Just don’t fret for Hong Kong’s dollar peg yet!

Hong Kong has undergone wrenching changes that were all but unimaginable little more than two years ago. The remaking of the city in the wake of pro-democracy protests in 2019 has touched upon areas such as freedom of speech and the legal system that are pillars of its standing as an international financial center. Yet if there is one aspect of this special administrative region of China that looks unlikely to change anytime soon, it is the currency peg to the dollar.
Tougher times may be coming, it’s true. The Hong Kong dollar has slid toward the weak end of its trading band against the US currency for the first time in more than three years. The economic cycles of the territory and the US are out of alignment. The Federal Reserve is contemplating aggressive interest rate increases to choke off inflation that reached 8.5% in March. Meanwhile, China’s economy is going through perhaps its most difficult period in three decades, battered by renewed Covid outbreaks, a collapsing property market and investor outflows driven by President Xi Jinping’s interventions in the private sector and support for Russia. The yuan has weakened sharply.
This mismatch, though, has always been the price of operating a currency board. The economy using such a system essentially gives up control of monetary policy, importing the interest rate decisions of its counterpart.
With a Covid-weakened business environment and inflation of less than 2%, Hong Kong needs higher borrowing costs like a hole in the head. But it has no choice. Arbitrage relationships limit the extent to which local rates can diverge from those in the US. If the city’s rates are too low, traders can borrow Hong Kong dollars and use them to buy the greenback, making a risk-free profit. This activity will cause Hong Kong’s monetary base to shrink and local interest rates to rise, bringing the system back into balance. It’s an automatic mechanism.
The tradeoff for this anchor of currency stability is that domestic asset prices must adjust where the Hong Kong dollar cannot. At times when, if allowed to move freely, the currency would tend to appreciate, the monetary base will expand, interest rates will fall and there will be pressure for prices to rise. Now, the bias is downward, so that’s negative for property values, which have already been sliding. It’s a mistake to conclude that this prospect means the peg’s future is in question. The system is just doing what it is designed to do.
In fact, there’s almost zero sign of stress so far. The one-month Hong Kong interbank offered rate is at a negligible 0.2% and the Hong Kong Monetary Authority’s aggregate balance, another key measure of liquidity, is still heavily positive. Bank deposits have seen no significant outflows, according to HKMA data as of March. A tight trading band of 7.75 to 7.85 to the dollar gives the monetary authority a measure of wiggle room, though this hardly amounts to a discretionary monetary policy.
Fiscal and institutional credibility are central to the successful maintenance of a currency board. Hong Kong has this in spades, with HK$1 trillion ($127 billion) of fiscal reserves and no external debt.

—Bloomberg