Hong Kong’s dollar peg is too tight

Shuli Ren, Bloomberg

Hong Kong is on the cusp of a big, beautiful bull run. But it’s in danger of being ruined.

The financial center is finally getting back on its feet. The city is leading in global initial public offerings rankings this year. Its stock market is one of the world’s best performing.

Meanwhile, rents have returned to pre-pandemic levels, giving homebuyers some comfort that a yearslong slump in residential real estate may be near its end.

We must not assume this animal spirit will prevail, however, even as US-China trade tensions ease.

A key factor underpinning Hong Kong’s recent outperformance is a collapse in local borrowing costs. As long as the existing dollar peg is in place, what we’ve been observing is fragile and unsustainable.

Hong Kong surrendered its monetary autonomy decades ago, thanks to a unique mechanism that restricts its currency to fluctuations in a narrow band of 7.75 and 7.85 per dollar.

That means the city’s borrowing costs should move in lockstep with those in the US, which are dictated by the Federal Reserve’s rate policies.

But as the Hong Kong dollar weakens to the low end of the band, the city’s de facto central bank has no choice but to step in and purchase the local currency. An unfortunate collateral will be a rise in the Hibor.

I cannot overstate how important borrowing costs are to the city’s asset prices. The stock market is strongly correlated with the central bank’s balance sheet, which shrinks when the HKMA has to sell dollars and defend the weak side of the band.

In residential real estate, a negative carry, whereby rental yields are lower than mortgage rates, has contributed to a prolonged slump in home prices. Lately, this carry has turned positive
thanks to a sharp fall in mortgage rates, which are tied to the 1-month Hibor. It’s now cheaper for the city’s residents to buy than to rent, boosting the case for apartment purchases.

So what’s the fix, now that the Hong Kong dollar is hovering close to the low end?

Abandoning the dollar peg entirely would be too radical. Right now, the offshore yuan, which the Hong Kong dollar would inevitably anchor itself to in the event of a depeg from the greenback, is not widely used enough. And a deep liquidity pool matters greatly to a financial center.

Rather, authorities should consider tweaking the current trading range, which has been around since 2005. One possibility would be widening the band, say to between 7.7 and 7.9 per dollar, so the HKMA doesn’t inadvertently tighten financial conditions in its attempt to defend the peg.

As long as chaos reins in the White House, Hong Kong can benefit from global asset managers’ rush to diversify and reduce their exposure to US assets. But intent doesn’t always translate into action. The administration of Chief Executive John Lee must step up, introduce meaningful capital-market reforms and make the city an attractive investment destination. Tweaking Hong Kong dollar’s trading range is a start.

Courtesy Bloomberg/Shuli Ren