Hong Kong’s linked exchange rate system will not fall?

  In the past three months, the exchange rate of the Hong Kong dollar has frequently hit the weak-side convertibility guarantee. Since May, the Hong Kong Monetary Authority has followed the arrangements of the Currency Board, and has withdrawn over HK$170 billion of currency from the interbank market at the weak-side exchange guarantee level of HK$7.85 to US$1, resulting in a corresponding reduction in Hong Kong’s base currency and foreign exchange. Reserves also fell by $24 billion. This reignited market concerns about the Hong Kong market, and even pessimistic about the collapse of the linked exchange rate system (hereinafter referred to as the “linked exchange rate system”).
  Recently, Hong Kong Financial Secretary Chen Maobo and Hong Kong Monetary Authority President Yu Weiwen have repeatedly stated that Hong Kong does not need and does not intend to change the linked exchange system. Hong Kong established the linked exchange system in 1983. After two optimizations in 1998 and 2005, an institutional arrangement was formed that framed the exchange rate of the Hong Kong dollar within the range of 7.75 to 7.85. It can be said that changes in the size of the base currency in Hong Kong are a by-product of stabilizing the exchange rate of the Hong Kong dollar, and the flow and stock of the base currency must be fully supported by foreign exchange reserves.
  The Hong Kong dollar triggering the weak-side conversion guarantee this time has strong similarities with 2018, and it all happened with the sharp fluctuation of the US-Hong Kong interest rate differential. Due to the rapid rate hike by the Federal Reserve, the rate of interest rates in the Hong Kong market has been rising relatively slowly, resulting in a rapid increase in the interest rate gap between the United States and Hong Kong. The Hong Kong dollar exchange rate transitioned from the strong-side guarantee level to the weak-side guarantee level after one and a half months. The HKMA began to consume foreign exchange reserves to withdraw Hong Kong dollars from the market, resulting in a rapid decline in the aggregate balance of banks, tightening market liquidity, and accelerating the rise of interest rates in the Hong Kong market, but it was not enough to catch up with the pace of the Federal Reserve’s interest rate hike. In fact, after 2005, the exchange rate of the Hong Kong dollar to the weaker side all happened during the Fed rate hike cycle, and there was a clear correlation between the exchange rate of the US dollar against the Hong Kong dollar and the US-Hong Kong spread.
  The main reason why the market is worried that the linked exchange rate system is unsustainable is that the adjustment mechanism of the linked exchange rate system will fail: if the market loses confidence in the Hong Kong Monetary Authority’s maintenance of the exchange rate within 7.85, even if Hong Kong’s liquidity tightens and interest rates rise sharply, it will not stop the market. A large amount of capital outflows may lead to insufficient foreign exchange reserves to cope with it, which may lead to the failure of the linked exchange rate system.
  At present, the possibility of Hong Kong’s linked exchange system falling apart is very small, mainly due to four reasons:
  First of all, judging from the experience in 2018, when the aggregate balance of the Hong Kong banking system falls below HK$100 billion, it will have a greater impact on the inter-bank market interest rate and trigger banks to raise loan interest rates. When the Hong Kong market interest rate and the US market interest rate converge, the depreciation pressure of the Hong Kong dollar will be significantly relieved. Secondly, at present, the scale of the base currency in Hong Kong is much larger than that in 1997/1998, which brings a high threshold for international capital to drive up interest rates in the Hong Kong market. If its capital volume is not enough to significantly raise the interest rate level in the Hong Kong market, it will not pose a strong threat to the linked exchange rate system. Thirdly, the scale of Hong Kong’s foreign exchange reserves and the support of the mainland have the ability to ensure the operation of the linked exchange rate system.
  Finally, Hong Kong, as an important gateway for Mainland China’s financial opening to the outside world, needs the support of the linked exchange system to maintain its status as an international financial center. With its courts and independent regulators more closely aligned with the common law system, Hong Kong is a link between mainland China and the global financial system. The linked exchange system, which makes the Hong Kong dollar and the US dollar “equivalent” (ensures that the Hong Kong dollar and the US dollar are fully interchangeable), provides key support for Hong Kong’s status as an international financial center. According to The Economist, the latest figures show that 97% of foreign exchange transactions, 58% of cross-border loans and other banking instruments, 43% of cross-border derivatives and 37% of deposits in Hong Kong are denominated in US dollars. Therefore, in order to maintain Hong Kong’s status as an international financial center, it is necessary to maintain the operation of the linked exchange rate system.
  This time when the Hong Kong dollar triggers the weak-side exchange guarantee, there are really two issues that need to be paid attention to:
  First, the impact on the Hong Kong economy. The increase in interest rates in the Hong Kong market this time may lead to an increase in the bank’s best lending rate of more than 25bp. Since the beginning of this year, Hong Kong’s GDP has experienced negative year-on-year growth for two consecutive quarters, which is even weaker than the economic fundamentals when Hong Kong banks raised the prime lending rate in September 2018. At that time, Hong Kong’s GDP growth rate was 2.6% year-on-year, which appeared after the rate hike. Continued declines and negative turns. The unemployment rate in Hong Kong has risen again since February this year, reaching 4.7% as of June, much higher than the 2.8% maintained from March 2018 to July 2019. It can be seen that if the loan interest rate of Hong Kong banks rises more significantly this time than the last time, the negative impact on the Hong Kong economy may be more obvious.
  Real estate (including property ownership) is an important pillar of Hong Kong’s economy, accounting for 19.6% of Hong Kong’s real GDP in 2021. Historically, every time a bank raises interest rates, Hong Kong housing prices turn from positive to negative year-on-year. Since February this year, the price index of private residential properties in Hong Kong has been negative year-on-year for five consecutive months.
  In addition, as a highly open port city, import and export trade and logistics play an important role in Hong Kong’s economy. Affected by factors such as the new crown epidemic, since March 2022, Hong Kong’s export trade has also shown great downward pressure. The three-month average seasonal adjustment of its overall export value has experienced a significant negative growth for four consecutive months, which is the highest since 2008. The largest month-on-month decline, while trade and logistics accounted for 19.8% of Hong Kong’s GDP in 2020. The resulting downward pressure on Hong Kong’s economy cannot be underestimated.
  Second, Hong Kong’s status as an international financial center faces competition from Singapore. Since 2017, Singapore’s global AUM has surpassed Hong Kong’s benchmark. With the expansion of its assets under management, there may be a trend of transferring to Singapore in the future for international capital that wants to invest in other Asian countries. This diversion effect may slow down the inflow of foreign capital and have a medium- and long-term impact on the exchange rate of the Hong Kong dollar.