Stabilizing Currency Peg to US Dollar May Be Too Costly for Hong Kong This Time: Expert

Hong Kong and US dollars in Hong Kong on Jan. 12, 2008. The Hong Kong dollar is a currency pegged to the U.S. dollar. Under the LERS, HK$1,000 is worth USD$ 127 as of Jul. 22, 2022. Laurent Fievet/AFP/Getty Images

Hong Kong’s central bank has spent over $22 billion in ten weeks to stabilize the exchange rate of the Hong Kong dollar (HKD) amid weakening market confidence in the city’s currency.

Since May 2022, the Hong Kong Monetary Authority (HKMA), the city’s central bank, has bought HKDs at its fastest pace to keep the U.S. dollar’s (USD) maximum convertible to the HKD at 7.85.

Since Oct. 17, 1983, Hong Kong has adopted the Linked Exchange Rate System, allowing the HKMA to stabilize exchange rates from the U.S. dollar to the 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 $1 U.S. dollar, and the weak-side CU is 7.85.

To cope with the aggressive U.S. dollar rate hikes since May, the HKMA has been requested to buy over HK$170 billion—about $22.1 billion—from note-issuing banks to stabilize the exchange rate of HKD.

Recently, concerns emerged about the dwindling funds available for the central bank to prevent the HKD from crossing to the weak side of the CU.

“Hong Kong peg defense reserves dwindling due to the HKMA’s buying HKD to prop up the failing peg—excess reserves down 44 percent since May,” Kyle Bass, one of America’s most widely respected hedge fund managers, wrote on Twitter on July 19.

“At the current rate of decline, peg defense reserves could be exhausted by the end of August or sooner.”

On July 22, Eddie Yue, the chief executive of the HKMA, issued an article aimed at dismissing “rumors” about the Linked Exchange Rate System (LERS). Yue did not specify what rumors he was trying to dismiss, but he said they were “groundless” and “even malicious.”

However, back in 2019, Bass had warned investors about the HKD’s potential downfall.

“Today, I’m releasing our views on the financial, political, and legal plight of Hong Kong. I think investors that have assets invested there should immediately move them into USD before it’s too late,” Bass wrote on Twitter on May 23, 2019. It was also his top pinned Twitter post of the day.

In the pinned tweet, Bass shared his April 2019 article, The Quiet Panic in Hong Kong.

“The economy that has selected to peg (HK) to the anchor currency (USD) must import (or mirror) the monetary policy (primarily interest rates) of that country. This means that if overnight rates diverge between the two, the divergence will cause large capital flows one way or the other, which immediately puts pressure on the currency board/peg,” the article read.

According to the design and operation of the LERS, more capital will flow out of the HKD market when “the differentials between the higher U.S. dollar interbank rates and the lower Hong Kong dollar interbank rates [widens],” it read. Hence, whenever the Federal Reserve increases its interest rate, the HKMA must follow suit.

New Record

Although the LERS has survived several economic cycles and global financial crises, the recent buying of the HKD has set a record for the HKMA.

On July 22, the closing aggregate balance (AB) dropped from approximately HK$11.2 billion ($1.5 billion) to HK$165.26 billion ($21.1 billion)—a record drop.

The AB refers to the sum of the balances in the clearing accounts maintained by the banks with the Hong Kong Monetary Authority (HKMA), representing the interbank liquidity, as defined by BNP Paribas, a France-based commercial banking group. The AB directly relates to the exchange rate of HKD to USD.

When market demand for HKD decreases and the HKD exchange rate slides to the weak side of the CU (7.85 HKD per USD), in this case, the HKMA—upon banks’ requests—commits to sell USD and purchase HKD from banks. Consequently, the AB will drop, and the HKD interbank rates will rise, thus stabilizing the HKD exchange rate within the CU.

Currently, the market demand for HKD is low, and the exchange rate of HKD is still lingering around the weak side of the CU band, which means that funds will continue flowing out of the HKD system, and the HKMA will have to keep the pace of buying HKD to defend the currency peg.

At the end of June, Hong Kong’s foreign currency reserves dropped to $447.3 billion—a decrease of $49.6 billion in the first six months of 2022.