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Hong Kong’s Financial System Remains Stable
The Hong Kong Monetary Authority (HKMA) has intervened after months of weakness in the Hong Kong Dollar (HKD) to maintain the HKD
- The mechanism for Hong Kong’s peg with the US dollar remains intact. Though aggregate balance has fallen throughout 2022, Hong Kong’s foreign exchange (FX) reserve is still large, with more than enough to cover the size of its monetary base, M0.
- If the US imposes financial sanctions against Hong Kong, then the HKD may have to be pegged with the Chinese Yuan. However, we see this as an unlikely black swan event.
Hong Kong’s Linked Exchange Rate System Still Robust
There have been many concerns regarding Hong Kong’s ability to maintain its currency peg with the dollar in recent months due to the fastest rate hike cycle in the US this year, recent capital outflows, and rising tension between US and China.
The HKD has been pegged to its counterpart USD since 1983 and trades within a permitted range of 7.75 to 7.85 HKD per USD. The stability of the Hong Kong Dollar exchange rate is maintained through an automatic interest rate adjustment mechanism and commitment by the HKMA.
This year’s strengthening of the USD and the weak side of the Convertibility Undertakings (CUs) has triggered intervention by the HKMA to uphold the peg. As a result, Hong Kong’s foreign exchange reserves have fallen, and interest rates in Hong Kong have recently started to rise.
Some investors confused the aggregate balance (a component of the Monetary Base) with the foreign exchange reserve. They worried that with the fast decline of the aggregate balance, the reserve might be depleted, and hence the peg might break down.
In fact, the aggregate balance is the sum of balances in the clearing accounts and reserve accounts maintained by commercial banks with the central bank. It represents the level of interbank liquidity. When the banking system is flooded with liquidity, the aggregate balance increases; when Hong Kong dollars flow out, the aggregate balance falls. Less interbank liquidity means local commercial banks have to raise interest rates (following the US rate cycle) to halt capital outflows and alleviate the downward pressure on the Hong Kong dollar.
Meanwhile, Hong Kong’s foreign exchange (FX) reserves are still large, more than enough to cover the size of Hong Kong’s monetary base, M0.
Change of System is a Black Swan Event
Hong Kong’s peg with the US dollar aligns with its national strategies and cements its position as a global financial centre. In Hong Kong Chief Executive John Lee’s recent maiden policy dress, he reaffirmed and introduced measures to enhance Hong Kong’s competitiveness as an international financial centre, to attract top global talent and enterprises. However, earlier this year, Financial Secretary Paul Chan and HKMA Chief Executive Eddie Yue did warn that Hong Kong must plan for various risks after the US weaponized SWIFT to sanction Russia.
In a nutshell, we don’t think it’s in the best interest of the Hong Kong government to disrupt the current dollar peg system and it will not seek to change the arrangement. However, in the event of an extreme scenario with the US imposing financial sanctions against the Hong Kong Special Administrative Region (SAR), the Hong Kong dollar might have to be pegged to the Chinese Yuan.
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