16 February 2019
The linked exchange rate mechanism helps uphold international investor confidence in Hong Kong, say defenders of the city's currency peg. Photo: Bloomberg
The linked exchange rate mechanism helps uphold international investor confidence in Hong Kong, say defenders of the city's currency peg. Photo: Bloomberg

Why the USD currency link is still the best option for HK

Capital outflows from Hong Kong have accelerated recently amid concerns over China’s economy and the renminbi’s prospects. The outflows have forced the Hong Kong dollar exchange rate down by the biggest amount in 12 years in just two days. The unit fell by more than 0.6 percent from 7.75 to near the 7.8 level per US dollar between January 7 and 8.

Meanwhile, locals are questioning again the usefulness of the 35-year-old HKD-USD currency link as the Hong Kong economy heads towards its sharpest slowdown in a decade on the back of rising US interest rates and a strong US dollar. Some hedge funds are taking bets again on Hong Kong breaking the currency link in order to salvage the local economy.

The key fundamental factor that makes Hong Kong uniquely different from the rest of China, and makes it one of the premier financial centers in the world, is its laissez-faire economy backed by the rule of law that respects intellectual property rights, transparency and integrity. The currency-link system that pegs the Hong Kong dollar to the US dollar protects these core values of Hong Kong by eliminating foreign exchange risk that stems from international market volatility and political noise in Hong Kong and elsewhere.

So it is the HKD-USD link that upholds international confidence in Hong Kong in the face of rising economic and political challenges. Try taking it away, Hong Kong’s risk premium would most likely soar, crushing the local economy.

Scrapping the HKD-USD link will not necessarily solve the alleged problems – high inflation and economic volatility, income inequality and asset bubble – that it has caused because there are a whole lot of other factors affecting the local economy.

Crucially, there seems to be no better alternatives to the currency link. Free floating would lead to a sharp rise in FX volatility, given the small open nature of the Hong Kong economy. This will surely hurt Hong Kong’s trade-dependent growth.

Re-pegging the Hong Kong dollar to the renminbi makes no sense at this time, as Hong Kong is still functionally more integrated with the US dollar areas, both in capital markets and international trade. The lack of well-developed RMB derivatives means that there are no hedging tools for renminbi FX risk, which has been aggravated by China’s policy flip-flops. Pegging to the renminbi will also require Hong Kong to be governed by China’s monetary policy, a clear implausibility for Hong Kong’s free market amid the lack of market discipline in China’s monetary policy.

Meanwhile, re-pegging the Hong Kong dollar to the US dollar at a different level will only hurt the credibility of the peg and invite recurring speculative attacks by creating one way bet for currency speculators. Local interest rates will become more volatile and more distorting for the investment environment.

Similarly, re-pegging the Hong Kong dollar to the euro or a basket of currencies would suffer from the same credibility problem as re-pegging it at a different US dollar level. It is also impractical. Pegging to the euro means that Hong Kong will inherit the ECB’s monetary policy. But the ECB’s inflexible policy stance may not suit Hong Kong’s small open economy, which needs flexible policy responses to economic shocks. Relative to the ECB, the US Fed has a more flexible policy stance.

If the Hong Kong dollar were to be pegged to a basket of currencies and retain its hard currency status with high liquidity, it could only be pegged against fully convertible currencies. The potential candidates for inclusion in the basket would be the US dollar, euro, yen, pound sterling, Canadian dollar, Singapore dollar, Aussie dollar, New Zealand dollar, Swiss Franc, Norwegian krone and the Swedish krona.

But the inclusion of small currencies that are not used for global invoicing and have only weak trade relationship with Hong Kong will make little sense. That leaves the US dollar, euro and the yen as realistic candidates. With the US dollar still a dominant currency in Hong Kong’s economic life, pegging the Hong Kong dollar to such a narrow currency basket will not make much difference from pegging it against the US dollar.

Hong Kong’s small open economy is affected by many international forces, so it has a high growth-volatility tendency. Monetary autonomy can do little to counteract the large economic shocks inflicted by international cross-currents. Anchoring its exchange rate to the currency of a large, flexible and relatively credible economy remains practical to preserve confidence and reduce FX risk caused by the external forces.

Nevertheless, the endgame for the Hong Kong dollar is already in sight. When the renminbi becomes fully convertible and is backed by credible economic and policy fundamentals, the Hong Kong dollar will cease to exist. But it will take some years to get there. For now, in the absence of a better alternative to the HKD-USD link, changing the status quo will only create chaos and not solve the problems. Hence, the currency link is likely to stay in the medium term.

From the asset market’s perspective, ceteris paribus, the rigid HKD-USD link will create market and economic volatility under the current uncertain international environment. But this is just exactly what the currency link mechanism is supposed to do – when the exchange rate does not adjust in the face of capital flow volatility, local economic and asset variables adjust to bring the market back to equilibrium.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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