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FXTrading.com \ FXT Analysis \ Will Hong Kong Continue Defend its Dollar Peg?

Will Hong Kong Continue Defend its Dollar Peg?

The US dollar has seen robust appreciation since the start of the year, after the Federal Reserve took the lead in adopting hawkish monetary policy to contain a prolonged episode of breakneck inflation unforeseen by its senior officials.  

The rapid appreciation of the dollar is highly disruptive for international markets and can cause immense pain for emerging economies. This is most particularly the case for developing nations that have borrowed copiously in the US dollar, as the weight of their debt burden further increases whenever the greenback appreciates.   

The rising value of the US dollar also has the potential to create problems for any economies that have pegged their own currencies to the greenback.  

This is because in order to maintain the peg, central banks need to tether their monetary policy decisions to those of the US Fed. The Fed’s monetary policy decisions may be completely unsuited to local economic circumstances however, and can even run contrary to their interests.   

Such may be the case right now in the financial hub of Hong Kong, which since 1983 has implemented a linked exchange rate system to keep the Hong Kong dollar in a range of HK$7.75 to HK$7.85 to the US dollar.   

In order to maintain the peg and match the monetary policy decisions of the Fed, the Hong Kong Monetary Authority (HKMA) is raising interest rates and reducing liquidity in the onshore banking system by buying up Hong Kong dollars.   

At present, however, the Hong Kong economy is in a completely different set of circumstances compared to the US. While the US has battled breakneck inflation since the start of the year, Hong Kong’s composite consumer price index climbed by a mere 1.9% YoY in August. YoY inflation in Hong Kong did leap to 4.1% in September, but it still remains well below US levels which continue to hover above 8%.  

Consequently, the HKMA is not subject to the same exigent need as the US Fed to crush inflation with interest rate hikes.   

If anything, the Hong Kong economy could do with looser monetary policy to deal with the economic pressures created by China’s insistence on maintaining a Zero Covid policy, as well as the adverse impacts on the local finance and tourism sectors caused by the intense spate of civil and political unrest just several years ago.   

While inflation has been moderate, Hong Kong’s economy has performed poorly in 2022. GDP shrank 1.3% in the second quarter of 2022 in annual terms, following a contraction of 3.9% in the first quarter.   

Yet efforts by HKMA to maintain the peg by purchasing local currency have seen interbank liquidity shrink 70% since May, severely impeding the ability of the financial system to provide support to the economy. Hong Kong’s aggregate balance – a measure of interbank liquidity – stood at around HK$100 billion on 21 October, as compared to HK$330 billion in May.   

Given the problems created by emulating the Fed’s hawkish tenor while facing an entirely different set of economic conditions, speculation has emerged that Hong Kong could break the dollar peg in order to achieve monetary policy independence.   

Other observers point out however, that the dollar peg is essential to Hong Kong’s financial stability and its status as an international financial hub, by creating a currency that is both stable and highly convertible. This makes it highly appealing to international investors in a way that the Chinese yuan isn’t, given the imposition of capital controls by Beijing.  

Hong Kong also retains ample foreign reserves at its disposal to defend the dollar peg, with around $431.8 billion as of the end of August.