HKD peg back in focus as SNB removes currency floor
The Hong Kong dollar’s peg to the US dollar has, once again, come under scrutiny after the Swiss National Bank’s (SNB) removal of its currency’s floor roiled currency markets globally.
Hong Kong’s financial secretary John Tsang
Earlier this week, Hong Kong’s financial secretary John Tsang reinforced the currency board mechanism of the Hong Kong Monetary Authority (HKMA), under which the Hong Kong dollar is pegged between 7.75 and 7.85 to the dollar, in response to a question he was asked during the Asian Financial Forum in Hong Kong.
Tsang pointed out the nature of the two systems were distinct and added “our currency board system is working well and we have no intention or a need … to make any changes at this point”.
Switzerland and Hong Kong are considered small, open and financially geared economies with stable political systems, with large current-account surpluses and reserves, endowing them with the status of safe haven. Their strong fundamentals and their limited control of domestic monetary conditions, through the currency pegs, left fiscal policy as the principal lever to influence inflation, growth and asset prices.
Both Switzerland, under the euro peg, and Hong Kong imported loose monetary policies and hot money, triggering run-away real-estate price appreciation.
The integrity of the Hong Kong peg to the dollar has been under question for years, from a minority of market participants, citing the inflation-fuelling effects of Fed policies on Hong Kong asset prices. Switzerland, by contrast, imposed a weaker exchange rate in 2011 to fuel inflation once the central bank hit the lower bound.
Nevertheless, the politics and technical arrangements of the respective currency management systems differ significantly.
A de-peg may not necessarily lead to a sudden and
Under the SNB’s currency floor mechanism, the franc was managed against an exchange-rate cap of 1.20 francs to a euro by building up foreign currency reserves and printing francs. By managing the currency through only the upper bound, the SNB communicated its intention to protect the country’s exporters by keeping the franc undervalued against the euro. The resultant increase in the Swiss monetary base brought it to nearly 70% of GDP.
In Hong Kong, the currency board requires that the monetary base be fully backed by foreign currency held in the exchange fund. Under the linked exchange rate system, the HKMA can intervene to manage the currency between a band of 7.75 to 7.85 to the dollar by expanding and contracting the monetary base. This influences short-term interest rates and so regulates buying and selling in the Hong Kong dollar.
Akin to Singapore’s currency board, the 32-year peg has been seen as an important driver of Hong Kong’s economic success and the stability of the monetary regime remains an article of faith among policymakers.
According to Patrick Bennett, executive director, capital strategy for CIBC Hong Kong, the franc, unlike the HKD, was pegged under an inappropriate system from day one.
“When the SNB put the cap in place, it was a fairly retrograde step,” he says. “It became unmanageable as economic fundamentals in Europe deteriorated.”
The HKD, on the other hand, is pegged to a currency with relatively strong economic fundamentals and is on course to appreciate this year. Therefore, state s Pauline Loong, managing director at Asia-Analytica, the HKD peg and the Swiss franc cap involved distinct mechanics.
“The mechanics involved are different,” she says. “The political context is different. Even the regulatory aspects are different. It is not even comparing apples and oranges. It is comparing an apple with a chair.”
The move in the Swiss franc should have no impact or provide no pressure on discussions around the HKD peg, says CIBC’s Bennett.
Others disagree. Nobel-prize-winning economist Paul Krugman notes the divergent institutional and political climate accounts for the continued enthusiasm for the peg in Hong Kong, despite the similarities, such as the pegging of both currencies to much larger economies, leaving them at the mercy of exogenous forces even with large reserves.
“The answer [to Hong Kong’s continued enthusiasm towards the peg], I’d argue, is that the institutional set-up and history of Hong Kong plays very differently with hard-money ideologues than the Swiss peg did, even though the facts on the ground weren’t very different at all.
“Swiss currency intervention looked to the usual suspects like activist monetary policy, runaway expansion of the central bank’s balance sheet, ‘printing money’ to debase the currency even if the goal was to keep it from getting stronger.”
He adds: “Meanwhile, Hong Kong has a currency board, which is the next best thing to the gold standard, so maintaining the peg — through the very same mechanisms Switzerland was using — became a demonstration of stern Victorian monetary virtue. Hence no chorus demanding that the peg be abandoned.”
Krugman concludes that, for all intents and purposes, the stable political consensus could continue to drive the Hong Kong peg, even if economic winds shift.
“Remember, there was no forcing event in Switzerland,” he says. “As far as the finances go, the SNB could have maintained the peg forever. It was the nagging from hard-money types that led to the debacle. Meanwhile, Hong Kong has managed to wrap the very same policy in libertarian clothes, and there’s no problem.”
The volatility in the Swiss franc has led to a relatively muted impact on the HKD itself. After the SNB’s announcement, the Hong Kong dollar strengthened to the undertaking level versus the US dollar to 7.75. It has since gone back down to the pre-floor removal level at around 7.7535.
According to Tommy Ong, executive director, treasury and markets for DBS in Hong Kong, the HKD was relatively strong even before the SNB move because of a higher short-term interest rate in Hong Kong than in the US.
Hong Kong is also seen as a safe haven, a status that Switzerland might have temporarily lost, leading it to potentially receive some of the world’s capital seeking a stable currency. Even if there was a repeat of last year’s capital inflow into the HKD, which saw the HKMA intervene to pump in close to $10 billion into the market to defend the peg, Ong says there is no incentive for the central bank to remove the peg or modify the level of the undertaking.
“The real effective exchange rate of the Hong Kong dollar has strengthened by over 20% since mid-2011, together with the US dollar,” he says. “A de-peg may not necessarily lead to a sudden and large magnitude in Hong Kong dollar strength.”
US monetary conditions over the next two years will drive the Hong Kong peg debate.
According to BCA Research: “Since the early 1980s, when the currency peg was established, the US dollar’s bear phases have always led to massive booms in Hong Kong asset prices as well as inflation. On the contrary, periods of a rising dollar have always preceded consumer price deflation and falling property and stock prices.”
As a result, the market consensus that the dollar will continue to stay strong relative to its G7 peers will pose as a deflationary force on Hong Kong asset prices, exposed to tightening through the FX and interest-rate channel in the event of a strong dollar and Fed rate hike.
In this context, without fiscal redress and offsetting capital flows from China, asset prices, particularly real estate, could be subject to disorderly falls in the coming years, as a direct consequence of the currency peg, other things being equal, notes BCA.
Hong Kong, therefore, is in a bind – China drives its real GDP, while US drives money growth – with the SNB move triggering an existential crisis in the integrity of currency pegs, more generally.
In conclusion, a public debate over the limits of the current monetary regime, and the benefits of a yuan peg, could take place sooner or later. Nevertheless, these calls have fallen on deaf ears for the best part of a decade and the decision is likely to be made in Beijing post-RMB convertibility, in any case.