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Hong Kong Dollar Bears Are Curiously Quiet. Thank the UK

If there’s one city in the world that has reason to welcome the latest bout of global currency turmoil, it’s Hong Kong. With Britain shooting down the pound, Japan intervening to support the yen for the first time in almost a quarter-century, and Europe’s single currency reaching a two-decade low, there’s less attention on the Chinese territory’s 39-year-old dollar peg.

And that, surely, is how the technocrats at the Hong Kong Monetary Authority want it.

Let’s be clear: The peg isn’t going anywhere, at least in the near term. But it has been a popular speculative target of hedge fund traders in the past, from George Soros to Bill Ackman to Crispin Odey, and so the current quiet is notable. Apart from some low-level chatter, there’s been no sign of a marquee bet by a high-profile name or a building wave of bearishness against the linked exchange-rate mechanism.

The implied volatility on Hong Kong-US dollar options — a measure of how costly it is to bet against the peg using these derivatives — has risen somewhat this year, but it remains below its pre-pandemic levels in 2019 and in 2016.

That’s a little surprising, given that conditions look potentially less favorable for the peg than at any time since the 1997-1998 Asian crisis. After a long period following the 2008 global financial meltdown, during which Hong Kong was a beneficiary of near-zero US interest rates, the cycle has decisively turned. Economic pain is here already. More looks almost certain to be on the way.

Any economy that runs a peg tying the value of its currency to another country’s effectively outsources its monetary policy. In return for the anchor of currency stability, the peg operator gives up control of domestic interest rates and money supply, tracking the policy decisions of its counterpart central bank. In the case of dollar pegs, that’s the Federal Reserve (the Saudi riyal and the United Arab Emirates’ dirham are among other currencies fixed to the US unit). For a small, open trading economy and financial center such as Hong Kong, this arrangement can make a lot of sense. However, it comes at a price.

Unless economic cycles are perfectly aligned, there’s always a risk of importing policies that are either too loose or too tight. For instance, if the US is growing strongly and Hong Kong is in recession, then the level of interest rates is likely to be higher than the city would prefer; and vice versa if the Fed cuts rates to stimulate the economy while Hong Kong is already expanding rapidly.

When too loose, things will (all else equal) tend to run hot and asset prices will appreciate. The flip side is less fun. When policy is too tight, funds drain out and asset prices fall. This is where Hong Kong finds itself now. The city’s foreign-exchange reserves have dropped 13.6% since November last year (though they remain ample to cover the monetary base), property prices are turning down after a long boom, and the benchmark Hang Seng Index of stocks has slumped to an 11-year low. 

The system is intensely pro-cyclical, removing liquidity just when it’s needed and adding it when things are already frothy. In effect, the volatility that is usually absorbed by a floating exchange rate is instead transferred to the domestic economy. Because the value of the currency can’t change, property and stock prices have to adjust instead.

The best way to see just how out of kilter Hong Kong is compared with the US right now is to look at relative inflation rates. The chart below uses moving averages to smooth out the peaks and troughs. Even so, it’s immediately clear how radically the US has moved apart:

Hong Kong hardly needs higher interest rates, yet it has no choice but to keep following the Fed’s tightening if it wants to maintain the peg. Meanwhile, the territory’s economy has shrunk for the past two quarters; Covid-19 restrictions have ravaged local businesses; housing prices have fallen for 11 consecutive weeks; and a record exodus of residents left the city in the 12 months through June amid Communist Party-imposed political changes. What’s more, China’s economy is also struggling and the yuan is its weakest since 2008, adding depreciation pressure.

The Fed is also far from done. Back in July, futures markets expected the fed funds rate to top out at 3.3% and to be falling by mid-2023. After a shocker of an August inflation report, they now predict a peak of almost 4.5%. If US inflation continues to disappoint on the upside, the pain will get worse for Hong Kong. The one-month Hong Kong interbank offered rate, against which many mortgages are priced, has risen by 2.4 percentage points since the end of May. It looks certain to go higher, judging by its Libor equivalent.

So why not just ditch the peg? There are multiple reasons. The yuan, not being fully convertible, isn’t a viable alternative. China may be trying to bind the former British colony closer to the mainland, but having Hong Kong as an offshore fundraising center still suits the country’s economic interests. Above all, there is hard-won institutional and market credibility — most notably during and after the Asian financial crisis, when the territory endured five years of deflation and a near-70% decline in property prices while holding the line on the currency. The city won’t give up that reputation easily.

Hong Kong dollar bears have long discounted these arguments. But why take on a tough and canny adversary like the HKMA when British government ministers are so accommodating? Speculators will doubtless be back at some point when the easier pickings have dried up. In the meantime, Hong Kong’s monetary chiefs can raise a glass to Liz Truss and Kwasi Kwarteng.

More From  Bloomberg Opinion:

Kyle Bass Takes on a Widowmaker Currency Trade: Mark Gilbert

Don’t Fret for Hong Kong’s Dollar Peg Just Yet: Matthew Brooker

The Hong Kong Dollar’s Peg Has Become Untenable: Richard Cookson

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Matthew Brooker is a Bloomberg Opinion columnist covering finance and politics in Asia. A former editor and bureau chief for Bloomberg News and deputy business editor for the South China Morning Post, he is a CFA charterholder.

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