In defense of Hong Kong’s currency peg Asia Pacific Economic Outlook, Q3 2016

As economies across the world ride the ebb and flow of business cycles, fixed exchange rate regimes sometimes come under immense pressure, mostly due to the limited ability of their central banks to respond to these cycles. And, given its strong economic links to China, Hong Kong’s currency peg with the US dollar has come under pressure due to the economic slowdown in the mainland.

A currency peg has its fair share of critics and not without reason. Economic theory suggests that with no capital controls, a fixed exchange rate regime means that monetary policy cannot be independent—referred to as the Impossible Trinity in economic parlance.1 In such a scenario, monetary policy is focused purely on defending the currency peg, and not on inflation and economic growth. As economies across the world ride the ebb and flow of business cycles, fixed exchange rate regimes sometimes come under immense pressure, mostly due to the limited ability of their central banks to respond to these cycles. Over the past year, questions have been asked about existing currency pegs in Asia and the Middle East, none more important than the Hong Kong dollar’s peg to the US dollar (HKD-US$ peg).

Over the last two years re-exports made up about 98.6 percent of Hong Kong’s merchandise exports, one reason why the territory is regarded as the world’s leading trade hub.

Given Hong Kong’s strong economic links to China, the HKD-US$ peg recently came under pressure due to an economic slowdown in the mainland and losses in equity markets there. China’s devaluation of the renminbi in August 2015 also did not help matters.2 The resultant capital outflow from the mainland, in turn, pushed up the difference between onshore (China) and offshore (Hong Kong) renminbi values, thereby posing problems for policymakers.3 Moreover, Hong Kong itself is bracing itself against a property downturn and declining trade revenues. In such a scenario, concerns about existing policies, including the HKD-US$ peg are natural. However, breaking the peg is not the ideal response.

Currency stability has aided Hong Kong’s role as one of the world’s leading trade hubs

Hong Kong’s external sector has played a key part in its economic success. In 2015, for example, exports amounted to 201.6 percent of the territory’s GDP (figure 1); total trade (exports and import) was 400.9 percent of GDP. A large share of Hong Kong’s exports is re-exports—goods imported from one part of the world and exported to another after minimal or no value addition. Over the last two years re-exports made up about 98.6 percent of Hong Kong’s merchandise exports, one reason why the territory is regarded as the world’s leading trade hub. While liberal economic and trade policies—along with history—have aided Hong Kong’s trade, currency stability through the HKD-US$ peg has also played a major role. Policymakers would be loath to change that, especially at a time when international trade faces headwinds from a slowing world economy. The peg also makes sense since a large volume of global trade is priced in US dollars, as is evident from the predominance of the greenback in global financial transactions. According to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), the US dollar had a 41.9 percent share (April 2016 data) of customer-initiated and institutional payments using the SWIFT platform. Data from the Bank of International Settlements (BIS) also confirms this trend (figure 2).5

Special-topic_Figure 1. Hong Kong’s trade amounts to a large share of the territory’s GDP

Special-topic_Figure 2. The US dollar leads others in the currency distribution of foreign exchange transactions

The HKD-US$ peg has also helped Hong Kong’s ascent as a global financial center

Hong Kong is also one of the world’s leading financial centers, competing with the likes of New York and London. By the end of 2015, Hong Kong had a net investment position of HKD 7.6 trillion or US$ 1.0 trillion. This amounted to about 316.6 percent of GDP, much higher than Singapore (209.8 percent of GDP)—the other major financial center in Asia. Hong Kong’s capital flows—both assets and liabilities—are also higher than those of Singapore (figure 3). Any change in the HKD-US$ peg will therefore create large volatility in currency returns, especially for the territory’s financial institutions whose assets are mostly denominated in US dollars.6 For example, Hong Kong had total claims on banks and non-bank customers worth HKD 9.0 trillion (US$ 1.2 trillion); the liabilities amounted to HKD 6.3 trillion (US$ 0.8 trillion).7 Abandoning the peg will also spark uncertainty for global banks and financial institutions seeking to use Hong Kong as a base to expand into fast-growing Asia.8

Special-topic_Figure 3. A comparison of international investment positions of Hong Kong and Singapore

Strong links with mainland China not reason enough to break the peg

Hong Kong’s strong economic links to China raise valid concerns about the future of the HKD-US$ peg. In 2015, China had shares of 49.0 percent and 53.7 percent in Hong Kong’s imports and exports, respectively. China also accounts for a sizable amount of Hong Kong’s external claims and liabilities (figure 4). This raises questions about a possible change in the HKD-US$ peg to a HKD-renminbi peg, a peg to a basket, or even a managed float in future. However, it would not be prudent to do so in the short to medium term. First, there is still great disparity between the economies of Hong Kong and mainland China. The gap has to be brought down before any change in Hong Kong’s exchange rate policy. Second, a peg to the renminbi in the short term does not make sense, given that the renminbi itself is heavily managed with respect to the US dollar. Third, the renminbi is not freely convertible and its offshore liquidity is low. For example, the renminbi made up just 1.8 percent of total transactions in the SWIFT platform in April 2016.9 While the renminbi’s inclusion in the International Monetary Fund’s (IMF’s) Special Drawing Rights is a good beginning, China has a long way to go before the currency is made fully convertible.10

Special-topic_Figure 4. China has a sizable share in Hong Kong’s external claims and liabilities in foreign currency

A new currency regime is not the answer to asset market problems

The recent decline in property prices in Hong Kong has put pressure on the Hong Kong Monetary Authority (HKMA) once again. Ideally, in such a scenario, monetary easing helps to revive demand. However, due to the currency peg, the HKMA has to mirror the US Federal Reserve (Fed), which instead is seeking to raise interest rates this year.11 In 2013, there were similar pressures on the HKD-US$ peg when the peg prevented monetary tightening to counter the rising cost of living—the Fed was on an easing spree then.12 As worrying as it might seem at first reading, a breaking of the peg—and hence independent monetary policy—will not necessarily help Hong Kong’s real estate sector. Given the level of Hong Kong’s property prices (prior to declining late last year), a correction was always on the cards.13 For example, between November 2008 (the last major trough) and September 2015 (the last peak), property prices had gone up an astounding 183.9 percent (figure 5) before heading down. In fact, declining house prices might help stoke demand in the medium term by increasing affordability. Also, monetary policy intervention to deal with asset bubbles have not always been successful, as the Fed would vouch, given its experience in 2007–08. The answer, as central banks are learning, is more macro-prudential measures, even in fixed exchange rate regimes.14

Special-topic_Figure 5. Breaking the peg will not help in stemming the decline in property prices in Hong Kong

The peg is essential for Hong Kong’s stability

Changing from a fixed exchange rate to something like a managed float would have made sense for a large economy trying to liberalize and shore up competitiveness. A good example is India, which has reaped the benefits of a managed float when it adopted liberalization in the early 1990s. Often, abandoning a currency peg is also suggested for commodity-dependent countries trying to diversify their economies. Saudi Arabia, which is under pressure from declining oil revenues, is an example.15 None of the above arguments, however, makes sense for Hong Kong. The territory is not commodity-rich, has a vibrant private sector, is highly competitive, and is one of the world’s most liberalized economies.16 To top it all, it has a healthy current account and is armed with about US$ 360 billion worth of foreign exchange reserves. And the HKD-US$ peg, which is now about 33 years old, has been one of the key reasons for this economic success. It has helped propel Hong Kong as Asia’s premier trade and financial services hub. That equilibrium shouldn’t be disturbed.