Hong Kong’s dollar peg is on increasingly thin ice

Some trades always seem to disappoint: long Argentina, short Japanese government bonds or attacks on Hong Kong’s currency peg against the US dollar. Recently, a new generation have tried the Hong Kong trade — including the hedge fund managers Kyle Bass and Bill Ackman — and drawn mockery for their ventures into this trader’s graveyard.

But while Bass and Ackman’s specific arguments may be weak, it is no longer risible to make long-shot bets against the Hong Kong dollar. Economically, the peg is close to impregnable. Politically, it is like an ice skater venturing out onto the lake every day as the weather starts to warm.

Bass made headlines for his Hong Kong dollar short in 2019. He claimed at the time that the Chinese territory “sits atop one of the largest financial time bombs in history” and had burnt through most of its foreign exchange reserves.

This was and still is nonsense. Hong Kong’s peg, in a narrow band around the level of HK$7.80 to the US dollar, is perhaps the best-founded fixed exchange rate since the gold standard. Its currency board mechanism is self-stabilising. The Hong Kong Monetary Authority holds enough liquid US dollar assets to back, more than one-for-one, the city’s whole monetary base. When capital flows out of the city, the HKMA buys back its currency from anyone who wants to sell at HK$7.85 to the US dollar. That reduces the monetary base, pushing up local interest rates until they are high enough to pull new capital in. It works the same way in the other direction: when capital flows in, the HKMA will buy dollars at HK$7.75, expanding the monetary base and pushing down local interest rates.

The system got a stress test during the Asian financial crisis of 1997-98 — an atmosphere of considerable political uncertainty following the transfer of Hong Kong’s sovereignty from Britain to China. The city’s interest rates peaked at almost 300 per cent, but the HKMA mauled the speculators and sent them packing. The system is less a financial time bomb than a rock of financial stability. Hong Kong is neither a mismanaged economy or a fraudulent stock to take down with a short selling campaign.

Ackman makes a more plausible case. He recently said: “The peg no longer makes sense for Hong Kong and it is only a matter of time before it breaks.” It is true, for example, that Hong Kong’s economy is increasingly synchronised with that of mainland China, so it makes less sense than it once did to import US monetary policy. Hong Kong interest rates rose from 0.5 per cent to 4.75 per cent this year, following the US Federal Reserve, at a time when the city’s economy was weak.

But one can overstate how much that matters. Importing US monetary policy leads to wild booms and busts in Hong Kong property, which require careful handling by financial regulators. The city’s prosperity, though, rests on its ability to finance trade between China and the rest of the world. For such purposes, the dollar peg still suits everyone — including Beijing — very well indeed.

Nor, for now, is there any obvious alternative. China’s currency is not freely convertible and the pool of offshore renminbi assets is too small for Hong Kong’s needs. Any change would be difficult and destabilising. There is little reason why Hong Kong or Beijing should want to attempt it.

If Hong Kong has the means and the desire to keep its peg, where is the risk? The system has just one weakness, but it is existential. To function as a financial centre, Hong Kong must have access to US dollar clearing. If the city’s banks ever lost access to the American financial system, then a dollar in Hong Kong would not be worth the same as a dollar in New York. Under such circumstances, the peg could not hold for long — and the US imposed exactly these sanctions on Russia after it invaded Ukraine this year.

To see what could happen, consider a serious crisis between America and China over Taiwan. In such a scenario, there would surely be outflows from Hong Kong. Local interest rates would rise as the currency board did its work. But the system’s smooth operation would be at Washington’s mercy, while from Beijing’s point of view, a part of its territory would be suffering a monetary squeeze because it was using its adversary’s currency during a crisis. Would the peg survive such stress? Maybe. But I would not bet on it.

It is therefore reasonable to bet against it, if you can do so cheaply, through options priced to reflect the stability of a currency pegged at the same level since 1983. Such trades may become over time a measure of political tension between China and the US, rising whenever a crisis seems in prospect.

“If you bet against the Hong Kong dollar, you are bound to lose,” Hong Kong’s financial secretary, Paul Chan, said recently. “You can verify my advice with certain hedge fund managers in the US who have been wrong about the Hong Kong dollar, time and again.” There is, to be clear, no active reason to flee the currency.

It remains well-managed and well-backed in a world of uncertainty. Speculative attacks against it, on any normal day, will fail. Between the US and China, however, there are too many abnormal days. In finance, nothing lasts forever, and Hong Kong’s dollar peg, in all probability, is closer to the end of its life than the beginning.

robin.harding@ft.com