What’s to become of the Hong Kong dollar? While peers such as Singapore have seen their currencies rise by as much as 40% against the US dollar over the past decade, Hong Kong remains firmly pegged to the greenback.
Some think this is set to change. The always headline-hungry hedge fund manager William Ackman says he’s buying options as a bet on a revaluation. And I know some MoneyWeek readers are pondering the same thing.
But I think it’s a long shot. If Ackman makes money, it will probably be by selling his options to others following him into the trade. Let’s see why revaluing the Hong Kong dollar is not as easy as it looks.
A very unusual currency
First, let’s take a quick look at the history. The Hong Kong dollar traded at a fixed exchange rate against sterling until the Bretton Woods currency system began to collapse in the early 1970s. From 1974-1983 it floated freely, but this proved difficult to manage.
So in 1983, the territory adopted a fixed rate against the US dollar, since the US was then its largest trade partner. This has remained in place ever since. The exchange rate is around HK$7.8 – technically a very narrow band of HK$7.75-7.85.
Although for simplicity we often say the Hong Kong dollar is pegged, Hong Kong actually uses a stronger form of link called the Linked Exchange Rate System (known as a currency board in most other countries that use it). Under this system, the whole stock of notes and coins in circulation is backed by US dollars at the fixed exchange rate, held in the territory’s reserve fund.
Hong Kong has never had a formal central bank – indeed, during its experiment with a free-floating currency, HSBC performed many of the stabilising functions normally associated with one. However, the de facto central bank today is the Hong Kong Monetary Authority (HKMA), which runs the reserve fund and underpins the exchange rate system, buying or selling Hong Kong dollars whenever the exchange rate moves to the edge of the band.
But unlike most countries where the central bank controls the size of the monetary base, this is mostly done by three local commercial banks (HSBC, Standard Chartered and Bank of China Hong Kong). They issue banknotes and have to provide the equivalent amount in US dollars to the reserve fund. HKMA only issues a small amount of the currency in circulation.
I’m not going to go into lots of detail about how the system works. But essentially, the fact that the monetary base must be fully backed by US dollars means that it’s the size of the monetary base and local interest rates rather than the exchange rate that respond to inflows and outflows.
That means that it’s hard (perhaps impossible) to break a currency board as long as maintaining the exchange rate is the only priority. But those changes in interest rates and the monetary base can result in price or asset inflation, which may be difficult to tolerate. And that’s exactly Hong Kong’s current problem.
The Hong Kong dollar is too popular
Normally, a currency peg cracks when too much money is leaving the country and the central bank can no longer defend its chosen exchange rate by using its reserves to buy back its currency. The 1997-1998 Asian crisis had many examples of countries being forced to abandon pegs because of this.
But the Hong Kong dollar has the opposite problem. Too much money is flowing into the Hong Kong economy and its US dollar fixed exchange rate means that the currency can’t rise to mitigate the effects.
This is causing inflation in consumer prices, now rising at its fastest rate since 1995. And it’s also creating what looks like a bubble in real estate prices (although money flowing in from mainland China is also playing a major part).
Many also argue that the peg is making the Hong Kong economy unstable, with the real estate boom being an example of this. The currency system means Hong Kong cannot set interest rates independently, but must match policy in the US.
While the Hong Kong and the US economies boomed and bust together, this was fine. But today, the link between the two is weaker. Hong Kong is more closely linked to mainland China and needs to be able to adjust policy to match conditions there.
What are the alternatives?
But abandoning the peg is easier said than done. Policymakers argue that as a small, open and trade-dependent economy, Hong Kong would find a floating exchange rate too volatile. It needs some kind of peg to give it stability.
That peg needs to be completely credible, especially given its status as a financial centre. The current arrangement has lasted almost three decades. It was the only fixed exchange rate to survive the Asian crisis. It would be reckless to throw away this hard-won stability, say policymakers.
In addition, changing the peg would not be a winning move for everyone. For example, many Hong Kong residents have US dollar assets. Banks have made loans in US dollars. These investments were made on the basis that the peg would remain intact. If the HKD is allowed to rise, they will take losses.
And of course, there’s the problem of what the current peg could be replaced with. Some argue for a peg to the renminbi. But the renminbi is still a controlled currency.
Renminbi deposits are building up in Hong Kong. This is actually putting its own strain on the financial system there, since residents’ preference for holding renminbi means that banks are struggling to attract Hong Kong dollar deposits to fund Hong Kong dollar loans. But there aren’t enough renminbi deposits and renminbi investments available for a renminbi standard to be practical.
Some analysts have suggested a synthetic renminbi peg – ie the Hong Kong dollar’s exchange rate to the US dollar is set at whatever the renminbi’s exchange rate is. But this would presumably worsen the flows into Hong Kong, because the Hong Kong dollar would then be a tradable proxy for the renminbi.
What about a big one-off revaluation against the dollar – say 15% – to deal with the Hong Kong dollar’s apparent undervaluation? This would only be a temporary solution. And if done once, it would encourage markets to bet on further revaluations.
The most practical solution is probably a peg against a basket of other currencies. This would mean Hong Kong is no longer hitched to the US dollar. The renminbi could be a small part of the basket, rising in weight as it becomes more tradable.
The system could be designed to allow the Hong Kong dollar to steadily rise against the basket when inflows pick up, dampening their impact. But it would be a major step given the importance of the current system and the HKMA clearly doesn’t want to rush into anything.
Should you bet on the Hong Kong dollar?
Can the US dollar peg last indefinitely? Almost certainly not. Hong Kong will have to change at some point.
How to do so is undoubtedly being discussed. And I don’t imagine that we’d get much notice of the change. The HKMA will probably deny that anything is happening up until the last minute, then we wake up to find a new system in place.
But my opinion is that this will not happen tomorrow. We’re more likely to be talking five years than five months. And that means that I don’t see betting on the peg breaking to be very attractive at the moment.
The downside for the Hong Kong dollar is probably pretty limited. No trade is ever a one-way bet, so I can’t say that there is no prospect of it devaluing against the US dollar in a crisis. But it seems unlikely: after all, it made it through the Asian crisis without doing so.
However, getting any upside is awkward. If an unpegging is years away, using options, futures or spreadbetting is likely to steadily lose you money.
Holding cash in Hong Kong dollars doesn’t present quite the same problems. But as long as the US dollar peg remains in place, British or other non-US investors holding cash are simply taking a position on the US dollar by doing this.
With interest rates negligible, you’re not earning much. And you’re incurring opportunity costs, since that money could be invested elsewhere.
Instead, if you’re willing to take on the additional risk of shares, consider buying Hong Kong stocks. Look for good quality dividend-paying firms, get some income (unlike cash) and treat any currency gains from an eventual unpegging as a useful bonus.
Alternatively, if you want to invest in currencies, the Singapore dollar operates in much the way that I’d expect the Hong Kong dollar to eventually do: it’s pegged to a basket of currencies and is allowed to rise against them over time.
I doubt we’ll see much currency appreciation there in the next few months. The Monetary Authority of Singapore will probably opt for stability in this kind of climate. But it seems a better medium term bet for appreciation than Hong Kong.