FX Watch – HKD peg to hold

by: Roy Teo , Arjen van Dijkhuizen

FX-watch-HKD-peg-to-hold.pdf ()

We expect the Hong Kong dollar (HKD) peg to the US dollar to hold in the coming years. Since 1983, the peg under the currency board served as the cornerstone for Hong Kong’s monetary policy. Market speculation that the HKD will be revalued stronger has faded recently. We judge that the HKD peg is more sustainable than the Swiss EURCHF floor, which was abandoned earlier this year. Obviously, the lack of freedom in monetary policy also brings certain risks. In the remote future, there is the possibility that the Hong Kong Monetary Authority (HKMA) will change the exchange rate regime to better reflect its trading partners, but not before China has fully liberalised its capital account and the Chinese yuan is fully convertible.

HKD peg to hold

After the Swiss National Bank (SNB) removed the Swiss franc (CHF) cap to the euro on 15 January 2015, there has been some market speculation that the HKMA will also be pressured to abandon the HKD peg to the US dollar (USD). This is reflected by a threefold increase in the options market demand to hedge and/or speculate further strength in the HKD. However such speculation has faded since the last week of February. This is also illustrated in the HKD spot rate which has eased slightly from the stronger limit of 7.75-7.85 trading band. We maintain our view that the HKD peg to the USD will hold for reasons further elaborated below. We will first give a brief overview of economic developments and some insights into Hong Kong’s currency board regime.

Economy has slowed in 2014

Hong Kong’s economy slowed to 2.2% yoy in Q4 of 2014, down from 2.7% yoy in Q3. This brought annual growth at 2.3% in 2014, down from 2.9% in 2013. There has been some impact of the social turmoil that broke out in the summer after Beijing made clear that only pre-approved candidates can run for the post of Chief Executive in 2017. The protests lasted for several months, but have not caused a wide disruption of the business environment and economic activity. Hence, although revenues from tourist visits have come under some pressure, the overall effects look rather temporary so far. The Manufacturing PMI dropped below 50 in the aftermath of the turmoil (to a trough of 47.7 in October), but has recovered since reaching a one-year high of 50.7 in February.

Slight acceleration expected in 2015/2016

Looking ahead, we expect economic growth to slightly accelerate to 2.5% in 2015 and 3% in 2016. We expect Hong Kong to profit from the pick-up in advanced economies. The regional trade hub’s economy is extremely trade-oriented (goods exports alone were 180% of GDP in 2014), with the US and Japan being the second and third largest export destinations. However, the ongoing gradual slowdown in Hong Kong’s largest export destination (China, 55% of exports in 2014) will keep a lid on growth.

HKD Chart 1

Currency board and peg provide nominal anchor …,

Since 1983, Hong Kong operates a currency board regime, which forms the basis for the peg of the Hong Kong dollar to the US dollar (7.8 HKD = 1 USD). A currency board ensures absolute, unlimited convertibility of the pegged currency and the anchor currency and  requires that foreign currency reserves must be sufficient to ensure full convertibility. Hong Kong’s Basic Law and the Sino-British Joint Declaration prescribe that Hong Kong will have full autonomy with respect to the currency regime. Given its small and very open and trade-oriented economy, the authorities have always sticked to the nominal anchor that the currency board and USD peg provides, even during extreme hectic times such as the Asia crisis in the 1990s.

… but also pose some risks

Although the exchange rate peg under the currency board has served Hong Kong well, the lack of  room for discretionary monetary policy also poses some risks. First, under the peg a relatively high inflation in Hong Kong risks the erosion of external competitiveness. The HKD’s real effective exchange rate has appreciated over the past years, although there are no hints of an extreme overvaluation (Hong Kong, for instance, enjoys structural surpluses on the current account).

HKD Chart 2

Second, the lack of room for discretionary monetary policy also risks the build-up of domestic financial imbalances. Over the past years, importing loose monetary conditions from the US has for instance contributed to a housing market boom and a doubling of the credit to GDP ratio since 2008. Deleveraging from high debt levels could become more painful, if Hong Kong would have to follow the US path of higher interest rates going forward. Still, we would like to add that even during the Asia crisis, when Hong Kong’s real estate market completely imploded, the peg to the USD was maintained.

HKD moving in the right direction

Since late 2011, the HKD has appreciated by 17% against its trade weighted basket of currencies, reversing more than the 10% decline when the US Federal Reserve embarked on unconventional monetary easing measures during the global financial crisis in 2009.  The stronger HKD has also pushed down inflation from 6% to about 4%. In our view, the HKD is moving in the right direction given that the USD is expected to continue its appreciation trend in the coming years. As a result, there is less need to revalue the HKD stronger.

HKD Chart 3

HKD peg more sustainable than SNB EUR/CHF floor

We judge that the HKD peg to the USD is more stable and sustainable than the SNB’s former EUR/CHF floor, which was set at 1.20 on September 2011. Indeed from September 2011 to December 2014, the SNB’s FX reserves rose by almost 50% compared to HKMA’s 18%. Furthermore, FX reserves growth in Hong Kong has slowed in the last few years. This reflects both a narrower current account surplus and less intervention activities by the central bank to weaken the HKD. Looking further back, FX reserves in Hong Kong have doubled since 2008, compared to an almost four fold rise in the case of Switzerland.  Moreover, and maybe more importantly, FX reserves accumulation by the central bank has become politically sensitive in Switzerland, but not in Hong Kong.

HKD repeg to CNY?

In our view, it is unlikely that the HKMA will repeg the HKD to the Chinese yuan (CNY) anytime soon. In late 2014, the HKMA said that if the anchor currency was changed to the CNY, they would need to hold nearly 2 trillion yuan worth of assets which far exceeds the amount of offshore yuan assets presently in existence. Furthermore the CNY is not yet freely convertible and the capital account is not fully liberalised.

Future of HKD exchange rate regime

We think that when China’s capital account is fully liberalised and the CNY is freely convertible, the HKMA is likely to adopt a trade weighted regime to better reflect Hong Kong’s trading partners. Indeed since the HKD was pegged to the US dollar in 1983, China has replaced the US as the largest bilateral trade partner. Japan and Singapore are the other large bilateral trading partners with Hong Kong.

Hong Kong bilateral trade with the US and China

HKD Table