Hong Kong Dollar

In this chartbook, we look at the balance of payments across DM and EM countries. The US does not fare well, but neither do a few other countries.

Taiwan, Singapore, and Korea's currencies might appreciate versus the USD, driven by capital repatriation from domestic private investors away from the US. This thesis is less pertinent to India, Indonesia, and the Philippines because they have large net foreign portfolio liabilities. Malaysia and Thailand fall in the middle, while China is an exception. Investors should play intensifying deflationary pressures in Asia by betting on lower interest rates in the region.

This week, we look at the sustainability of the HKD peg as the next whale to move markets, given what is happening to tariffs. After careful analysis, our bias is that it is here to stay. With the DXY dipping below 100, we are likely to see a rebound, which is actually bad news for the Hong Kong region of China, since it will tighten financial conditions. We have no new short-term trades, but if the peg broke, you want to be short HKD/JPY.

In this week’s report, we release an update to our long-term REER valuation model and expected future returns for major currencies.

In this Special Report, we update our thinking on the Hong Kong SAR dollar peg, with implications for domestic asset markets.

The HK dollar is under an assault from rising US interest rates and a weak economy. To defend the exchange rate peg, the HKMA will continue to tighten liquidity, which will boost HK interest rates above those in the US across the entire yield curve. That will cause major damage to this economy and HK-domiciled companies' stocks. Downgrade the MSCI HK equity index within a global portfolio from neutral to underweight.

Executive Summary Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Property Prices In Hong Kong Will Drop Property Prices In Hong Kong Will Drop Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning Banks In Hong Kong Are Facing A Tough Reckoning Banks In Hong Kong Are Facing A Tough Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive The HKD Is Expensive The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting  a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor  qingyunx@bcaresearch.com Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong The HKD is facing its most critical test in several decades. While the peg is likely to survive (Feature Chart), the economic costs for Hong Kong SAR will be far reaching. Critically, monetary policy in Hong Kong SAR is being tailored behind a hawkish Fed, while economic ties with China increasingly warrant easier policy settings. This tug of war will be resolved via a reset in domestic spending and asset prices. Equity shares have been the first shoe to drop. Real estate values and consumer spending will be next. A hypothetical delinking of the peg will see the HKD depreciate since it is expensive on a real effective exchange rate basis. Longer term, the rising use of the RMB in Hong Kong SAR will render the peg a relic. It will also fit with China’s aims to internationalize the RMB.​​​​​. Bottom Line: The HKD peg is likely to survive in the near term, but the economic repercussions from maintaining the linked exchange-rate system will trigger a rethinking by the Hong Kong Monetary Authority (HKMA) and mainland authorities. Eventually, HKD could be replaced by the CNY. For now, HKD interest rates are slated to rise further, which will have ramifications for domestic spending and asset prices. Feature Chart 1HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates HKD Has Been Tracking Interest Rates The Hong Kong dollar (HKD) has been trading on the weak side of its convertibility band since May. In theory, this suggests there is intense pressure for the peg to be delinked, which should lead to a much weaker exchange rate. In practice, interest rates in Hong Kong have failed to keep up with the surge in US rates, which has led to widening interest rate differentials between Hong Kong and the US. As a result, investors have embarked on a massive carry trade, funding USD purchases with HKDs (Chart 1). HKD’s weakness has raised questions about whether the exchange rate could face a crisis of confidence. This will be a severe blow to the HKMA whose sole role is currency stability, with the HKD being the underlying bedrock of Hong Kong’s financial system. In this report, we suggest that the HKD will survive this crisis, just as it has navigated previous shocks since 1983. The brunt of the adjustment will be domestic, first from Hong Kong equities, but spreading to real estate and consumer spending. Longer term, the HKD might become a relic as transactions in Hong Kong are increasingly conducted in RMB. Will The Peg Be Sustained? Historically, currency pegs more often than not fail. Specific to the HKD, the peg is facing its most critical test in decades but is likely to survive for a few reasons. First, every HKD that the region of Hong Kong has ever printed is backed by USD reserves, to the tune of 1.8 times. Quite simply, FX reserves are much higher than the Hong Kong monetary base (Chart 2). This suggests the HKMA’s “convertibility promise” remains credible. Second, Hong Kong also ranks favorably when looking at the ratio of broad money supply to FX reserves. Every 42.3 cents of broad money creation can be backed by foreign currency, a ratio much higher than China and on par with Singapore (Chart 3). With a monetary base fully backed by FX reserves and a broad money-to-FX reserve ratio largely in line with other linked exchange rate systems, our bias is that the peg will remain in place at least over a cyclical horizon (12-18 months). Chart 2In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg In Theory, The HKMA Can Defend The Peg Chart 3The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC The HKMA Ranks Favorably To The PBoC This credibility will come at a huge cost to the domestic economy, however. By having a fixed exchange rate system and an open capital account, Hong Kong has given up control over domestic monetary policy. Consequently, it must import monetary policy from the US. As interest rates rise in the US, demand for US dollar deposits from Hong Kong concerns goes up, putting downward pressure on the exchange rate. To maintain the convertibility ratio, the HKMA must drain the system of Hong Kong dollars to lift domestic interest rates. This is quite visible not only from the drop in foreign exchange reserves, but also the drawdown in the aggregate balance of domestic banks parked at the HKMA (Chart 4). From May 11 through August, the HKMA has absorbed a total of HKD 213 billion, shrinking the aggregate balance in the banking system by more than 60%. Chart 4Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Liquidity Will Shrink Further In Hong Kong Historically, the aggregate balance has had to drop much more to restore an equilibrium between interest rates in the US and Hong Kong SAR. The implication is that liquidity will continue to be drained from the system to ultimately defend the peg, and local interest rates will rise. There is one important caveat: Hong Kong SAR’s net international investment position stands at 580% of GDP, much higher than broad money supply. As such, the Hong Kong SAR does not have a solvency problem. What it faces is too much domestic liquidity, which is pushing HKD interest rates lower (Chart 5). Chart 5The HKD Is Facing A Liquidity, Rather Than A Solvency Crisis The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Ramifications Of The USD Peg When the HKD was tied to the US dollar in 1983, it made economic sense. Hong Kong SAR’s economy was more linked via trade to the US, compared to China (Chart 6). As such, stability vis-à-vis the US dollar was a vital appeal for traders, financiers, and all industries tied to the Hong Kong hub. Since then, there has been a tectonic shift in economic dependence. Exports to China now account for almost 60% of the total, while those to the US have fallen well below 8%. Quite simply, Hong Kong SAR still imports monetary policy from the US, while it is increasingly dependent on the Chinese economy. Nonetheless, there have been a few adjustments. The use of the RMB in Hong Kong SAR has been gradually gaining momentum. RMB deposits have risen to over HKD 800bn. As a share of narrow money supply (M1), it is almost 50% (Chart 7). There are also over 140 licensed banks in Hong Kong allowed to engage in RMB-based business. Chart 6Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Hong Kong And China Are Tied To The Hip Chart 7Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System Hong Kong Is Transitioning Into A Defacto RMB System These links extend beyond just banking turnover. First introduced in 2014, the southbound trading links between China and Hong Kong SAR have become a major conduit for mainland investors to gain exposure to foreign firms. The China-Hong Kong stock connect has now handled over 2.6tn RMB in cumulative flows. This represented as high as 40% of the equity turnover in Hong Kong SAR (Chart 8). Capital account transactions have also been progressively relaxed, and the issuance of RMB bonds has been rising rapidly since 2008. Chart 8Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Lots Of Financial Links Between The HKD and RMB Hong Kong SAR’s strengthening ties with China comes with some good news. The increase in Chinese domestic liquidity is lowering the cost of capital for local enterprises. At the same time, it might also be fuelling very low domestic interest rates, forcing locals to chase higher rates elsewhere. This does not affect the peg if people sell the RMB to buy other currencies, including the dollar or maybe even the HKD. The bad news is that Hong Kong has now become a high-beta play on China as both economies are inexorably interlinked. Chart 9 shows that consumers in Hong Kong SAR tend to have much more volatile spending patterns compared to China, especially when economic growth is about to slow. One reason is that Hong Kong concerns are highly levered notably to the property market (Chart 10). For example, the debt service ratio in Hong Kong SAR sits at 32% of disposable income, much higher than China or other indebted economies (Chart 11). This makes the economy very vulnerable to rising interest rates. Chart 9Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Hong Kong Is Economically More Volatile Than China Chart 10Hong Kong Cannot Escape A Hard Landing (Part 1) Property Prices In Hong Kong Will Drop Property Prices In Hong Kong Will Drop Chart 11Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) Hong Kong Cannot Escape A Hard Landing (Part 2) The bottom line is that as the HKMA withdraws domestic liquidity, this will reassert downward pressure on business activity and asset prices, particularly real estate. With private consumption a whopping 65% of GDP, household deleveraging will also prove to be a formidable headwind for domestic spending. Outside interest rates, Hong Kong SAR remains a trade hub. If global trade slows down meaningfully, this will lead to a deterioration in the current account. This triple whammy from slowing global trade, rising interest rates and consumer deleveraging could prove indigestible for Hong Kong assets. Policy Options Chart 12The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong The Government Could Bail Out Hong Kong As highlighted above, the HKD peg will remain in place for the foreseeable future, but this will come at a huge cost. The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor also imposes fiscal discipline since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 12). The drawback of a fixed exchange-rate regime is that Hong Kong SAR has relinquished control over independent monetary policy. Such a union was justified when the economic cycles between the US and Hong Kong SAR were in sync, but now the region needs easier policy settings. The roadmap of the late 1990s could be what is in store for Hong Kong SAR. In short, the peg survived but the region went through a severe internal devaluation. During the Asian crisis, property prices fell by more than 60%. If that were to occur today, it would herald a prolonged period of high unemployment and stagnant wages to realign the region’s competitiveness with its trading partners. Hong Kong SAR stocks have already borne the brunt of an internal adjustment and are trading at very cheap multiples (Chart 13). The MSCI Hong Kong stock index is composed of mostly financials (47% of market cap) and property stocks (21% of market cap). As HKD rates are rising, loan growth in Hong Kong SAR is contracting and net interest margins have collapsed (Chart 14). This does not bode well for the near-term performance of financials. Chart 13Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Markets Have Already Discounted A Pessimistic Scenario For Hong Kong Shares Chart 14Banks In Hong Kong Are Facing A Tough ##br##Reckoning Banks In Hong Kong Are Facing A Tough Reckoning Banks In Hong Kong Are Facing A Tough Reckoning The good news is that similar to the late 1990s, banks are unlikely to go bust. Hong Kong SAR banks are well capitalized and delinquency rates are quite low, suggesting a banking crisis is unlikely to be a source of pain for the HKD peg (Chart 15). In fact, Hong Kong SAR banks rank favorably among their global peers in terms of capital adequacy (Chart 16). Chart 15Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Banks In Hong Kong Are Well Capitalized (Part 1) Chart 16Banks In Hong Kong Are Well Capitalized (Part 2) The Future Of The Hong Kong Dollar Peg The Future Of The Hong Kong Dollar Peg Specific to the currency, Hong Kong is also running recurring current account surpluses. This is boosting its FX reserves (Chart 17). That lends credibility to the peg in the near term. The bad news is that as the domestic economy slows down, and global trade comes close to a standstill, these surpluses could evaporate. One cost to Hong Kong is that the peg to the US dollar has made HKD incrementally expensive. Our model shows that the real effective exchange for HKD is about 2.5 standard deviations above fair value (Chart 18). Our view on the US dollar is that we could see depreciation over a 12-to-18-month horizon, but an overshoot in the near term is quite likely. A drop in the US dollar will help realign competitiveness in the HKD. Meantime, the market has also been pushing the currency towards the weaker side of its convertibility band. Chart 17Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Balance Of Payments Remain Favorable For The HKD Chart 18The HKD Is Expensive The HKD Is Expensive The HKD Is Expensive Longer term, as Hong Kong SAR continues to become more entwined with China, a peg to the CNY will make sense. This process will be the initial step in the region’s official embrace of the RMB system. That said, the process will be gradual since the US dollar remains very much a reserve currency, and the relevance of Hong Kong SAR as a financial center hinges upon easy access to the USD. What is more likely is that any re-pegging to the RMB will come many years down the road, when the yuan has become a fully convertible currency. The de-pegging of the HKD from the USD or adjusting the peg is as much a political discussion as an economic one. Political conditions for this change are not yet present given such a change will have major ramifications for the economy of Hong Kong SAR and will likely also reverberate through financial asset prices. One can imagine a scenario where HKD yields are forced to adjust to a new nominal anchor. Investors have been convinced through almost 30 years of history to treat the HKD as a proxy for the US dollar. That said, the economic pain associated with maintaining the HKD-USD peg will ensure authorities accelerate the use of RMBs in Hong Kong, with a goal of eventually adopting the yuan as the de facto currency. Adopting  a currency board akin to Singapore is another option that makes sense, especially since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. That said, this is unlikely to be politically palatable, especially for Beijing. A link to the yuan that already does this job makes sense. Finally, there is always the option to fully float the peg, but this would probably increase currency volatility. This is unlikely in the near term. The Goldilocks scenario for policymakers is when the US dollar eventually depreciates against major currencies, easing financial conditions for Hong Kong SAR concerns. This will dovetail nicely with the goals of the monetary authorities, maintain credibility while easing financial concerns for a very levered economy. Investment Conclusions The HKD peg will remain in place, but the financial dislocations will lead to significant internal devaluation in Hong Kong SAR. As US interest rates rise, the HKD will be under considerable pressure. The HKMA will have no choice but to allow HKD interest rates to rise. This will tip the property market and thrust the economy into deflation and a recession. Chinese bonds are the best hedge against this risk. Avoid property and financial shares for the time being. Were the peg to break today, the HKD will depreciate according to our valuation models. This suggests markets are right to push the HKD-linked rate towards the weaker end of the convertibility band. Despite the economic and financial pain, the HKMA will not abandon the peg. That means carry trades will continue to make money. Using the HKD as a funding currency still makes sense in the near term. In long run, the economic pain associated with maintaining the HKD-USD peg will make authorities in Beijing accelerate the use of the RMB in Hong Kong’s special administrative region. The eventual goal will be for Hong Kong SAR to adopt the yuan as its currency.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Qingyun Xu, CFA Associate Editor  qingyunx@bcaresearch.com

Dear clients, The Foreign Exchange Strategy will take a summer break next week. We will resume our publication on September 4th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Feature The economy of Hong Kong SAR1 has been held under siege by two tectonic forces. With the highest share of exports-to-GDP in the world, and at very close proximity to China, the epicenter of the pandemic shock, economic growth has been knocked down hard. The second shock to Hong Kong’s economy has been political instability. The extradition bill that was proposed in February 2019, followed by the enactment of the national security law this past June, has been accompanied by cascading street-wide protests and social unrest. The spirit of the bill is that crimes committed in Hong Kong can be trialed in China. The US has moved to impose sanctions on Hong Kong, as it no longer sees the city-state as autonomous, the latest of which is revoking its extradition treaty with the former colony. Some commentators have defined this as the end of the one country, two systems socio-economic model that has been in place since the handover from British rule in 1997. From a currency perspective, these shocks put in question the sustainability of the Hong Kong dollar (HKD) peg. Historically, currency pegs more often than not fail, especially in the midst of both geopolitical and economic turmoil. This was the story of the Asian Financial crisis in the late 1990s, and the Mexican peso crisis earlier that decade. Is the Hong Kong dollar destined for the same fate? If so, what are the potential adjustments in the exchange rate? Finally, what indicators can investors look to as a guide for any pending adjustment? A Historical Perspective Chart 137 Years Of Stability 37 Years Of Stability 37 Years Of Stability The HKD is no stranger to shifting exchange-rate regimes. Over the last 170 years, it has been linked to the Chinese yuan, backed by silver, pegged to the British pound, free-floating, and, since 1983, tied to the US dollar. Therefore, a bet on the unsustainability of the peg is historically justified. That said, the stability of the peg to the US dollar has survived 37 years of economic volatility, suggesting the Hong Kong Monetary Authority (HKMA) has been able to successfully navigate a post-Bretton Woods currency era (Chart 1).   Beginning as a bi-metallic monetary regime in the early 19th century, the HKD was initially linked to gold and silver prices, akin to the commodity–monetary standard that dominated that era. When Britain colonized Hong Kong in 1841, and as new trade alliances developed, the drawbacks of the bi-metallic monetary standard became apparent. As bilateral trade boomed, adjustments to imbalances (surpluses or deficits) could not occur through the exchange rate since it was fixed. Therefore, they had to occur through the real economy. This led to very volatile and destabilizing domestic prices. The stability of the peg to the US dollar has survived 37 years of economic volatility. Most Anglo-Saxon countries finally converted from bi-metallic exchange rates to the gold standard in the late 1800s, and strong ties to China dictated that Hong Kong naturally adopted the silver dollar in 1863. However, the silver system had the same drawbacks as the bi-metallic standard. Specifically, when your money supply is fixed, any increase in output leads to “few dollars chasing many goods.” This is synonymous with falling prices, just as “many dollars chasing few goods” is synonymous with rising inflation. The petri dish for this phenomenon was the post-World War I construction boom. A fixed money supply under the gold (and silver) standard meant rapidly falling prices globally. By the late 1920s, most countries had overvalued exchange rates relative to gold (and silver), that exerted powerful deflationary forces on their domestic economies. This forced most Western governments to debase fiat money vis-à-vis gold to stop price deflation. Correspondingly, China had to abandon the silver standard in November 1935, with Hong Kong shortly following suit. At the time of debasement, the United Kingdom was the leading economic power. As a colony, it made sense for the Hong Kong government to link the HKD to the British pound. The established rate was GBP/HKD 16, giving birth to the currency board system (Chart 2). Meanwhile, as a trading hub, a peg with an international currency made sense. The problems there were two-fold. First, the pound was still gold-linked. And second, Britain’s subsequent decline in economic power was accompanied by a series of sudden and dramatic devaluations in the pound, which was hugely disruptive to Hong Kong’s financial system. By 1972, the British government decided to float the pound, which effectively ended the GBP/HKD peg. Chart 2A History Of The HKD Peg A History Of The HKD Peg A History Of The HKD Peg In July 1972, the authorities made the decision to peg the Hong Kong dollar to the US dollar at USD/HKD 5.65, which was another policy mistake. The switch made sense given the rising economic power of the US, as well as rising trade links (Chart 3). However, the dollar was also under a crisis of confidence following the Nixon devaluation in 1971. In February 1973, the HKD was freely floated. Chart 3The Peg Is Usually Against The Dominant Economic Power The Peg Is Usually Against The Dominant Economic Power The Peg Is Usually Against The Dominant Economic Power Counter-intuitively, the free-floating era for HKD was arguably the most volatile for its domestic economy. For one, discipline in monetary policy was gone. Money and credit growth exploded, inflation hit double-digits, home prices soared and the trade balance massively deteriorated. Political instability was also rife, given the uncertainty surrounding the end of British claims on the island. As the dialogue included China’s reclaim of political control over Hong Kong, there was uncertainty over the rule of law. This cocktail of political and economic uncertainty led to a 33% depreciation in the HKD between mid-1980 and October 1983. Panicked policymakers returned to the US dollar peg. Paul Volcker, then Federal Reserve chairperson, was establishing himself as the world’s most credible central banker, having dropped US inflation from almost 15% in 1980 to below 3% by 1983. Economic and financial links with the US also justified a peg. In August of 1983, the authorities announced a USD/HKD fixed rate of 7.80, which has remained in place since. The Current Peg: Advantages And Disadvantages Chart 4Fiscal Prudence In Hong Kong Fiscal Prudence In Hong Kong Fiscal Prudence In Hong Kong The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. First, the US dollar is an international reserve currency dominating international trade, which helps to facilitate settlements while instilling confidence among transacting participants. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor imposes fiscal discipline, since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. In the extreme case, the central bank can run out of reserves, causing the peg to collapse. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 4). The drawback of a fixed exchange rate regime is that a country or a region relinquishes control over independent monetary policy. In the case of Hong Kong, this means that interest rates are determined by the actions of the US Fed. Such a marriage was justified when the business cycles between the two economies were in sync, but in times of economic divergences, the fixed exchange rate leads to economic volatility. Chart 5Currency Peg And Internal Devaluation Currency Peg And Internal Devaluation Currency Peg And Internal Devaluation Chart 6Hong Kong Interest Rates In The Late 90's Hong Kong Interest Rates In The Late 90's Hong Kong Interest Rates In The Late 90's This divergence was clearly evident in the 1990s, as falling interest rates in the US supercharged a housing and stock market bubble in Hong Kong. When the Asian crisis finally came around in 1997, the lack of exchange-rate flexibility led to a vicious internal devaluation (Chart 5). A prolonged period of high unemployment and stagnant wages was needed for Hong Kong to finally improve its competitiveness. Most importantly, in 1998, in the depths of the Asian financial crisis, the peg attracted a concerted attack from speculators who believed a devaluation of the Hong Kong dollar alongside other regional currencies was inevitable. Their assault inflicted considerable pain, driving short-term HKD interest rates (Chart 6) and wiping out over a quarter of the local stock market in a matter of weeks. At the time, the Hong Kong government was successful in fending off the speculative attacks by intervening massively in both the foreign exchange and equity markets. Is An Adjustment Pending? If So, When?      Chart 7USD/HKD And Interest Rate Spreads USD/HKD And Interest Rate Spreads USD/HKD And Interest Rate Spreads As the above narrative suggests, the HKD is no stranger to socio-economic shocks and speculative attacks, and it has, more recently, weathered them pretty well. The more immediate question is whether the shift in the political landscape could be potent enough to crack the peg this time around. While plausible, it is unlikely for a few reasons. First, the HKD continues to trade on the stronger side of the peg as US interest rates have collapsed, wiping off any positive carry that would have catalyzed outflows. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely (Chart 7). A currency board has unlimited ability to defend the strong side of the peg, since it can print currency and absorb foreign reserves (print HKDs and use these to buy USDs in this case). On the weak side, these foreign exchange reserves are drawn down. Therefore, any threat to the peg should be preceded by consistent trading on the weaker side, questioning the HKMA’s ability to keep selling FX reserves to defend the peg. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely. Second, the Hong Kong peg remains extremely credible, since the entire monetary base is backed over two times by FX reserves (Chart 8). Even as a percentage of broad money supply, Hong Kong reserves are ample and very high by historical standards (Chart 8, bottom panel). Meanwhile, since 1983, the currency board system has undergone a number of reforms and modifications, allowing it to adapt to the changing macro environment. This represents a powerful insurance policy for the HKMA’s ability to defend the currency peg, significantly enhancing the system’s credibility. Chart 8Ample Foreign Exchange Reserves Ample Foreign Exchange Reserves Ample Foreign Exchange Reserves Chart 9Hong Kong Runs Recurring Surpluses Hong Kong Runs Recurring Surpluses Hong Kong Runs Recurring Surpluses Third, ever since the peg was instituted, Hong Kong has mostly run budget surpluses. As a result, government debt in Hong Kong is almost non-existent, as we illustrate above. This has removed any incentive to monetize spending, which remains an open argument in the US, Japan or even the euro area. One of our favored metrics on the health of a currency is the basic balance, and on this basis, Hong Kong scores much more favorably than the US. While Hong Kong has transitioned from being a goods exporter to that of services, it remains extremely competitive, with a healthy current account surplus of 5% of GDP (Chart 9). These recurring surpluses have propelled Hong Kong to one of the biggest creditors in the world, with a net international investment position that is a whopping 430% of GDP and rising (Chart 10).   Chart 10Hong Kong Is A Net Creditor To The World The Hong Kong Dollar Peg And Socio-Economic Debate The Hong Kong Dollar Peg And Socio-Economic Debate Fourth, over the past few years, productivity in Hong Kong has outpaced that of the US and most of its trading partners (Chart 11). This has lifted the fair value of the currency tremendously. This means it is more like that when the peg adjusts, the outcome will be HKD appreciation. On a real effective exchange rate basis, the HKD is not that overvalued compared to the US dollar, after accounting for the massive increase in relative productivity (Chart 12). It is notable that during the Asian financial crisis, currencies like the Thai bhat were massively overvalued, which is why the adjustment was back down toward fair value. Chart 11Hong Kong Is Highly Productive Hong Kong Is Highly Productive Hong Kong Is Highly Productive Chart 12Trade-Weighted HKD Is Slightly Expensive Trade-Weighted HKD Is Slightly Expensive Trade-Weighted HKD Is Slightly Expensive Fifth, there is a strong incentive for both Beijing and Hong Kong to defend the peg, because the relevance of Hong Kong is no longer as a shipping port, but as a financial center. The peg reduces volatility, as transactions are essentially dollarized. The relevance of Hong Kong in Asia can be seen by looking at the market capitalization of the Hang Seng index compared to that of the Topix index in Tokyo or the Shanghai Composite index. Any escalation in the US-China trade war, especially in the technology sphere, will only lead to more listings on the Hong Kong stock exchange. Equity flows through the HK-Shanghai and HK-Shenzhen stock connect program are rising, suggesting the market still considers Hong Kong an important intermediary in doing business with China (Chart 13).  On the political front, the most potent risk is that the US Treasury moves to unilaterally limit access to US dollars by Hong Kong banks. While this was discussed by President Trump’s top advisers, it was also dismissed as unwise due to the potential shock to the global financial system. Meanwhile, with massive swap lines with the Fed, Hong Kong’s international banks can always draw on US liquidity. Tariffs on Hong Kong goods are another option, but this again will not really deal a severe blow to the peg, since Hong Kong mainly re-exports, with very little in the way of domestic goods exports (Chart 14). Chart 13Hong Kong Is An Important Financial Center Hong Kong Is An Important Financial Center Hong Kong Is An Important Financial Center Chart 14Hong Kong Is Partially Insulated From Tariffs Hong Kong Is Partially Insulated From Tariffs Hong Kong Is Partially Insulated From Tariffs   Property Market Blues The property market is the one area in Hong Kong where a sanguine view is difficult to paint. Hong Kong is one of the most unaffordable cities on the planet, and high income inequality has been a reason behind resident angst. The gini coefficient, a measure of inequality in a society, is more elevated in Hong Kong compared to Singapore, China or even South Africa. After years of loose monetary policy, property prices in Hong Kong have completely decoupled from fundamentals. Housing is even more unaffordable now than it was back in 1997, and domestic leverage is very high. With such a high debt stock, even a gradual uptick in interest rates will have a significant impact on the debt service burden (Chart 15). Stocks and real estate prices are positively correlated, suggesting deleveraging pressures will likely be quite high if both unravel (Chart 16). Chart 15High Debt Service Burden##br## In Hong Kong High Debt Service Burden In Hong Kong High Debt Service Burden In Hong Kong Chart 16Hong Kong Stocks Are Tied To The Property Market Hong Kong Stocks Are Tied To The Property Market Hong Kong Stocks Are Tied To The Property Market However, there are offsetting factors. First, it is unlikely that interest rates in Hong Kong (or anywhere in the developed world for that matter) will rise anytime soon. COVID-19 has provided “carte blanche” in terms of global stimulus. More importantly, the US is at the forefront of this campaign, meaning interest rates in Hong Kong will remain low for a while. Second, in recent history, Hong Kong has proven that it has the resilience to handle volatility in the property markets. During the Asian crisis, property prices fell by 60%, yet no bank went bust. Share prices also collapsed but are much higher today, suggesting the drop was a buying opportunity. And with such a low government debt burden, any systemic threat to banks will nudge the authorities to bail out important companies and sectors. In terms of asset markets, the performance of the Hang Seng index relative to the S&P 500 is purely a function of interest rates. The US stock market is dominated by technology and healthcare that do well when interest rates fall, while banks and real estate dominate the Hong Kong market. So rising rates hurt the US stock market much more than Hong Kong (Chart 17). Meanwhile, the recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore (Chart 18). This suggests that a lot of the potential equity outflows have already occurred, based on today’s situation. Chart 17Interest Rates And The Hong Kong Stock Market Interest Rates And The Hong Kong Stock Market Interest Rates And The Hong Kong Stock Market Chart 18Hong Kong Has Cheapened Relative To Singapore Hong Kong Has Cheapened Relative To Singapore Hong Kong Has Cheapened Relative To Singapore The Future Of The Peg A peg to the Chinese RMB makes sense. The Hong Kong economy is now heavily tied to the Chinese economy, with over 50% of exports going to China (previously mentioned Chart 3). However, that will sound the death knell for Hong Kong’s status as a financial center, since the US dollar remains very much a reserve currency. There is also a risk that if Beijing uses RMB depreciation as a weapon in a blown-out confrontation with the US in the coming years, it will threaten the sustainability of the HKD peg, since it could inflate asset bubbles. What is more likely is that the option of re-pegging to the RMB comes many years down the road, when the yuan has become a fully convertible currency. The recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore. There is the option to assume another currency board akin to Singapore. This option makes sense, since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. Such an overhaul will require significant technical expertise and political will from both Beijing and Hong Kong. It is not very clear what the cost/benefit outcome would be of this initiative, but it is worth considering since the RMB itself is managed against other currencies. Finally, there is always the option to fully float the peg, but this is likely to increase volatility. As well, for policymakers, it makes sense to continue pegging the exchange rate to the US dollar as it depreciates against major currencies, since it ends up easing financial conditions for Hong Kong concerns.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Special Administrative Region of the People's Republic of China  Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades