When tensions between the US and China intensify, Hong Kong finds itself in their crossfire. Renewed political uncertainty between Washington and Beijing adds to Hong Kong’s increasingly fragile economic state, already grappling with social unrests and the impact from the Covid-19 pandemic.
Beijing’s move to impose a bespoke national security law in Hong Kong is the latest flashpoint. Uncertainty feeds speculation, where all outcomes become possible.
Now that the US has removed Hong Kong’s special trading status in retaliation to Beijing - colourfully described as the extreme ‘nuclear option’ - Washington’s decision to restrict Hong Kong’s USD access would tarnish the city-state’s reputation as a global financial hub.
Should capital leave, pressure on the HKD peg follows.
Solution To Capital Outflows
When money exits Hong Kong, this renews the long-running debate over the HKD peg, which was famously targeted by George Soros in 1997. Because the HKD does not float but sits in a targeted band between HKD$7.75 and HKD$7.85, the Hong Kong Monetary Authority (HKMA) intervenes by utilising dollar reserves. When the HKD strengthens, the HKMA sells HKD and buys USD, and vice versa to keep the exchange rate within the band.
The argument stems that floating rates responds to market conditions without creating any subsequent imbalances. Should the HKD weaken, exports become more competitive, and a new equilibrium is achieved.
But in Hong Kong this matters less, given that export manufacturing is a fading contributor to the economy over the past fifty years. In the 1970s, manufacturing contributed to 40% of Hong Kong’s jobs, today this activity accounts for less than a percentage of the economy. “Since Hong Kong no longer competes in manufacturing, a weaker HKD will lead to significant wage deflation” according to Britney Lam, Chief Investment Officer of the LAM Group speaking to FinanceAsia.
There are two pieces of good news. First, with the HKMA acting as a de facto central bank, money demand and supply sets borrowing costs. If capital outflow and a weakening HKD persists, interest rates rise to make HKD assets more attractive.
Economists refer this as the impossible trinity, where economies are unable to have capital mobility, fixed exchange rates, and an independent central bank. In practice, one is sacrificed for the other two. However, Hong Kong has essentially chosen a peg and de facto central bank to get some of each.
Second, the current data is relatively favorable. Coordinated global central bank easing has pushed more than $11 trillion of government bonds into negative territory, resulting in some flows to migrate into Hong Kong where the 3-month paper traded near a 1% premium to its US equivalent in early June. With the HKD strengthening, the HKMA intervened, selling nearly HKD$5 billion into the market, bringing year to date selling to almost HKD$26 billion, halving the spread.
Expiration Date Approaching
The good news is the monetary system works, the bad news is that this arrangement is set to expire.
Previously, Hong Kong’s country risk premium was set to what happens after 2047 when ‘one country, two systems’ formally ends, according to Eric Ritter, a former Asia equities hedge fund manager and current adjunct professor of economics for Lakeland University in Tokyo.
Analysts note that as Hong Kong draws closer to China, the HKD peg may become a political liability rather than a financial asset. Although moving the HKD to RMB aligns with business in mainland China, removing the currency linked to the world’s largest economy and towards a currency which only accounts for 2% of global exchange, increases the cost of doing business.
The HKD peg matters for China too. Capital controls are closed in China, which limits individuals from taking more than $50,000 out of the country each year. With about $3 trillion in foreign exchange reserves, it takes less than 5% of the population to run China’s USD supply dry. The HKMA holds more than $440 billion in USD reserves, twice the value of money currently in circulation in Hong Kong.
Ironically, as Hong Kong’s capital market incorporates more Chinese businesses, the USD footprint grows. While shares of mainland business account for 73% of Hong Kong’s stock market, rising from 31% two decades earlier, the trend is expected to continue when more Chinese ADR’s plan to float a secondary offering. Netease and JD.com together are expected to raise nearly $7 billion in Hong Kong this month.
The HKD peg is linked to politics but also to the reality that fewer alternatives exist, particularly since China’s current account remains closed. However, the concern that the fate of the HKD peg is justified. 2047 is within a 30-year home mortgage, possibly creating a currency mismatch near the end of the loan where asset values may not match rising liability costs.