HK Dollar Peg

Why the Link is important to Hong Kong

The Linked Exchange Rate system suits the needs of a highly open economy such as Hong Kong’s. It is simple, consistent and well understood. It enables Hong Kong to adjust to shocks without the damage and volatility of a sudden currency collapse. The Link suits Hong Kong’s economic conditions. Hong Kong is a very externally oriented economy, with a completely open capital account and a large financial sector. The total value of our external trade in goods and services in a year is equivalent to well over three times our GDP. These factors leave us heavily exposed to financial shocks stemming from volatilities in external markets. The Link provides Hong Kong with a firm monetary anchor which, among other things, reduces the foreign exchange risk faced by importers, exporters and international investors. The choice of the US dollar as an anchor is logical, since it is the predominant foreign currency in which our external trade and financial transactions are denominated. The effectiveness of the Link is helped by a number of economic attributes enjoyed by Hong Kong:
First, the structure of Hong Kong economy is flexible and responsive. Markets such as the labour market, property and retail markets respond quickly to changing circumstances: this flexibility facilitates adjustments in internal prices and costs, which in turn bring about adjustments to external competitiveness without the necessity of moving the exchange rate.
Secondly, Hong Kong’s banking system is strong and solvent, and well able to cope with the fluctuations in interest rates which may arise under the Linked Exchange Rate system.
Thirdly, the Hong Kong Government pursues a prudent fiscal policy, with large accumulated fiscal surpluses and a target of budgetary balance over the medium term. Thus there is no fear that the exchange rate system might be undermined by monetary financing of government expenditure. Fourthly, Hong Kong possesses ample foreign currency reserves for
supporting the Link. These reserves, held in the Exchange Fund, amounted to US$122.8 billion at the end of September 2005. They are equivalent to over six times the currency in circulation – one of the highest levels in the world. Since the establishment of the Link in 1983, the Hong Kong dollar exchange rate has remained stable in the face of various shocks. It remained unaffected by the 1987 stock market crash, the Gulf War in 1990, the Exchange Rate Mechanism turmoil in Europe in 1992, the Mexican currency crisis of 1994/ 95, and the Asian financial crisis of 1997/98.

he Hong Kong Dollar Link, as the local currency peg to the US dollar is officially called, was set up in 1984 to guarantee currency stability in the run-up to the handover of Hong Kong to China in 1997. No one doubts the fundamentals behind the peg in the short term: Foreign exchange reserves are ample, government debt is small, and Hong Kong is a net external creditor (see "Hong Kong's Peg"). But there are signs that the government is losing faith in the currency peg, and it may be considering delinking the currencies in the medium term to escape the effects of what is becoming a widespread expectation of prolonged deflation in the world economy.

The single most important factor that makes a strong supporter of the Hong Kong dollar peg, including myself, rethink its viability is the threat of entrenched global deflation. The Achilles heel of the peg is the Hong Kong government's worsening fiscal position, which is tied to unfolding deflationary forces. Crucially, the recent rise in Hong Kong's fiscal deficit reflects the government's unwillingness to suffer more economic adjustment pains than it already has under the peg.

Why deflation makes the peg a burden
Since the share of land premiums and stamp duties account for a big chunk of total fiscal revenues in Hong Kong, the collapse of the property market since the 1997 Asian crisis has significantly slowed government revenue inflows. In the current climate of deflation, the days of rampant property price growth are unlikely to return soon. The shrinking of revenues from the local property market suggests that Hong Kong's budget deficit has become structural under the peg.

The rising fiscal deficit and consequent erosion of fiscal reserves are undermining the foundation of the Hong Kong dollar peg. This is because the fiscal reserves form a major part—almost 40 percent as of late 2002—of the Exchange Fund that underpins the peg. If the annual fiscal deficit remains at around HK$70 billion ($8.98 billion), as the current trend indicates, Hong Kong's fiscal reserves will be depleted in four years. But investor confidence will crumble before the fiscal reserves run out, causing massive capital outflows that will pressure the peg.

The view that a complete depletion of the fiscal reserves, which will still leave HK$570 billion ($73.11 billion) in the Exchange Fund, will not necessarily crush the peg is naive. When it comes to defending the Hong Kong dollar peg, it is not what the Hong Kong Monetary Authority (HKMA) expects to commit in case of a crisis that matters. Rather, it is what the HKMA eventually would have committed—defined as the amount that depositors would withdraw from the banking system in case of a loss of confidence—that matters.

The Exchange Fund (excluding fiscal reserves) amounts to 240 percent of Hong Kong's monetary base, which includes notes and coins in circulation, banks' aggregate balance with the HKMA, and Exchange Fund securities. But the survival of the peg in a crisis of confidence would involve the whole Hong Kong dollar deposit base. Yet, the Exchange Fund covers only 30 percent of all Hong Kong dollar deposits. So if every holder of Hong Kong dollars were to convert their deposits into US dollars or other hard currencies, there would not be enough foreign reserves to meet demand; the Hong Kong dollar peg would break. Local public confidence is indeed fragile—the growth of Hong Kong dollar deposits has fallen steadily since the Asian crisis and has been negative since January 2002. As a result, falling fiscal reserves will erode public confidence and the margin of safety provided by the Exchange Fund and impede the authorities' ability to deal with contingencies effectively.

If the government resorts to borrowing to plug the deficit hole, the rise in public debt will only exert more stress on the Exchange Fund and erode public confidence further. The fund will either act as a direct lender or a guarantor for borrowing. Both acts will require it to commit more resources to fund the fiscal deficit, thus reducing its ability to protect the peg.

Forcing a choice
The combination of deflation and Hong Kong's structural fiscal deficit are forcing the government to choose between lowering the external price of money (un-pegging the Hong Kong dollar) and lowering asset prices (chronic asset price deflation). Re-setting the peg is not an option because re-setting the peg once would create expectations that the government would re-set it again. The currency link system would lose credibility and speculative attacks on the peg would follow, leading to its eventual collapse.

The survival of the peg thus depends on the political will to tolerate the economic adjustment pains that are necessary under the currency peg. This means the government cannot intervene in the economy even at times of economic stress. The persistent rise in Hong Kong's public spending to boost growth is the most notable sign of recent interference. Since 1997, fiscal spending has risen from 17 percent of GDP to 24 percent—one of the highest ratios of nondefense public spending to GDP in Asia.

Large fiscal spending looks likely to stay, as government policy has shifted from laissez-faire to hands-on. From the currency peg perspective, however, any market-supporting measures distort the peg's adjustment mechanism. To keep the territory competitive when other Asian currencies depreciate, Hong Kong prices need to fall under the currency peg. But the government's supportive measures are preventing the necessary decline in the city's domestic prices, thus distorting the peg's adjustment mechanism. These supportive measures also show that the authorities are hitting their tolerance limit for economic pain caused by the peg and, hence, may be mulling a policy shift. All this is best summarized by Antony Leung's anti-peg comments since he took over as financial secretary in late 2000—in essence, he has said that the peg is an obstacle to Hong Kong's development.

No constitutional backing
Indeed, it would be easy for Hong Kong to sever the peg because the Hong Kong dollar peg does not have robust constitutional backing. Article 111 of the Basic Law only guarantees the Hong Kong dollar as the legal tender in the Hong Kong Special Administrative Region and ensures that the issuance of Hong Kong dollars is fully backed by a reserve fund. It does not guarantee the Hong Kong dollar peg and its convertibility rate of HK$7.80 per US dollar. On the other hand, the Argentine peso peg unraveled under severe economic stress, even though it was enshrined in the constitution and approval from both houses of Congress was needed to scrap it.The fate of a currency regime is more a political choice than an economic one, and the advent of a new era of prolonged low inflation, with periodic deflation, has cast doubt on the desirability of the Hong Kong dollar peg. The government is increasingly uncomfortable with the long-term burden the peg imposes on the economy under deflation. But it will likely do nothing in the short term, if only because of the difficult steps that would be required, among them reforming the HKMA into an independent monetary policy manager.

Hong Kong’s Peg
Hong Kong has had a fixed exchange rate system since 1983, when the value of the Hong Kong dollar was fixed at HK$7.80 per US dollar in response to currency instability and general uncertainty about Hong Kong's future in the years before its return to China. Under this system, all notes and coins in circulation are backed by US dollars. The three banks that issue notes in Hong Kong—Hong Kong and Shanghai Banking Corp. Ltd., Standard Chartered Bank, and Bank of China—must, for each 7.8 Hong Kong dollars they issue, deposit a US dollar in what is known as the Exchange Fund. In return, they receive a Certificate of Indebtedness, which allows them to redeem US dollars when they pull Hong Kong dollars out of circulation.

Good pegs have currency boards. Currency boards keep a fixed exchange rate, ensure that every note and coin of local currency issued is backed by the anchor currency, and exchange the local and anchor currencies on demand. They do not participate in monetary policy and are independent of the government. The Hong Kong Monetary Authority (HKMA), set up in 1993, oversees the Hong Kong peg system. But because HKMA performs some of the functions of a central bank, such as regulating banking and financial systems, it is not a true currency board.

In addition, most currency boards have a firm legal base—that is, their role is written into law. Hong Kong has no such law, other than the Exchange Fund Ordinance. This ordinance gives the financial secretary not only control of the fund (no separation from government) but also rather broad, but vague, powers: "...the Financial Secretary may...use the fund as he thinks fit to maintain the stability and the integrity of the monetary and financial systems in Hong Kong." On the other hand, HKMA is not a true central bank either, as it does not issue notes or act as a banker to the government.

How the peg works
As HKMA explains, "Under the currency board system, ...interest rates rather than the exchange rate ... adjust to inflows or outflows of funds. The monetary base increases when the foreign currency ... to which the domestic currency is linked, is sold to the currency board for domestic currency (capital inflow). It contracts when the foreign currency is bought from the currency board (capital outflow). The expansion or contraction of the monetary base causes interest rates for the domestic currency to fall or rise respectively ...[causing investors to move funds]..., while the exchange rate remains stable. This process is very much an automatic mechanism, which does not require the HKMA to exercise any discretion." (Hong Kong's Linked Exchange Rate System)

Benefits of the peg
In Hong Kong's case, one of the most important benefits of the peg is still the guaranteed currency stability in a time of political uncertainty over Hong Kong's future. Though Hong Kong has now been a special administrative region of China for more than five years, new sources of uncertainty—such as interpretation of the Basic Law, recent proposals for an anti-sedition law, and lack of confidence in the current Hong Kong government's ability to keep the economy running smoothly—show that the peg is still useful.

As a center of international trade and finance, Hong Kong is extremely vulnerable to external economic shocks. The linked exchange rate guarantees a stable currency, which eliminates much of the foreign exchange risk faced by actors in Hong Kong's small, open economy. According to HKMA, local markets respond quickly to economic pressures: Prices adjust fairly rapidly to restore competitiveness without changing the exchange rate. Yet the smaller number of economic levers available to policymakers in Hong Kong compared to economies with floating exchange rates means that Hong Kong's economy must make structural changes to cope with economic pressures. Though painful in the short run, such changes benefit the economy in the long run.

Drawbacks
On the downside, internal wage and price adjustments may be more wrenching than they would be if the exchange rate were free to adjust. The linked exchange rate also effectively links the interest rates of the US and Hong Kong economies, which prevents HKMA from using interest rate adjustments as levers on the Hong Kong economy. And when the economic cycles of Hong Kong and the United States are out of synch, US interest rates may not be at levels appropriate for Hong Kong. Indeed, a few years ago, the United States raised interest rates to cool down its overheating economy just when Hong Kong was struggling to recover from a recession brought on by the Asian financial crisis. Another drawback is that the Exchange Fund ties up reserves that, some have argued, could be put to better use—invested in the local economy or spent on improving Hong Kong's education, health, and welfare systems, for instance.

Rationale remains
The above argument does not deny the merits of the Hong Kong dollar peg for Hong Kong's small, open economic system. After all, scrapping the peg will not solve Hong Kong's structural problems, among them a rising skills mismatch, an education system in dire need of reform, and an outdated economic model based on asset trading.

Moreover, the alternative currency regimes are unlikely to be any better for the Hong Kong economy. The volatility that characterizes a floating exchange rate would hurt the city's competitiveness as a financial center, while a managed float (which would entail frequent government interventions to keep the exchange rate from moving freely) would risk over-politicizing the exchange rate.

If the peg goes
Given the signs of wariness about the peg, investors would be wise to prepare for its demise. The immediate effect would likely be a sharp drop in the Hong Kong dollar-US dollar exchange rate. In such a case, how would Hong Kong's asset prices behave? As a reference, we can look at stock market behavior in Argentina and the United Kingdom, both of which have broken their currency pegs in recent years.

Argentina
Argentina pegged its currency to the US dollar in 1991 to combat hyperinflation and stabilize the economy. The peg succeeded for a few years, but because of imprudent economic policies, it came under pressure in the late 1990s. The peso peg severely damaged Argentina's export competitiveness and its ability to repay foreign debt. The government eventually defaulted in November 2002 and abandoned the peg in January 2003. Argentina's stock market surged 100 percent in the month before the peso-dollar peg was scrapped, as the markets expected major relief from the economic pains of deflation, bankruptcy, unemployment, and economic contraction that the adjustment mechanism was inflicting.

For the same reason, Hong Kong's asset prices could also start rising if signs emerge that the government may decide to sever the peg. What would happen next to asset prices would depend on whether Hong Kong was able to restructure to survive in the new economic era. In Argentina's case, hesitation to eliminate structural woes in the economy caused asset prices to plummet after the peso peg was abandoned. The Argentine government imposed strict capital and deposit controls and created a dual exchange rate to skirt full devaluation and restructuring pressures. But these measures have only postponed thorough adjustments, and thus have haunted the markets.

United Kingdom
Britain's experience was very different. Britain had joined the Exchange Rate Mechanism (ERM), which fixed European currencies' cross-exchange rates within specific bands, in 1990. During a speculative attack in September 1992, the Bank of England decided to drop out of the ERM. UK stock prices rose steadily after the British pound dropped out of the ERM. The ascent of UK equity prices lasted until late 1999, when the global investment bubble burst. This sustained rise of British asset prices after the break of the peg from the ERM was a result of successful economic restructuring, notably in the rigid labor market. Britain's productivity and economic growth have consistently outperformed many other European economies and thus supported asset price growth.

The upshot
What all this means is that though severing the peg may give an initial push to Hong Kong's asset prices, what happens in the post-peg era would depend on the city's restructuring efforts and the macroeconomic environment. Because the macroeconomy is outside of Hong Kong's control, the territory's ability to reinvent itself would determine whether Hong Kong's asset markets would revive in a post-peg era.

Why Hong Kong Won't Dump the Dollar

The Hong Kong currency's fixed peg to the greenback has contributed to the city's financial stability. Also, a renminbi peg isn't feasible yet

Is a speculative attack on the Hong Kong dollar looming? That's one of the more interesting questions in global finance right now, given the recent disclosure by Hong Kong's former financial secretary Antony Leung that back in 2002 the government seriously contemplated abolishing its currency peg to the U.S. dollar. On top of that, both Kuwait and Syria in recent weeks have dropped their currency pegs, thanks in large part to the weaker outlook for the U.S. dollar and economy at a time of big account and budget deficits.

So there is plenty of market chatter at the moment about the fate of Hong Kong's dollar peg which has been fixed at 7.80 to the greenback since 1983. Back then, it was introduced to stem capital flight caused by uncertainty over the former British colony's future. The Hong Kong Monetary Authority, which acts as a sort of central bank, spent billions for currency interventions to defend the peg during the Asia financial crisis a decade ago and says it has no intention of tampering with the peg now. Here's a quick overview of the situation:

What is the likelihood Hong Kong will abandon or adjust the peg anytime soon?

Almost zero, since there is little need to. Consider that back in 2002 when Leung and Tung Chee-hwa. then Hong Kong's chief executive, considered scrapping the peg, the local economy was in grim shape. Hong Kong property prices were plunging, deflation gripped the economy, and the government was running a budget deficit of $8.1 billion.
Flash forward five years to today: Property prices are buoyant, inflation is mild, and the government is expected to register a budget surplus of $7 billion this fiscal year. Furthermore, the currency can trade five Hong Kong cents on either side of the peg, i.e., between 7.75 and 7.85, but monetary authorities have always managed to keep trading within this band.

Has Hong Kong suffered economically from tying its currency to the changing fortunes of the U.S. dollar?

Though the Hong Kong economy took a hit during the Asian crisis when its defense of the peg caused several years of price deflation, in recent years the arrangement has worked fine. It's true that Hong Kong monetary authorities in theory must keep its interest rates in sync with the U.S. Federal Reserve, but the reality is that the cost of borrowing in both economies has diverged by as much as 150 basis points at times. So Hong Kong has more flexibility than is sometimes assumed to adjust its monetary policy to economic realities on the ground.

Wouldn't Hong Kong be better off pegging its currency to the Chinese renminbi?

It's true that China is Hong Kong biggest trading partner and the long-term outlook for the mainland economy is phenomenal. Yet the reality is that most of the international trade in goods and services is transacted in U.S. dollars. Also, any sort of renminbi peg for Hong Kong is technically impossible until China adopts a freely convertible currency and lifts its capital controls. That is probably many years away from happening.

How vulnerable is Hong Kong to a speculative attack on its currency now?

The Hong Kong Monetary Authority has about $136 billion in foreign reserves, roughly seven times the currency in circulation. Hong Kong successfully maintained the peg throughout the Asian financial crisis when the currency was arguably highly overvalued compared to other regional currencies. The fact that Hong Kong has so rigorously defended the peg for more than two decades is in itself a bulwark against rampant speculation.

What would happen if Hong Kong abandoned the peg?

One big advantage of the peg has been the relative certainty about the direction of the Hong Kong dollar, and that has made the former British territory a good financial center for the region. The virtual absence of currency risk has been one of Hong Kong's biggest selling points. Volatility in the exchange rate could lead to potential capital flight, and could push downward pressure on stocks and property prices.