Continuing to Defend Currency Peg to US Dollar May Be ‘Dangerous’ for Hong Kong: Expert

Yuan’s depreciation against US dollar impacts Chinese economy

Hong Kong's economic cycle increasingly resembles that of mainland China, but its financial sector continues to follow the pace of the Fed’s interest rate hikes, placing it in a challenging position. AFP

Hong Kong’s latest foreign currency reserve showed another $10.014 billion drop in August, down from July’s $441.8 billion, pushing the accumulated reduction since last December to $67.563 billion.

On Sept. 30, the Hong Kong Monetary Authority (HKMA), the city’s central bank, released an analysis of the city’s foreign currency reserves and foreign currency liquidity. The data showed the city’s foreign currency reserves had shrunk to $431.821 billion at the end of August, from $499.384 billion at the end of November 2021.

According to the Half-Yearly Monetary and Financial Stability Report (pdf) issued by HKMA in September, the currency’s weak-side Convertibility Undertaking (CU) was triggered 31 times during the review period from the end of February to the end of August.

Since Oct. 17, 1983, Hong Kong has used the Linked Exchange Rate System (LERS). The system allows the HKMA to stabilize exchange rates from the U.S. dollar to the Hong Kong Dollar (HKD) between 7.75 and 7.85, also known as the Convertibility Undertaking (CU). As a currency pegged to the USD, the HKD’s strong-side CU is 7.75 to one U.S. dollar, and the weak-side CU is 7.85.

The HKMA report said that the HKD “traded within a range between 7.814 and 7.850 against the [USD]” during the review period, adding that “since the first triggering of the weak-side CU on [May 11 (U.S. local time)], the HKMA has purchased a total of $HKD 213.1 billion (as [of] the end of August) at the request of banks in accordance with the design of the linked Exchange Rate System.”

Challenges Ahead for Hong Kong Dollar

The report warned the HKD would likely face a multitude of challenges as it copes with aggressive U.S. dollar rate hikes amid high inflation.

“Looking ahead, fund flows may be subject to heightened volatilities amid elevated uncertainties on various fronts, including the pace of U.S. monetary policy normalization, the evolving pandemic developments, and the lingering geopolitical tensions,” the report states.

Albert Song, a senior financial analyst and expert on the Chinese financial system, told The Epoch Times that the climate is increasingly “dangerous” for Hong Kong’s financial system as the HKD remains pegged to the U.S. dollar amid the Fed’s interest rate hikes.

“Hong Kong’s economic cycle is becoming more and more similar to that of mainland China, but its financial sector is following the pace of the Fed’s interest rate hikes, which has already impacted Hong Kong’s property market and economy. To defend the currency peg, the HKMA will have to continue selling USD to buy HKD,” Song said.

“In fact, the Hong Kong dollar is in its most dangerous position.”

Yuan Depreciates Despite Official Optimism

China, which relies heavily on Hong Kong as a financial gateway for foreign currency reserves, has no way to fend off the impact of its depreciating currency.

Although the Chinese yuan has depreciated sharply against the U.S. dollar since August, a press release from the People’s Bank of China (PBC) claimed that “the yuan exchange rate has remained basically stable at an adaptive and equilibrium level.”

The press release reported the findings of a national virtual conference on Sept. 27, hosted by the China Foreign Exchange Market Self-Regulatory Framework (SRF), a central bank-led self-regulatory group. The conference aimed to analyze recent developments in the foreign exchange market.

It added that the yuan is “one of the few strong currencies in the world, [as it] strengthened markedly against the Euro, British pounds and Japanese yen.”

However, the following day, the onshore Chinese yuan exchange rate to the U.S. dollar (USD) hit its lowest level since 2008 by crossing the 7.2 level on Sept. 28. The rate is also its weakest offshore exchange rate since 2011.

Depreciation May Trigger Sell-off

Regarding the currency’s value, Song told The Epoch Times that the yuan’s depreciation would make yuan assets less attractive and may cause investors to sell off.

“With a widening interest rate differential between the U.S. and China, capital outflow will become more severe, bringing China’s foreign exchange reserves lower. China requires more than $800 billion a year to import energy, [semiconductor] chips, and food,” Song said.

“The increase in raw material prices will also cost more foreign currency, so those Chinese industries relying on imported raw materials will be in a worse position.”

Export Sector ‘Trapped’ by Rising Prices, Supply Chain Issues

Song noted that some Chinese economists believe the yuan depreciation will benefit Chinese exports, but the reality may be the opposite.

“Theoretically, the depreciation of yuan is beneficial to foreign trade exports, but the benefit will not be visible to the export sector immediately. Furthermore, the export sector will be trapped by the increase of raw material prices and the lack of [a] smooth logistics supply chain caused by the [regime’s] zero-COVID policy,” Song said.

Guan Tao, the global chief economist at BOC International, a securities firm and wholly owned subsidiary of the Bank of China, shared a research report on Sina Opinion Leaders on Sept. 30, investigating how the export sector would be affected by yuan depreciation.

“Foreign demands have a much greater impact on Chinese exports than low exchange rates, so don’t expect too much that the yuan depreciation could benefit Chinese exports.”

To stabilize foreign exchange market expectations, China’s central bank raised the foreign exchange risk reserve ratio from zero to 20 percent, effective from Sept. 28.

“China’s central bank has recently taken measures to guide market expectations, such as raising the reserve requirement ratio for foreign exchange deposits. But the most effective way to manage the yuan exchange rate is still to sell USD and buy yuan, which in turn will cause the foreign exchange reserves to fall,” Song added.