Will Hong Kong End Its Currency Peg to the Dollar?

Hong Kong is economically tied to mainland China to such a degree that a slide of China’s yuan is putting downward pressure on the Hong Kong dollar. But the Hong Kong dollar is pegged to the US dollar. According to Bloomberg Business the Hong Kong dollar has dropped the most since 2003 as speculator bets mount on the peg’s end as Hong Kong repeatedly adjusts the currency’s trading range.

The Hong Kong dollar sank by the most in more than a decade and speculation mounted in the options market that the city’s 32-year-old currency peg will end as investors lose confidence in Chinese assets.

While the yuan’s depreciation does drive haven demand for the Hong Kong dollar, “another dynamic has entered the equation and that dynamic is a potentially large devaluation of the renminbi,” said Mirza Baig, head of foreign-exchange and interest-rate strategy for Asia Pacific at BNP Paribas SA in Singapore. “That dynamic has perhaps become a bit more acute in recent days. If the renminbi weakens a lot, I don’t see how Hong Kong would escape speculation of de-pegging as well.”

The Hong Kong dollar has traded in a range pegged to the US dollar ever since the former British colony returned to Chinese rule in 1983. The Hong Kong Monetary Authority says that it is fully committed to maintaining the currency peg to the dollar. But Hong Kong is experiencing currency outflows on a smaller scale but similar to what mainland China is experiencing and may be forced to act.

Pegging Currencies to the US Dollar, Euro or Yen

Many economists have commented that if Greece still had its own currency and did not use the Euro that it would not have gone through the threat of debt default. It would simply have devalued its currency. Investopedia writes about the pros and cons of a pegged exchange rate.

Pros

Countries prefer a fixed exchange rate regime for the purposes of export and trade. By controlling its domestic currency a country can – and will more often than not – keep its exchange rate low. This helps to support the competitiveness of its goods as they are sold abroad.

When Chinese and Vietnamese manufacturers translate their earnings back to their respective countries, there is an even greater amount of profit that is made through the exchange rate. So, keeping the exchange rate low ensures a domestic product’s competitiveness abroad and profitability at home.

Cons

A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves as the country’s government or central bank is constantly buying or selling the domestic currency.

The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effects – namely higher inflation. The more currency reserves there are, the wider the monetary supply – causing prices to rise. Rising prices can cause havoc for countries that are looking to keep things stable.

The problem for a country like China today is that its economy is slowing dramatically and investors are changing their money to dollars, euros and yen moving assets offshore. This prompts authorities to continually reset the peg to a low level. Investors see this and move more money offshore before the next devaluation in a self-sustaining feedback loop. Hong Kong, because it is linked so closely to mainland China is caught in this cycle. Will Hong Kong end its currency peg to the dollar? It may have to before all the money goes offshore to Japan, North America or Europe.