Months of political unrest and anti-government protests have thrown Hong Kong into one of its deepest crisis in decades, shaking the financial hub’s economy and its stock market.
Taking it back to the start, the Hong Kong dollar (HKD) linked itself to the U.S. dollar (USD) using a semi-peg system back in the early 1980s. What this means is that the Hong Kong Central Bank – also known as Hong Kong Monetary Authority (HKMA) – must control the supply and demand of HKD in order to keep it pegged to the USD at the agreed exchange rate.
Since May 2005, the pegged exchange rate trades within a band of 7.75 to 7.85HKD for every 1 USD; suggesting that if the HKD nears the bottom of the 7.75 edge (meaning it’s stronger), the HKMA must sell HKD and buy USD (to decrease the HKD’s value).
However, if the HKD nears the top of the 7.85 edge (meaning it’s weaker), the HKMA must buy HKD and sell USD (to increase the HKD’s value).
Mixing this up with the U.S. Federal Reserve’s tightening since late 2015, the U.S. dollar has soared in value causing capital to flow from Hong Kong into the U.S.
Despite the HKD weakening, the peg has proven resilient since it was conceived in 1983 and probably won’t break – here’s why we think so.
Its Current Linked Exchange System
The HKD is governed by a linked exchange rate system, which is written into the Basic Law of the Hong Kong Special Administrative Region. According to THINK Economic and Financial Analysis (THINK) what can be changed is the linked currency (now the US dollar), and the range of the linked exchange rate level.
But since the HKD is freely traded internationally, it suggests that the HKMA will stick to the existing linked exchange rate system to benefit China in doing businesses with the rest of the world.
Despite the HKD weakening, the peg has proven resilient since it was conceived in 1983 and probably won’t break.
Hong Kong Backed by World’s Largest Reserve Arsenal
A South China Morning Post report stated: “As its first line of defence, Hong Kong has US$440 billion in foreign exchange reserves, 1.4 times its GDP and almost twice its base money.”
Additionally, it has the support of Beijing where a liquidity swap line with the People’s Bank of China means 400 billion yuan can be tapped straightaway. Having the backing of the world’s largest reserve arsenal at US$3.1 trillion, breaking the Hong Kong dollar peg is nearly impossible – that is for as long as Hong Kong (and Beijing) wants to defend it.
Renminbi Is Not Yet Fully Convertible
While many can argue that HKD should be pegged to geographically-closer currencies, such as the renminbi (RMB) – this would lead to a huge problem.
As the RMB is not yet fully convertible (the RMB can’t be freely exchanged into another currency for any purpose), having the Hong Kong dollar linked to a non-convertible currency would expose Hong Kong to the same degree of capital fccontrol as the mainland.
The result of that would lead to a lack of free capital flows – causing detrimental damage to Hong Kong as a financial centre. With that said, it points to authorities (both in Hong Kong and Beijing) to not let go of the currency soon.