Hong Kong's status as a global financial centre is under increased scrutiny following weeks of popular protest and growing tensions with China. Might this crisis spill over to hurt the Hong Kong dollar, which has been linked to the US dollar since 1983?

Most investment industry executives AsianInvestor spoke to say not. Despite the odd sceptical voice, notably that of US hedge fund manager Kyle Bass, they argue that the currency's dollar peg (which is between HK$7.75 and HK$7.85 per US dollar) isn't under imminent threat.

Still, tail risks that would have seemed totally implausible a few months ago – such as a possible Chinese military crackdown – are now being mooted as potential game-changers.

“For the coming few months, I see the peg holding, but there will be pain for Hong Kong,” Alicia Garcia-Herrero, chief economist for the Asia-Pacific region at French bank Natixis. “If outflows [from the local banking system and capital market] are massive, it will be very hard to support the currency.”

Alicia Garcia-Herrero, Natixis

“Even if the Hong Kong dollar withstands the pressure and the peg holds, deposit outflows would create pain for the economy and [local] interest rates will rise,” she told AsianInvestor.

Any non-resident money in Hong Kong could exit very quickly, Garcia-Herrero said, and the city’s very rigid monetary regime might not be able to bear the consequences of huge sudden capital outflows.

Hong Kong’s $439 billion in foreign exchange reserves can cover the city's roughly-$200 billion monetary base more than twice over but the lack of capital controls implies that capital flows can be very volatile, Natixis said in a note on August 20.

Yet deposits in Hong Kong amount to $1.7 trillion, which means foreign exchange reserves couldn't cover the entire monetary base in the case of large deposit withdrawals, the bank added.

The Hong Kong Monetary Authority (HKMA) does not have a policy interest rate, explained ING Bank in a note published yesterday; the Hong Kong interest rate is driven by the money flowing in and out (see chart below).

A strengthening US dollar would further complicate matters, said Philip York, managing director of Myo Capital Advisers, a Hong Kong-based firm focused on global macro and special situations. 

The US Dollar Index, which measures the greenback against a basket of currencies, is trading close to a 27-month high. And for the first time since the global financial crisis of 2008, $1 these days buys you more than Rmb7.00.

“As the US dollar is looking to take another leg up, this increases pressure on the Hong Kong dollar,” York said. “It doesn’t mean the peg will break at this coming pressure point. But all pegs break eventually – if not this coming pressure point, then the next.”

ADJUSTMENT NEEDED?

York thinks the HKMA should make an adjustment to how it manages its currency, especially given the current political situation.

The HKMA, however, has no intention to change the system, a spokeswoman for the de facto central bank told AsianInvestor on Tuesday (August 20).

The peg is underpinned by the “massive” Exchange Fund, the government's prudent fiscal management and the city’s robust banking sector, she added, and this triple system “has served Hong Kong well through many economic cycles in the past 36 years".

HOW THE HONG KONG CURRENCY PEG OPERATES
(Click for full view; Source: HKMA)

It's also been “operating very smoothly even with the massive fund flows in the past few year”, she added.

Others, too, are confident in the HKMA’s ability to prop up the currency, if need be – especially if backed by China’s central bank with its $3 trillion-plus in reserves, as several suggest it would be.

Given the size of its reserves, “there’s not sufficient pressure on the Hong Kong dollar [to break the peg], and there never will be”, a Hong Kong-based investment head at a large asset owner told AsianInvestor.

Ultimately, he said, “you’re a fool if you think you can make money by expecting the peg to be removed".

It is possible to make such a strategy work in respect of, for instance, the Argentine peso because Argentina doesn't hold sufficient levels of foreign currency to protect it. But that isn't the case with Hong Kong, said the investment head.

He did, however, concede that money can be made by trading the carry between the Hong Kong and US currencies, as he sees hedge fund manager Bass doing.

ING Bank also expects the HKMA to retain the peg, "now more than ever", it said in the note published yesterday.  

“DANGEROUS TRADE”

Andy Seaman, chief investment officer at Stratton Street Capital in London, who runs a renminbi bond fund, takes a similar view.

Andy Seaman, Stratton Street

Shorting the Hong Kong dollar is a “dangerous trade”, he said. Unless, that is, one believes the renminbi will weaken in the long term, because the Hong Kong dollar will have to be in step with the Chinese currency at some point.

Ultimately, Seaman argues, the renminbi is more likely to strengthen, as that would suit both China and the US. Hence, “if the Hong Kong dollar were to unpeg from the US dollar in the future, it would likely strengthen rather than weaken [against the greenback].”

Moreover, Hong Kong can use its huge reserves to squeeze anyone who’s short, Seaman added. It may be uncomfortable for the HKMA to do so at times, “but any short-seller would have to close their bets eventually”.

“Either the shorters don’t understand the trade properly or they are hoping others will be sucked in and will exit after that,” he said. “Either way, it’s a dangerous play.”