Spotlight

No, the Peg isn’t going away anytime soon 


A quick look at how the peg works:

As a reminder, the exchange rate mechanism that pegs the Hong Kong Dollar to the U.S. Dollar is operated through a “currency board.” What does this mean? A currency board links a currency (here the HKD) to an anchor currency (USD in Hong Kong’s case) by law, and requires the monetary base to be fully backed by foreign reserves, in that theoretically every banknote could be exchanged for a U.S. Dollar. Additionally, the Hong Kong Monetary Authority (HKMA) cannot set discretionary monetary policy. The stability of the exchange rate is maintained through an automatic interest rate adjustment, where interest rates rather than the exchange rate adjust to the inflow or outflow of capital.

The peg mechanism is passive and automatic. If HKD liquidity drains due to outflows, the money supply contracts and interest rates (HIBOR) naturally rise. Higher rates attract money back to the system, creating a natural balance between interest rates, the exchange rate, and money supply. The HKMA can operate it on autopilot, and it’s worked well for nearly 40 years.

As a currency board, the HKD peg is much more robust in withstanding market pressures than a normal fixed-exchange rate system. Since a currency board must hold anchor-currency reserves at least equal to or exceeding the value of the domestic currency it issues (or the monetary base), it always has sufficient reserves to back its obligation to exchange local currency for the anchor currency (and vice versa) on demand at the official exchange rate.

It’s important to note that properly managed currency boards don’t break from market forces (i.e. capital inflow and outflow) alone. In fact, a well-managed currency board has never broken since John Maynard Keynes established one of the earliest ones for the North Russian government. Although Argentina was technically running a currency board when it was forced to de-peg, the key word is “well-managed” and Argentina broke nearly every rule for properly managing their currency board peg. 

Next, we would like to address some frequently asked questions.

Question#1: Is the HKMA depleting reserves?

Our take: No. Foreign currency reserves have been stable. It’s important to distinguish between foreign reserve assets and banks’ excess reserves held at the HKMA. Foreign reserves, i.e. FX reserves, are an important feature of the safety of the system and used to guarantee the stability of the exchange rate, while excess reserves are merely a portion of the money supply and a measure of interbank liquidity.

In looking at the HKMA’s reserves, excess reserves have been declining, while foreign reserves have been rising. Currently, foreign reserves designated to defend the peg, namely the backing assets, stand at over 100% of the monetary base and have remained steady in recent years. No HKD has been created without an equivalent USD set aside in reserves. We think that seeing banks excess reserves decline is simply a sign the system is working, as liquidity has tightened on the back of higher USD rates over the past few years. It does not constrain the HKMA’s ability to defend the currency peg. Furthermore, the key word is “excess”—for many years, this balance was functioning at zero and the peg worked without a hitch.  

Question #2: Could rising interest rates make the peg too painful to maintain?

Our take: While the HIBOR-LIBOR spread (the interest rate difference between HKD and USD) has widened recently, capital flows have been fairly benign. In line with the recent increase in rates, money has flowed back into HKD due to the higher carry. In other words, the system seems to be functioning as it should. Furthermore, given all the stress on Hong Kong over the past year – COVID recession, protests, risk of losing U.S. “special status” – rates have barely budged in relative terms. In 1997, the Hong Kong economy shrank by 10% year-over-year, and local shorter-term rates skyrocketed to nearly 30% per annum—and the peg survived. A move higher in rates, again, simply shows the system is working, and the “stress” is far from levels sustained in the past. 

Question #3: Are high debt levels a risk?

Our take: While the overall ratio of credit-to-GDP has increased since the Global Financial Crisis and does present some concern, there is nothing particularly alarming about Hong Kong banks or overall system leverage. The loan-to-value limits on lending for commercial mortgages have progressively tightened. Further, for households, debt-to-GDP in Hong Kong stood at 72.2% at the end of last year. This is below the 76.3% figure for the U.S. Nonfinancial corporations in Hong Kong, which registered a debt-to-equity ratio of 37.2% at the end of last year. This is way below the comparable 259.9% leverage ratio for the S&P 500 nonfinancial corporations in the U.S..

Question #4: As the Hong Kong business cycle moves more in line with China than the US, does re-pegging to the Renminbi (RMB) make more sense?

Our take: This might be true over the very long term, but for the foreseeable future, the peg is in every party’s best interest. Stability makes sense for Hong Kong, China benefits from a pool of offshore USD liquidity, and there simply isn’t another near-term option. This kind of shift might well happen many years down the road when the Chinese capital account is fully open, the Renminbi is fully convertible, and there’s no longer any clear reason for Hong Kong to have its own currency. But in the meantime, although Beijing policymakers have a clear interest in developing an offshore presence for the renminbi, they just as clearly have expressed no view or on how to manage Hong Kong’s currency. Furthermore, there offshore renminbi market has shrunk over the last five years as China more aggressively closed the capital account to stem outflows. Without a liquid pool of offshore renminbi it would be impossible to adopt the RMB outright or shift to a renminbi-based rule. In other words, it’s not going to happen anytime soon.  

Summing up:

In short, we don’t believe there is any de-pegging on the horizon. This doesn’t mean that the Hong Kong dollar couldn’t be used as a hedge for other trades, or as a way to express a view on volatility. However, a break out of the band looks highly unlikely.

All market and economic data as of June 15 2020 and sourced from Bloomberg and FactSet unless otherwise stated.

For illustrative purposes only. Estimates, forecasts and comparisons are as of the dates stated in the material.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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