Hong Kong-Dollar peg makes less sense than ever

Shuli Ren, Bloomberg

Whenever the Federal Reserve turns more hawkish and the cost of dollar funding soars, debate over whether Hong Kong should change its currency’s peg resurfaces. The fixed exchange rate system has been around for more than four decades, with a narrow trading ban of HK$7.75 to HK$7.85 introduced in 2005.

As the rate differential between the US and China hits a record high, it’s increasingly clear that this currency regime, which inevitably ties the city’s lending rates to those of the US, is outdated and needs a revamp. The US 10-year Treasury yield is flirting with 5%, while it’s only a matter of time before China goes to sub-1%.

Because of the dollar peg, Hong Kong can no longer be Asia’s go-to fundraising platform, eroding a key selling point for the financial center. For blue-chip companies, borrowing in the mainland has become a lot cheaper than in the city, where benchmark lending rates move in lockstep with the fed fund rate. Hong Kong-based flagship real estate developer New World Development Co., for one, has been ramping up its onshore yuan borrowings to lower interest repayments. The company said in August that it obtained a 12-year yuan loan at only 3.1%, while the average rate of its offshore bank loans were roughly 1.1% above Hibor, or 5.2% at the prevailing rate.

Or consider what the peg does to the spluttering local economy. The $3 trillion residential property market is in its fourth year of downturn. But it still suffers from negative carry, which discourages home purchases because it’s cheaper to rent than to buy. Adding salt to the wound, for the first time in history, new mortgage rates in Hong Kong are higher than in Shenzhen, the neighboring tech hub in mainland China.

In other words, when the Fed is making it clear that we won’t go back to the zero-rate era after the Global Financial Crisis, it’s time for the city to move on and get its monetary flexibility back.

The Hong Kong Monetary Authority said in a statement [earlier this month] that it had no intention and no need to change the dollar peg.

The biggest roadblock is timing and perhaps political paralysis. Over the years, foreign hedge fund managers, including long-time China skeptic Kyle Bass, have bet against the Hong Kong dollar — and lost big. When market pressure is on, policymakers rightly worried that any tweak to the exchange rate — not carried out on their own terms — would encourage more speculative trades and trigger a financial crisis in the city. As such, they would dig in and stay firm. But in better times, such as now when the currency is trading at the strong end, they tend to lose a sense of urgency and choose to just stay put. After all, few question Hong Kong’s ability to defend the peg. The government holds about HK$4 trillion ($515 billion) in reserves, with HK$2.1 trillion in highly liquid, dollar-based assets to fully back its monetary base.

Nonetheless, it’s not ability but suitability that counts. It makes no sense for a financial hub to keep a rigid monetary regime when, in the foreseeable future, the source of cheap funding has flipped from the US to China. Behind closed doors, policymakers should start to prepare for an orderly change to its dollar peg.

Courtesy Bloomberg/Shuli Ren