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US-China spat puts future of Hong Kong dollar in the spotlight

Hong Kong has become a focal point in tensions between the US and China, which means that the linked exchange-rate system in place for the past few decades — tying the local dollar to the US dollar — is also in the spotlight. Speculators including Kyle Bass have talked of a collapse in Hong Kong’s currency under pressure from heavy outflows.

But if Eddie Yue is worried about a breakdown, he does not show it. The head of the Hong Kong Monetary Authority, the city’s de facto central bank, told the Financial Times recently that the task of defending the Hong Kong dollar has become easier in a world of rock-bottom interest rates.

“If there was a strong outflow, raising interest rates is our most important mechanism,” Mr Yue told the FT. “It would only take a mild . . . adjustment for inflows to come back.”

He argues that circumstances today are a far cry from more than 20 years ago, when the Asian financial crisis included dramatic corrections in the Thai baht and Indonesian rupiah, as well as the South Korean won, the Malaysian ringgit and the Taiwanese dollar. The Hong Kong dollar came under fierce pressure too.

Given rates are so low now, “it would only take a 10 to 15 per cent premium for people to come back”, said Mr Yue, noting that the base was much higher in 1997. On “Black Thursday” in October that year, overnight rates spiked as high as 280 per cent as banks scrambled to lay their hands on Hong Kong dollars to avoid negative balances in their clearing accounts.

These days, the gap between three-month US and Hong Kong rates is about half a percentage point, which means the incentive for holding the local currency is small. Even so, the Hong Kong dollar is trading towards the strong end of its band, thanks in large part to inflows caused by the local listings of Chinese champions such as JD.com and NetEase, along with quarter-end dividend payments from Chinese state-owned enterprises listed in the city.

The HKMA’s first line of defence, of course, is its $442bn in foreign exchange reserves — a sum roughly double the monetary base. Mr Yue also notes that the authority’s “surveillance” techniques are more advanced than during the Asian financial crisis, so that it has good intelligence on “when banks are lending to speculators”.

Yet if the link were to come under sustained pressure, and higher interest rates proved inadequate to stem outflows, the HKMA might not look to the US Federal Reserve to supply a flow of US dollars.

One person close to the HKMA said that it could turn to the People’s Bank of China, rather than the Fed, if the system really needed an external source of US dollars.

That Hong Kong would rely on China rather than the US for support in maintaining the level of the Hong Kong dollar is a sign of the politicisation of central banks, as the stand-off between Beijing and Washington endures.

Tapping the PBoC rather than the Fed would be “a good indication that relations have become more political than ever before”, said Zhiwu Chen, head of the Asia Global Institute at Hong Kong University. The HKMA would do that only if goodwill with the US were “totally exhausted”, he added.

Dino Kos, a former head of markets at the New York Fed, said that “in the minds of Fed officials, there is a clear line between monetary policy and foreign policy and the Fed is always conscious of that”. In that context, the US central bank would be “crazy” to allow a drawdown of US dollars to the HKMA “without permission from the US Treasury”, added Mr Kos, who is now a senior executive with CLS, a forex settlement provider.

Would all that firepower be enough to protect the link? This time the context is very different, meaning that confidence in the system does not depend simply on the weapons that the HKMA is able to deploy.

In the past, the strength of the exchange-rate system was ultimately about confidence in the future of Hong Kong as the meeting ground between the worlds of Western capitalism and so-called socialism with Chinese characteristics. But as demonstrated this week by the new national security law for Hong Kong, hurriedly approved by Beijing, it is now very much a Chinese city. If that is the case, say some, does it not follow that the days of the old system are numbered?

“Hong Kong has been like West Berlin during the Cold War,” said Kevin Lai, head of economic research for Daiwa Capital Markets in Hong Kong. In time, he said, “it will become East Berlin”.

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