This summer’s protests against a proposed extradition law with China have shaken Hong Kong to its foundations. But when some in the protest movement tried to put the squeeze on the city’s financial system — where the local currency has long been pegged to the US dollar — the effort barely registered.
One user of the protesters’ main online discussion forum called for massed cash withdrawals and currency conversions a couple of weeks ago, to try to cause grief for local banks. “Converting to a foreign currency (like the US dollar) also protects yourself, so if the currency peg goes pear-shaped you won’t be left holding Hong Kong dollars,” the protester urged.
Pictures showing large stacks of banknotes withdrawn by Hong Kongers peppered social media that day but the Hong Kong dollar, which can move within a narrow trading band against the greenback, finished trading just fractionally weaker.
Indeed, despite worries over China’s strengthening grip on its special administrative region, a gloomy economic outlook and bearish talk on the Hong Kong dollar from investors including Kyle Bass, the 36-year-old exchange rate peg shows few signs of breaking down.
“The Hong Kong economy is obviously going through one of its toughest times, but I do not see the peg breaking,” said Ben Kwong, senior multi-asset strategist at State Street Global Markets.
The peg was introduced in 1983 to stop runaway depreciation of the then free-floating currency, which was sparked by negotiations between the UK and China over Hong Kong’s future. Bar some tweaks in the 2000s, the system has gone mostly unchanged since then.
The currency board is run by the Hong Kong Monetary Authority, which acts as a de facto central bank but does not engage in monetary policy like the Bank of England or US Federal Reserve. Instead, the HKMA has a mandate to buy up Hong Kong dollars for US dollars when outflows push the exchange rate to the trading band’s weaker limit. This leaves banks with fewer funds for short-term lending and eventually drives up interest rates enough to make Hong Kong dollar assets more attractive than their US dollar counterparts, encouraging inflows that strengthen the exchange rate. The reverse is done when the currency gets too strong.
Perhaps the most serious challenge to the peg came in 1998 during the Asian financial crisis when George Soros, fresh from successful short attacks on the currencies of Thailand and Malaysia, launched a dual assault on Hong Kong’s currency and stock market. The HKMA was forced to spend about HK$120bn ($15.1bn) fending off Mr Soros and other short sellers, but won out.
The latest notable attempt to undermine the currency came in April from Mr Bass, a Dallas-based fund manager who rose to prominence by shorting the US housing market ahead of the global financial crisis.
In an investor letter sent that month, Mr Bass claimed that the HKMA had spent 80 per cent of its reserves — which he identified as the “aggregate balance” — over the previous 12 months, leaving it with precious little firepower, around HK$54bn ($7bn), to defend the peg. “Hong Kong currently sits atop one of the largest financial time bombs in history,” he concluded.
Invesco chief economist John Greenwood, who proposed the currency board to Hong Kong’s government in 1983, said Mr Bass’s argument was flawed.
“He’s confusing assets and liabilities,” Mr Greenwood said, pointing out that the aggregate balance was the total reserve accounts of commercial banks held at the HKMA and thus “would never be used, couldn’t be used” to defend the peg.
At almost $450bn, he said, Hong Kong’s actual foreign exchange reserves were enough to cover all publicly circulating banknotes, the local currency holdings of banks and their reserves held at the HKMA more than twice over. “Bass has just got that wrong and he’s frankly ignorant,” Mr Greenwood said.
Mr Bass told the Financial Times that the aggregate balance was equivalent to excess reserves. He said the cumulative pressure from outflows, lack of faith in Hong Kong’s government, the inevitable collapse of untenably high real-estate prices and other factors would ultimately break the peg.
“When pegs break it’s never monocausal,” Mr Bass said. “You’d have to be an absolute fool today to not convert all your Hong Kong dollar deposits into [US dollars],” he said.
Mr Bass has also argued that the HKMA’s available firepower is “a meagre 13 per cent of reported reserves” and “woefully inadequate,” on that basis.
But Howard Lee, deputy chief executive of the HKMA, said forex reserves held in the currency board’s portfolio specifically dedicated to providing full US dollar backing for every Hong Kong dollar were composed of high-liquidity assets like US Treasuries equivalent to 111 per cent of the monetary base.
Analysts say that further down the line, the peg could come under greater pressure as the 2047 deadline approaches for the end of the “one country, two systems” framework, which preserves Hong Kong’s civil freedoms and independent legal system for 50 years after the handover from Britain in 1997.
Some speculate that a re-pegging to the renminbi could come before then to ease the transition, but the HKMA has stressed that such a move would remain impossible until certain conditions were met, including China’s currency becoming freely convertible and its capital account fully opening.
As one top Hong Kong government official joked about the peg’s long-term prospects: “Don’t certify this death yet.”
Additional reporting by Nicolle Liu