Morning Brief – Here we go again

Here we go again

As the China-US trade war progressed and the Hong Kong protests continued last year, there was increasing chatter of the implications to the USDHKD peg. 2019 saw bets against the Hong Kong Dollar reach record levels as investors positioned themselves for a potential organised devaluation. We cautioned at the time that markets have tried to break this peg before but the Hong Kong Monetary Authority (HKMA) was a tough opponent to go up against. The most recent flare up in tensions has the trade front and centre in speculative foreign exchange markets, so what’s different this time?

Let’s start off with the background. The Hong Kong Dollar is pegged to the US Dollar with a managed exchange rate. The peg is defined by a band of between 7.75 and 7.85 HKD per US Dollar. The currency is therefore free to trade with a little over a 1.25% range. There is a considerable budget overseen by the HKMA to enforce this peg and since 2016 the vast majority of it has been depleted by its purchase of USD to that end. Due to the status of Hong Kong as a financial hub, the peg was created to support financial stability and encourage investment into the region. Given the managed nature of China’s own currency and the high level of trade between Hong Kong and the mainland, it was also created to prevent stresses between the two regions. The problem now grows for the HKD peg as the Yuan approaches record lows of 7.20 once again having broken its 7.0 ceiling.

The protests that began in the middle of 2019 centred upon an extradition bill. The legal initiative would have allowed extradition of Hong Kong citizens to mainland China. This sparked fear that Hong Kong’s judicial and civil powers would be undermined and the two systems of Hong Kong and the mainland were merging together. The potential threats were considerable to the Hong Kong Dollar and caused not only from the protests and the economic spillovers therein but also by the potential loss of its status as a financial hub. Coronavirus did what the removal of the extradition bill in September failed to do and stopped the protests in their tracks. Despite tangible stresses in the HKD market shown within forward rates and implied volatility measures, the spot rate stayed within the 7.75-7.85 band.

Protests have resumed in Hong Kong in recent days as China attempts to impose a new security law on China. Global condemnation of the measures has also followed. The law in its draft form aims to exist to prevent “splittism, subversion, terrorism, [and] any behaviour that gravely threatens national security and foreign interference”. The details of the law as they emerge are expected to mimic China’s own security law which gives the state vast power to control just about anything it wishes to. Beijing will effectively be in the driving seat of Hong Kong’s political economy.

The National People’s Congress have, as of a few minutes ago, passed the controversial draft. The HKMA thus far claims that there have not been any noticeable outflows from its currency or banking system. The spot rate interestingly remains towards the lower bound of the peg with considerable pressure building for it to rise. Yesterday, Secretary of State Mike Pompeo announced to Congress that Hong Kong is no longer politically autonomous. The special relationship between the US and Hong Kong has been one significant factor in facilitating the peg, encouraging investment in the region. As the political developments spill over into US-China tensions, the case of a higher USDHKD peg is growing.

Discussion and Analysis by Charles Porter

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