The Hang Seng Index fell last week as the Hong Kong Monetary Authority, Hong Kong’s de facto central bank, waded into the currency markets to defend the Hong Kong dollar 13 times, selling HK$51 billion of its foreign currency reserves. HKMA Chief Executive Norman Chan Tak-lam strove to reassure the public that “there is no need to be concerned” and Financial Secretary Paul Chan Mo-po said that the government had “enough money to deal with the capital outflow”.
Were they right? Does the HKMA have the remit, the resources, and the resolve to defend the fixed link to the US dollar for much longer?
Yes to all the above.
The Hong Kong dollar has been loosely linked to the US dollar since October 1983 at a fixed rate of HK$7.8 to US$1. The result has, despite the occasional severe hiccups, been currency stability. This arrangement, under which the central bank or monetary authority guarantees to exchange its currency for another currency at a fixed rate, is called a “currency board”.
An inevitable consequence of currency boards is that interest rates in the countries that have them are linked to interest rates in the countries to which their currencies are pegged. This means that nations that adopt currency boards lose the power to set interest rates that are best for their economies.
Why do interest rates have to move together? Because of the “carry trade”, or “arbitrage”. “Arbitrage” simply means buying cheap in one market so you can sell dear in another one and make a profit. If the price of money, known as interest rate, is 5 percent in the US and 3 percent in Hong Kong, it makes sense to sell Hong Kong dollars and buy US dollars, so pocketing the 2-percentage-point difference in interest rates.
After the great recession, during which the US cut its base interest rate almost to zero, Hong Kong dollar and US dollar interest rates were roughly the same until 2016, when they started to diverge. Of course, there is no single interest rate (your bank is probably not paying you the same on your deposit account as you pay on your mortgage), but there is a comparable set of rates: US interest rates are measured by the London Interbank Offered Rate (Libor) and Hong Kong’s by the Hong Kong Interbank Offered Rate (Hibor). To make it easier to measure small changes in these rates, the unit used to describe variations is one-hundredth of a percentage point, known as a “basis point”. The gap between Libor and Hibor has widened from zero at one point in 2017 to around 100 basis points a week ago.
The US Federal Reserve has for the past two years been steadily raising interest rates following the recovery of the US economy. It needs to do this not only to prevent inflation but, equally importantly, to ensure that rates are high enough for them to be lowered when the next downturn arrives. Although the US economy is doing well in terms of GDP growth and low unemployment, this has been the longest recovery in recent history, so a downturn is on the cards before long.
Because of “quantitative easing” during the recent crisis, the US pumped massive amounts of cash (“liquidity”) into its economy, stoking asset booms around the world. An inflow of around US$130 billion into Hong Kong contributed directly to rocketing housing prices. Rising US interest rates, without similarly rising Hong Kong rates, are now sucking much of this money back out, so lots of Hong Kong dollars have been sold to buy US dollars, driving down the Hong Kong dollar exchange rate.
Since 2005, the HKMA has been charged with keeping the exchange rates no higher than HK$7.75 per US$1 and no lower than HK$7.85 per US$1. This week’s intervention to protect what the HKMA calls the “weak-side Convertibility Undertaking” is the first since then.
The Hong Kong dollar is backed by the Exchange Fund, which currently totals around HK$4 trillion, with HK$3 trillion of this in foreign currency assets. Even if the entire HK$1 trillion in capital inflows since 2008 were to flee abroad — and it won’t — the fund would easily cover this.
The government has demonstrated a determination to keep buying Hong Kong dollars to protect the peg. Investors are getting the message: The currency has strengthened by several basis points last week not just because of the HKMA purchases but also because it is clear that the government will continue with them, even though the result will be higher interest rates.
Hong Kong needs higher interest rates. When the world economy decelerates, Hong Kong will, like the US, need to have interest rates that are high enough for it to be able to lower them to kick-start growth. And higher interest rates are needed to slow the potentially destabilizing growth in debt in Hong Kong. While first-time buyers will find the going tough as mortgage rates are raised, they will have the consolation that higher interest rates will help choke off the property boom and make a small contribution to restoring housing affordability.
The author is former chief economist, Asia and Hong Kong bureau chief of the Economist Intelligence Unit and senior economist in the OECD’s investment division.