Pressure on the Hong Kong Dollar Peg Keeps Building



I wrote in April that the economic and social costs of maintaining the Hong Kong dollar’s peg to the US dollar was becoming untenable and may need to be abandoned. The pressure I described has only grown and is now probably greater than anybody outside of the Hong Kong Monetary Authority – which took issue with my original analysis – realizes.

The HKMA has a mandate to keep the currency trading in a range of HK$7.75 to HK$7.85 per US dollar. The current band was set in 2005 and has never been broken. When it gets too close to either end of the band, the HKMA intervenes, either by buying or selling the city’s currency. As the chart below shows, the currency has traded at the extreme weak end of the range for most of the year, pressured by the rising US dollar. That pressure has subsided somewhat recently as interest-rate expectations have eased a bit. But this is only likely to be short-term relief, because the social and economic costs of defending the peg are huge. The Hong Kong dollar peg is like being on the gold standard, and like the gold standard the frailties of such mechanisms are always social and economic.

Because of the peg to the US dollar, Hong Kong has no independent monetary policy; it has had to follow the Federal Reserve and tighten at a time when it should be doing the opposite. If the Chinese economy as a whole has struggled mightily due to its extraordinary “zero-Covid” policies and the mother of all debt-bubble hangovers, Hong Kong’s has done even worse, shrinking 4.5% in the third quarter from a year earlier. The benchmark Hang Seng Index is down by almost half since its high in 2018 even after a recent bounce.

With growth going in the wrong direction and the HKMA having to raise rates, Hong Kong has had to resort to the only option for countries on currency pegs: massive government spending. There is very limited room, though, for any country to ramp up fiscal spending without investors worrying about the accompanying increase in borrowing (debt) and sustainability of the peg. Small wonder, then, that fiscal policy has done little to soften the savage downturn.

Nor is this merely a cyclical problem. Hong Kong’s best days are behind it. China’s political interference has only risen. The working population, especially higher earners in finance, is shrinking. I doubt the weakness is merely cyclical and if it isn’t, Hong Kong’s tax base has been permanently eroded. Which is a problem, for Hong Kong is now a massively leveraged economy.

That the government has very little debt is not really the point because private sector debt more than makes up for it. Andrew Hunt, an independent economist who has followed Asia closely for decades, points out that foreign debt is almost $500,000 for each person working in Hong Kong. Domestic debt levels have doubled since 2007, according to the World Bank. Property debt has grown especially fast, and despite a drop in prices that shows every sign of gathering momentum, Hong Kong property is still among the world’s most expensive.

It is that huge surge in debt, falling asset prices, and ever cloudier outlook for Hong Kong’s economy which makes defending the peg so much more problematic than during the Asian crisis of the late 1990s. You can see the effects of all this in the HKMA’s Exchange Fund, which, among other things, manages Hong Kong’s foreign-exchange reserves. Its assets have tumbled to $417 billion from $500 billion late last year, according to the HKMA, its largest drop ever.

However, most of the drop in the Exchange Fund’s assets over the past few months have come not from intervention but from two other sources. The first is that the government has had to tap the Exchange Fund to make up for revenue shortfalls, according to HKMA and government data. Apart from a slight surplus in 2020-2021, the government has run a consolidated fiscal deficit since 2019. To reduce those deficits — and create that very small surplus — the government has tapped the accumulated fiscal surplus managed by the Exchange Fund. From a peak of HK$1.17 trillion ($150 billion) in 2018-2019, the fiscal surplus shrunk to HK$957 billion by the end of March and to HK$704 billion by the end of September. Over four years, starting in 2019-2020, the government has also transferred HK$82.4 billion put aside as a housing reserve, according to government and HKMA data. Though kept separate, this was also money from previous fiscal surpluses.

These transfers are counted as current income in the government’s accounts, though they are the product of previous years’ income. The government says that this is because it uses cash accounting. That is also the reason it gives for counting the proceeds from $10 billion of   “Green Bonds” it has issued as income. It hasn’t treated other debt this way nor would this happen in any other accounting system on the planet. Last year, the government doubled the Green Bond debt it could have outstanding at any one time.

Potential government liabilities are, moreover, mounting. Since 2019, the amount of loan guarantees the government has provided, mainly to smaller companies, has risen from HK$27.8 billion to HK$133.4 billion, annual reports show. These will only go on the government’s balance sheet when companies default, and the current default rate, the government says, is only 2.6%. But you can keep even insolvent companies on life support if you lend them enough money at rock-bottom rates.

To me, the intriguing ways in which the government is having to find revenue smacks of desperation. And if spending is cut, the economy will almost certainly do even worse, creating a vicious circle of even slower growth, more defaults and less revenue. The government says these are one-off problems caused by the pandemic and other isolated incidents. The trouble is that the fiscal deficits predated Covid. And given the likely profile of China’s economy in general and Hong Kong’s in particular, I can’t see this changing.

The second reason that assets at the Exchange Fund have dropped is because of investment losses. Although most look at overall assets when they think of the firepower at the HKMA’s disposal, this isn’t quite right. The peg is backed not by the whole of that $417 billion but by the Backing Fund, which is about half that amount and just 10% above the HKMA’s calculations of the monetary base (the same percentage higher as a year ago). However, the overall amounts are smaller because the money supply has shrunk by about 9%. Although this provides some indication of the deflationary forces gripping Hong Kong, the money supply would have shrunk more had the HKMA not tapped the Exchange Fund.

In various annual reports and statements, the HKMA says that, if necessary, it could utilize the rest of the portfolio to defend the peg. There is a mechanism whereby it will automatically do so were the assets of the Backing Fund shrink to only 5% higher than the monetary base. In contrast, if the value of the Backing Fund is at least 12.5% higher than the monetary base, money is transferred to its investment portfolios. What the HKMA won’t tell me is if there is any discretion in this process.

There are three other portfolios: the Strategic Fund, which contains only the shares of its holdings in Hong Kong Exchanges and Clearing; the Investment Fund, which contains public debt and equities; and the Long-Term Growth Fund, which invests in real estate and private equity.

How much are all these funds worth now? The HKMA doesn’t count the profits and losses on its strategic fund toward overall returns. Just as well. But the Backing Fund doesn’t contain anything other than dollars and, presumably, short-dated Treasuries or close substitutes (but since it has had mark-to-market losses, we can’t be sure). The other two portfolios are where most of the HKMA’s risk is sitting. Based on some reasonable assumptions, probably about a quarter of the funds’ exposures are to non-US dollar assets.

Also sitting in them, according to the HKMA, are the overwhelming bulk of the HKMA’s equity and credit risk, of which there is a lot. Total equity exposures outlined in its annual report at the end of last year amounted to HK$745 billion. But there is almost certainly more. Exposures to private equity and real estate joint ventures are lumped together with real estate in another category of unlisted and rather nebulous “investment funds” amounting to HK$443 billion The HKMA makes it very hard to find out what is where.

All publicly traded bonds and equities are contained in the Investment Fund. It is reasonable to assume, though I do not know for sure and the HKMA won’t say, that all the holdings are marked-to-market monthly. Its Long-Term Strategic Growth Fund is another matter. At the end of last year, this fund had assets worth roughly HK$515 billion. Valuations on its unlisted investments are published semi-annually, but the latest performance numbers used valuations as of the end of March.

Apparently, the HKMA is very good at real estate and private equity investments since, contrary to the performance of just about everyone else, it showed a small profit. One should take these results with a pinch of salt. As anyone involved in such valuations will know, they tend to be reflections of hope, modeling and heroic assumptions rather than anything approaching a price at which such assets could be sold. And things have got much worse since then in any case.

Call me old fashioned but a government clearly in need of cash and a chunk of assets whose value has probably further to fall make it rather likely that the Exchange Fund’s assets have further to shrink — and that the reasons for that will put still further pressure on the peg.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Richard Cookson was head of research and fund manager at Rubicon Fund Management. Previously, he was chief investment officer at Citi Private Bank and head of asset-allocation research at HSBC.

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