By Wei Hongxu*
As the Federal Reserve continues to raise interest rates, the Hong Kong dollar exchange rate under the linked exchange rate system is also facing increasing pressure. After the Fed raised interest rates by 75 basis points in November, the Hong Kong Monetary Authority (HKMA) responded by raising the discount window base rate by 0.75% to 4.25%. At the same time, the Hong Kong dollar (HKD) was under pressure again, approaching the exchange rate floating ceiling of 7.85.
According to the Hong Kong Economic Times (HKET), on November 5, the HKMA bought HKD 3.054 billion from the market to defend the linked exchange rate system. So far, the aggregate balance of the Hong Kong banking system has fallen below HKD 100 billion to HKD 96.977 billion on November 8. This is the 40th market intervention by the HKMA since May 12 this year, with a total of HKD 241.171 billion. Under the influence of the Fed’s interest rate hike, the huge pressure on the Hong Kong dollar has also made whether the linked exchange rate system can withstand capital shocks a focus of attention, reflecting the concerns about the stability of the city’s financial system.
Researchers at ANBOUND believe that Hong Kong’s foreign exchange reserves, financial strength, and the stability of financial institutions and financial markets can guarantee the maintenance of the linked exchange rate system. Coupled with Mainland China’s policy support for Hong Kong and the increasing influence of Mainland capital, it would be more conducive to maintaining the stability of the value of the HKD and thus sustaining the linked exchange rate system. HKMA President Eddie Yue said that inflation in the United States caused rate hikes in the U.S. dollar (USD), resulting in interest rate gaps between other currencies against the USD. This happens not just to the HKD. He specifically mentioned that China has sufficient economic support for Hong Kong to be an international financial center.
However, judging from history and reality, the linked exchange rate system based on the peg to the USD has also made Hong Kong pay a considerable price. As HKD adopts an exchange rate policy pegged to the USD, Hong Kong cannot implement an independent monetary policy and will be affected by changes in the Federal Reserve’s monetary policy. In fact, the previous Fed rate hikes, even if the local inflation level in Hong Kong was not high, it needed to follow the increase in interest rates as well. This not only hit the Hong Kong stock market but also affected the real estate market as well. This, in turn, damaged the city’s economy. Therefore, despite the stability of the HKD, the value of assets denominated in it will inevitably suffer losses. These situations occurred not only in the Asian financial crisis in 1997 but also in the global financial crisis in 2008 and in the Fed’s previous interest rate hike cycles. The Fed’s rapid rate hike this time has also had a significant impact on Hong Kong. The Hang Seng Index has fallen by 50% from its high in February 2021, effectively being caught in a new round of stock market crashes. Impacted by the COVID-19 pandemic, Hong Kong’s economy is expected to fall into negative growth this year as interest rates increase.
Maintaining the linked exchange rate system also imposes substantial costs on Hong Kong, as it not only needs a large number of USD reserves but also a fiscal surplus to sustain the stability of the HKD value. To this end, Hong Kong has to consume a large amount of USD reserves and at the same time tighten the liquidity of the HKD. On November 7, the HKMA announced that its official foreign exchange reserve assets at the end of October 2022 were USD 417.2 billion, down slightly from USD 419.2 billion at the end of September. The total foreign exchange reserve assets of USD 417.2 billion are equivalent to more than five times the currency in circulation in Hong Kong, or about 41% of the HKD M3. Previously, the official foreign exchange reserve assets in Hong Kong were USD 447.3 billion at the end of June and USD 465.7 billion at the end of April. It can be seen that the rate of continuous reduction of foreign exchange reserves has been very significant. In addition, the Hong Kong SAR government is also facing increasing financial pressure. The city’s financial secretary Paul Chan has recently said that the government is expected to face a fiscal deficit of more than HKD 100 billion in the 2022-2023 fiscal year, second only to the historical record of HKD 232.5 billion in the previous year. This also means that the financial reserves of the Hong Kong government may be reduced to HKD 800 billion. The continuous decline of foreign exchange reserves and fiscal surplus means that the ability to maintain the linked exchange rate system in the future is gradually weakening, and the resource potential of the Hong Kong government to drive economic development continues to decline.
Since 2018, the intensification of U.S.-China trade disputes has caused the aggravation of geopolitical risks and the trend of global trade de-globalization, which has affected Hong Kong as a trade and financial hub. The financial decoupling between the United States and China is also increasingly evident. With such development, Hong Kong needs to reconsider its positioning and development direction. Researchers at ANBOUND pointed out that Hong Kong is currently facing a “dislocation” between “economic Mainlandization” and “U.S.-dollarization of the Hong Kong currency”. On the one hand, Hong Kong now has become more closely integrated with Mainland China economically and politically, and its economic cycle will also be in line with the Chinese economy. On the other hand, the current linked exchange rate system requires Hong Kong to link its monetary policy to the United States, which is also a structural departure in essence. The intensification of this divergence will rupture Hong Kong’s financial market and economy.
Implemented from October 1983 onwards, the linked exchange rate system has reduced the risk of fluctuations in the HKD. To this day, the system has become an important pillar for maintaining Hong Kong’s status as an international financial hub, with the other cornerstone being free trade in the city’s development. Linking the HKD to the USD can enhance the international recognition and liquidity of the HKD, which is beneficial to the overall development of Hong Kong. This advantage still has a practical effect to this day. However, in the context of changes in the international trade and financial landscape, from the perspective of Hong Kong’s long-term development, it is necessary for the city to think about how the HKD exchange rate mechanism and currency issuance mechanism will change in the future to adapt to the general trend of the international financial and geopolitical environments.
It has been suggested that if Hong Kong abandons the linked exchange rate mechanism, this would mean the decline of the HKD and could spell the beginning of “renminbization”. However, researchers at ANBOUND believe that although the internationalization of the RMB is in the process of steady progress, in terms of the financial and monetary system, the HKD still needs to exist as a relatively independent currency to continue allowing Hong Kong assumes the role of “bridgehead” and offshore RMB center for the Mainland’s opening up. This is especially under the circumstance that when the RMB capital account cannot be fully opened, the HKD can maintain its unique status as a currency tool for communication between the Mainland and the international financial market. This means that Hong Kong needs to consider an independent currency issuance mechanism led by the government. The HKD can then adopt a “basket currency” exchange rate mechanism similar to that pegged to the USD, the RMB, and other major currencies, as a balancer for the connection between the Mainland and the global trade and financial markets. A relatively flexible exchange rate mechanism and independent currency issuance mechanism can not only strengthen its connection with the Mainland but also open up new space for Hong Kong’s financial and economic development.
Yet there remain many controversies regarding the linked exchange rate system and its role in Hong Kong as an international financial center. There are not many countries or regions that still insist on adopting a fixed exchange rate system. Singapore, also an international financial center, has adopted an independent monetary policy system and a flexible exchange rate mechanism. From the actual effect, Singapore’s independent monetary policy not only did not reduce its international recognition but made it more flexible in maintaining currency stability, as well as economic and financial vitality. Therefore, for Hong Kong, it is necessary to break through the inherent limitations in the research of a relatively flexible exchange rate mechanism with flexible currency issuance adapting to new environmental changes and the needs of economic and financial market development.
Final analysis conclusion:
As the Federal Reserve continues to hike the interest rates, the Hong Kong dollar exchange rate is also under increasing pressure. While Hong Kong currently adopts the linked exchange rate mechanism and there is not much pressure to maintain the stability of its currency exchange rate, the long-term misalignment of its economic foundation and monetary system will not be conducive to the city’s economic stability and the consolidation of its status as an international financial hub. From the perspective of Hong Kong’s economic and financial stability and long-term development, it is necessary to consider a relatively flexible monetary system and exchange rate mechanism.
*Wei Hongxu is a researcher for ANBOUND