kong dollar exchange rate.
It’s a political decision
Even a currency board such as the LERS cannot survive without strong political support and strict adherence to currency board rules. The decision to maintain the Hong Kong dollar peg is first and foremost a political one. The resolve to do so remains strong, even at the cost of significant economic pain.
In our view, expectations that Beijing will abandon the Hong Kong dollar peg on account of Hong Kong’s diminished role in China are misguided, at least until the economic-political backdrop changes. [6]
Hong Kong still plays a crucial role for China. [7] It helps address the distorted capital allocation problem, which channels most capital to inefficient companies and starves efficient operators of credit. This has led to excess capacity created in inefficient sectors and under-investment by efficient sectors.
Debt reduction alone cannot resolve this problem. [8] China’s closed capital account does not allow the credit-starved companies to access foreign capital as an alternative funding source.
Hong Kong’s open capital account fills that void by allowing Chinese companies access to foreign capital, helping to improve China’s capital allocation. This role is irreplaceable: Hong Kong’s financial, legal and institutional frameworks command a high level of international trust that China’s system lacks. Notably, China has recently reiterated that Common Law would remain Hong Kong’s legal foundation. [9]
Financial liberalisation lab
Finally, in its role as a laboratory for financial liberalisation, Hong Kong combines a big population and a highly skilled labour force, a free market mechanism, an open capital account, a hard currency, and a rule-based framework. Beijing can use Hong Kong for a variety of experiments under the national reform framework. No other Chinese city can play this role.
As the renminbi is not yet convertible, China has to rely on Hong Kong as its main gateway to global capital. The city is a small open economy, with total exports accounting for over 200% of GDP and a large, globally integrated financial sector amounting to over 20% of GDP.
It is thus exposed to large and volatile cross-border flows. Since Hong Kong predominately uses the US dollar for trade and financial transactions, the Hong Kong dollar peg has provided a stable monetary and financial environment for investors by eliminating foreign exchange risk. This remains central to maintaining Hong Kong’s role as a global trade and financial centre.
In summary, keeping the Hong Kong dollar peg is a political decision, and Hong Kong (and China’s) resolve to maintain it has always been – and remains – categorical. Moreover, Hong Kong has all the monetary resources it needs to defend the peg.
References
[1] For example, see “Hong Kong Dollar Peg Tests Another Round of Doubters”, Finance. Asia, 28 November 2022 (here).
[2] For our most recent research, see “Chi Time: A Fireside Chat About the Hong Kong Dollar – It Hits 7.85 Again”, 13 May 2022 (here), and “Chi Time: Questions About the Hong Kong Dollar Peg, Answered”, 5 August 2022 (here).
[3] See “Chi Time: What Decoupling From China? A New Thesis From Asia’s Supply-China Shift”, 19 August 2021 (here).
[4] “Chi on China: Decoupling From China Easier Said Than Done”, 22 July 2020 (here).
[5] “Chi Time: Questions About the Hong Kong Dollar Peg, Answered”, 5 August 2022 (here).
[6] See “Chi on China: The Hong Kong Dollar Peg is Different – Long Live the Peg”, 28 May 2019 (here).
[7] See “Chi Time: The Ultimate Question of the Hong Kong Dollar Peg”, 23 August 2019 (here).
[8] See “Chi on China: The Conundrum of China’s Excess Capacity”, 14 September 2016 (here).
[9] “Beijing Officials Urge Hong Kong to Highlight Its Common Law Heritage, Strong Legal System to Contribute to Belt and Road Plan”, Chris Lau, South China Morning Post, 3 December 2022 (here), and “Hong Kong Will Stay a Common Law Jurisdiction”, rthk.hk, 8 November 2022 (here).
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