INTRODUCTION

The Hong Kong dollar is trading at the weak end of its trading band, leading the HKMA to intervene today for the first time since early 2019.  While we see no threat to the peg, ongoing weakness in the mainland China economy is likely to keep HKD weak for the foreseeable future.  This in turn will put downward pressure on the Hong Kong economy.

RECENT DEVELOPMENTS

The Hong Kong Monetary Authority (HKMA) intervened today to defend the HKD trading band, as expected.  HKMA bought HKD for USD several times as USD/HKD tested the weak end of the trading band at 7.85 for the first time since early 2019.  The total amount was not particularly large ($722 mln) but the commitment is there.  This is quite the change from much of 2020, when inflows into Hong Kong and mainland China led to HKD strength that required the HKMA to sell HKD for USD at 7.75, the strong end of the band.   

The last time HKD traded at the weak end of the band was 2019 as protests over a planned extradition law intensified.  While originally meant as a response to a 2018 murder in Taiwan that was committed by a Hong Kong resident, the extradition law triggered concerns that it would open the door to greater mainland influence on Hong Kong’s legal system.  Those protests were eventually successful in forcing Chief Executive Lam to withdraw the bill from consideration in September of that year.  Yet this proved to be a hollow victory.  In 2020, China imposed the Hong Kong National Security Law and began to exert much more direct control over Hong Kong affairs.

The leadership change in Hong Kong is unlikely to have much impact.  Former security chief John Lee was just selected to take over as Chief Executive this month from outgoing Carrie Lam, who declined to seek a second term.  Lee was the only candidate approved by Beijing and so received all but eight of the 1424 valid ballots cast by the Election Committee that was overhauled in the wake of the 2019 protests.  Because policy is now being directed by Beijing, there will be little change under Lee.

We think this current bout of HKD weakness is more economic in nature.  That is, the Chinese and Hong Kong economies are both coming under pressure; China due to Xi’s COVID Zero policy and Hong Kong due to souring investor sentiment with regards to China as well as Emerging Markets more broadly.  With the Fed and other major central banks tightening aggressively, capital that once flowed freely into EM is now flowing out.

Investor faith that the so-called “one country, two systems” will be maintained until 2047 has already been shaken.  Any heavy-handed efforts by the mainland to modify or end the HKD would be the final straw.  Breaking a peg typically leads to a sharply weaker currency, a spike in inflation, higher interest rates to stabilize the currency, and a deep recession; equity markets would most likely sink sharply.  We do not think China would risk such a drastic change when local markets are already under pressure, investor sentiment is weak, and the leadership is struggling to boost growth.  Since Hong Kong is also the financial gateway to the mainland, such disruption locally would most likely spread to the mainland; CNY/CNH would likely come under pressure too.  Once lost, trust and credibility may never be regained. 

A BRIEF HISTORY LESSON

The U.K. gained control of parts of Hong Kong via three treaties with China.  Because these agreements were signed under duress, China came to call them the “unequal treaties.”  In 1842, the Treaty of Nanking ended the First Opium War and ceded control of Hong Kong to the U.K.  In 1860, the Convention of Peking ended the Second Opium War and ceded control of Kowloon to the U.K. was well.  Lastly, China’s defeat in the First Sino-Japanese War gave the U.K. the opportunity to squeeze further concessions with the Second Convention of Peking in 1898, which forced China to lease the New Territories to the British for 99 years.

After China gained a seat at the United Nations in 1971, it embarked on the long and winding road of regaining sovereignty over Hong Kong and Macao.  No progress was really seen until 1979, when then-Governor of Hong Kong Murray MacLehose traveled to Beijing to discuss Hong Kong’s status with then-leader Deng Xiaoping.  In 1982, former Prime Minister Heath was asked by Prime Minister Thatcher to meet with Deng.  It was then that Deng first outlined his plan to make Hong Kong a special economic zone that would retain its capitalist system.  Thus, the notion of “one country, two systems” was born.

Thatcher herself visited China in October 1982 to meet with Deng.  The U.K. was pushing to maintain its presence in Hong Kong.  On the other hand, China was taking a hard line, refusing not only to extend the 99-year lease for the New Territories but also refusing to recognize the so-called “unequal treaties” that had ceded Hong Kong and Kowloon sovereignty to the U.K.  

By all accounts, these talks were testy.  It is said that Deng even hinted at the possibility of taking Hong Kong by force.  Thatcher then traveled to Hong Kong, becoming the first U.K. Prime Minister to visit the colony whilst in office.  She stressed that all three treaties were valid and must be respected.  At around the same time, the National People’s Congress was in session and passed the Article 31 amendment that allowed for the establishment of Special Administrative Regions (SARs) when necessary.

Markets began to take notice of the difficult situation.  The Hang Seng Index fell over 60% from its July 1981 peak to its October 1983 trough.  With HKD freely floating then, it weakened from around 5 per USD in early 1981 to almost 9 per USD in September 1983 before the peg was introduced in October and stabilized the situation.   

By late 1983, the U.K. backed away from its intent to administer Hong Kong after 1997.   This led to the signing of the Sino-British Joint Declaration in May 1985.  China would regain sovereignty over Hong Kong, Kowloon, and the New Territories effective July 1, 1997.  In return, China pledged to maintain “one country, two systems” for a period of 50 years until 2047.  Interestingly, we are now exactly halfway there.  

HKD PEG BASICS

Under the original peg arrangement, HKD could not trade on the weak side (above) of the 7.8 peg rate, but could appreciate without limit to the strong side (below 7.8).  It has only been truly tested once, during the Asian Crisis that started in 1997.  When the crisis deepened in 1998, interbank rates soared as foreign reserves fell and the domestic money supply shrank.  The HKMA also took some unorthodox steps then, such as buying Hong Kong stocks as the Hang Seng plunged.  Ultimately, the HKMA prevailed and we would expect similar success if the HKD were to come under sustained pressure again.  

The HKMA runs a strict currency board.  Simply put, this means that every HKD in circulation is backed by an equivalent amount (at the official exchange rate) of USD held at the HKMA.  When run correctly, such a peg simply cannot be broken.  With full reserve coverage, holders of every HKD in circulation would be able to exchange them for USD at the official exchange rate; HKMA simply would not run out of dollars.  Argentina’s peg was broken because it violated several of the basic tenets of a currency board, including no central bank financing of the budget deficit.

A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate.  The HKMA is obliged to buy and sell USD to prevent the HKD from breaching either side of the band.  It did not have to defend this new arraignment until April 2018, when USD/HKD first started to bump up against the top of the trading band.  Yet the mechanics of the peg remain intact.  That is, intervention to defend HKD will shrink the money supply, which will then boost local interest rates and lend support to HKD.  

HKD PEG OUTLOOK

In its annual Article IV consultation this March, the IMF did not see any reason to change the peg.  It noted that “The LERS (Linked Exchange Rate System) remains the appropriate arrangement for Hong Kong SAR as an anchor for economic and financial stability. The credibility of the currency board arrangement has been ensured by a transparent set of rules governing the arrangement, ample fiscal and FX buffers, strong financial regulation and supervision, the flexible economy, and a prudent fiscal framework. The FSAP stress test found that the LERS mechanism and the substantial amount of FX reserves would mitigate the impact of potential large capital outflows on the HKD interest rate, thus helping maintain the solvency and resilience of the banking system.”  We concur.

Yet we continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future (perhaps in 10-15 years?).  It seems that if and when conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China, etc.), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan.  This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware.  For now, we see no change to the HKD peg.  Policymakers certainly wouldn’t make such a monumental change when both China and Hong Kong are slowing significantly and foreign capital is already flowing out.

ECONOMIC OUTLOOK

The Hong Kong economy is likely to continue contracting in Q2, dragged down by the mainland slowdown.  GDP contracted a larger than expected -2.9% q/q vs. 0.2% growth in Q4.  With China still struggling under COVID Zero, we expect Hong Kong GDP to contract in Q2 as well.  Hong Kong growth is forecast by the IMF to decelerate sharply to 0.5% in 2022 from 6.4% in 2021 before accelerating to 4.9% in 2023.  With mainland weakness persisting and local liquidity conditions to continue tightening, we see clear downside risks to the growth forecasts.  As it is, China will be hard-pressed to meets its growth target this year of “around 5.5%.”

Price pressures remain minimal.  CPI rose 1.7% y/y in March, the highest since December.  However, the Hong Kong Monetary Authority (HKMA) does not have an explicit inflation target nor does it run an independent monetary policy due to the HKD peg to USD.  The HKMA has raised the base rate twice since March to 1.25% currently, in lockstep with the Fed.  With the Fed expected to hike rates another 200 bp (or more) over the next 12 months, local rates will also rise sharply and will be exacerbated by any HKMA intervention to support HKD.  This will come at a huge cost to growth.

Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Base Rate.  Indeed, the Prime rate has still been kept at the 5% trough by the two largest commercial banks despite the 75 bp of Fed tightening already seen this cycle.  This is because Hong Kong liquidity remains ample, keeping most local markets rates low.  This will change as the HKMA intervenes; as it buys HKD and sells USD, local currency liquidity will dry up, pushing HIBOR higher and leading to tighter liquidity that eventually supports HKD. 

The external accounts remain in good shape.  Hong Kong has run a current account surplus since 1998.  The IMF expects that surplus to be around 11% of GDP in both 2022 and 2023.  Hong Kong runs a large positive Net International Investment Position (NIIP) that’s over five times GDP.  HKMA foreign reserves stood at $465.7 bln in April, just below the record high $499.4 bln in November.  Clearly, Hong Kong has very low external vulnerability across virtually all metrics.  This supports our view that any selling pressures on HKD are unlikely to break the peg.

INVESTMENT OUTLOOK

We see no near-term change to the peg.  However, with much of EM likely to remain under pressure, we expect USD/HKD will continue to trade largely at or near the weak end the trading band (7.85) well into H2.  This will lead to FX interventions as needed, which in turn will remove local currency liquidity and drive up HIBOR.  It will get more expensive to short HKD, but this weakness is more than just a speculative attack.  Foreign investors are pulling out of EM and China as risk appetite sours.  Eventually, sentiment will turn again (see below) but for now, we see a continuation of the outflows.

Hong Kong equities are outperforming China so far in 2022.  The Hang Seng is -17% YTD and compares to -20% for the CSI 300.  For comparisons sake, the S&P 500 is -17.5% YTD, the NASDAQ is -27% YTD, the DAX is -13.5% YTD, and the Nikkei is -10.5% YTD.  Hong Kong underperformance should intensify as growth slows from both the mainland slowdown and from rising local interest rates.

Hong Kong bonds have underperformed.  The yield on 10-year local currency government bonds is +148 bp YTD.  This is ahead of only the worst DM performers Greece (+204 bp), Australia (+176 bp), Israel, (+156 bp), Sweden (+154 bp), Italy (+154 bp), and is tied with Canada (+148 bp).  Inflation is likely to remain under control, but with the HKMA likely to continue tightening local liquidity, we think Hong Kong bonds will continue to underperform.  

Whether EM (and HKD) can gain some traction will largely depend on how the Fed narrative evolves.  We believe that EM is likely to remain under pressure at least until the Fed gets close to a neutral rate.  Our best guess is September after three successive 50 bp hikes that takes the Fed Funds ceiling to 2.5%.  Once it does, we believe markets will be better able to gauge just how much Fed tightening remains in the pipeline.  Based on our view that inflation will be stickier than markets anticipated, our call right now is for a terminal Fed Funds of 3.5%.  If that proves to be correct, EM and HKD are likely to remain under pressure through year-end.