Hong Kong Raises Interest Rate, its USD-Pegged System May Detonate Asset Bubble

A man walks past a dollar sign in Hong Kong, on Jan. 31, 2008. Ted Aljibe/AFP via Getty Images

The Hong Kong Monetary Authority (HKMA) recently announced an interest rate hike after the region’s foreign exchange reserves hit a two-year low. Stabilization of the HKD exchange rate would eat into many foreign exchange reserves, and create a pressing threat to the assets bubble, experts warned.

HKMA’s move comes the day after the Federal Reserve announced on May 4 a 50-basis point interest rate hike and  a shrinking of its balance sheet.

On May 5, HKMA said that it would raise the prime rate by 50 basis points to 1.25 percent in accordance with a pre-set formula, effective immediately.

The formula is part of the Linked Exchange Rate System (LERS) used to fix the exchange rate between the HKD and the USD to 7.75-7.85:1 through the automatic interest rate adjustment mechanism and currency board system.

LERS was implemented in Hong Kong on Oct. 17, 1983, playing a significant role as “the cornerstone of the region’s monetary and financial stability,” the HKMA said on its website.

Speaking of the U.S. interest rate hike, Eddie Yue, president of the HKMA, said that it will widen the interest rate differential between Hong Kong and the United States, triggering arbitrage transactions under the LERS, and driving capital flow out of the HKD to the USD, so the HKD exchange rate will weaken accordingly; but it is a normal phenomenon, Yue said.

Arbitrage transaction refers to a strategy of buying an asset in one market while at the same time selling it in another market at a higher price to earn a profit.

While admitting that this round of capital outflow will be faster than ever before, Yue stressed that the Fed’s rate hike is within market expectations and will not affect the financial and monetary stability of Hong Kong, citing that there are considerable exchange funds bolstering Hong Kong’s LERS to secure the global economic hub’s financial environment, according to Chinese Communist Party-backed Xinhua news media on May 5.

However, HKMA on May 5 released the latest data showing that at the end of April, foreign currency reserves stood at $465.7 billion, down $15.9 billion from the end of March, hitting the lowest amount since December 2020.

A woman exchanges money at a currency exchange shop in Hong Kong on Sept. 15, 2011. Hong Kong said it has no plans to unpeg its currency from the US dollar, amid growing calls to end the 28-year peg to allow the Hong Kong dollar to appreciate against the greenback. Laurent Fievet/AFP via Getty Images

Albert Song, a political and economic researcher familiar with China’s financial system, told The Epoch Times on May 7 that the Federal Reserve would further increase interest rates to ease inflation, and the HKMA would strictly follow the Fed’s move given its HKD-USD pegged LERS.

But in this case, HKMA has to release enormous foreign exchange reserves to stabilize the Hong Kong dollar exchange rate, which Hong Kong’s current financial status is seemingly unable to afford, according to Song.

LERS is somehow Hong Kong’s financial defense. If it fails to hold its linked exchange rate of 7.75-7.85, Hong Kong would find it hard to withstand the impact of an economic recession, Song said.

Additionally, it will pose a sharp threat to the asset bubble of Hong Kong, even ripping the global assets bubble, as Hong Kong is a typical international market. “Therefore, highly leveraged, and highly indebted groups should be wary about it, especially those with poor income stability,” Song added.

Based on the LERS, the HKMA is required to provide a Convertibility Undertakings (CU). HK$7.75 is the “strong-side CU” while HK$7.85 is the “weak-side CU.”

When the outflow of funds from the Hong Kong dollar weakens the market rate to the “weak-side CU,” the HKMA stands ready to buy Hong Kong dollars from banks to push up the local currency interest rate and bring it back to the level of between 7.75 and 7.85. That is, the HKMA commits to selling Hong Kong dollars to the bank for U.S. dollars when the exchange rate is 7.75, otherwise, it will buy Hong Kong dollars and sell U.S. dollars at the banks’ request when the exchange rate is 7.85.