Could Hong Kong find itself at the Center of the “Next Financial Crisis”?

In the past year or so, the US economy has been volatile yet strong, with interest rates rising more quickly and aggressively than previously thought. The general sense has been one of worry, and in particular, the market is concerned that every cycle of a US interest rate hike is followed by a financial crisis somewhere in the world: The Latin American debt crisis in the 1980s, the Southeast Asian financial crisis in 1997-1998, and the global economic crisis in 2008…

In the Asian markets, the Hong Kong/US dollar exchange rate continued to weaken this year. The Hong Kong dollar fell to 7.85 in April against the US dollar, setting a new low in more than 33 years since the end of 1984, and the weakest since the introduction of the linked exchange rate system. Since the Hong Kong Monetary Authority’s (HKMA) first move on April 12, a total of 26 purchases of Hong Kong dollar have been made this year to stabilize the exchange rate. The cumulative purchase of the Hong Kong dollar has exceeded 100 billion, reaching approximately HK$103.4 billion. The HKD’s current rate remains at its all-time low at 7.81. So, could this mean that Hong Kong may find itself at the center of the “next financial crisis”?

How does the HKMA’s interest rate adjustment mechanism achieve exchange rate stability of the Hong Kong dollar?

If market demand for the Hong Kong dollar exceeds supply and the exchange rate reaches HK $7.75 to US $1, the HKMA will sell Hong Kong dollars to the Banks to buy US dollars. This will increase the base currency of the Hong Kong dollar, decrease its interest rate, and weaken the Hong Kong dollar back to the exchange range of 7.75 to 7.85.

On the contrary, if the supply of Hong Kong dollars exceeds the market’s demand, and the exchange rate weakens to HK $7.85 to US $1, the HKMA will use US dollars to buy Hong Kong dollars from the banks. The total amount of Hong Kong dollars in the market will decrease and the interest rate of Hong Kong dollars will rise. As a result, the exchange rate will gradually strengthen to the range of 7.75 to 7.85.

The Hong Kong Dollar depreciates in 2018

Why did the HKD depreciate this year?

The analysis points out that the main reason for the depreciation of the Hong Kong dollar this year is the widening interest rate gap between the U.S. and Hong Kong. With the economic recovery, the United States took the lead in returning to the normalization of interest rates. Although the HKMA and the Federal Reserve maintained a consistent rate hike path under the linked exchange rate system, the Hong Kong interbank-offered rate HIBOR did not rise by the same amount, enabling speculators take advantage of the widening interest rate spread through arbitrage trading. They gain profits through the interest margin, by selling Hong Kong dollars at low interest rates and buying US dollars at high interest rates.

However, everyone can rest assured. According to figures released by the HKMA, as of the end of February 2018, Hong Kong’s foreign exchange reserve assets were $443.5 billion, a slight increase from the end of January 2018. The scale of foreign reserves is equivalent to more than seven times the total amount of currency in circulation in Hong Kong. In other words, even if every single Hong Kong dollar note on the market were converted into US dollars, Hong Kong’s financial authorities would be able to handle it more than adequately.

Can the Hong Kong property market withstand the pressure?

Hong Kong housing prices also play a role in the depreciation of the Hong Kong dollar. According to statistics from industry institutions, from March 2016 to the end of 2017, Hong Kong’s housing prices have risen for 22 consecutive months, during which the rate of increase exceeded 25%. High housing prices tend to reduce hot money’s favor in Hong Kong’s property market, and as a result, capital flows out and the Hong Kong dollar depreciates. Industry insiders are concerned that this capital outflow may become a factor that dominates the exchange rate fluctuations of the Hong Kong dollar.

Will the Hong Kong dollar be decoupled from the US dollar?

From the lessons of Argentina and other countries, under what circumstances will an economy that implements the “Currency Board System” , like Hong Kong, be forced to “decouple”?

If both the government’s fiscal and trade deficits are large (which will cause the value of the country’s currency to be artificially high), and the financial system has insufficient reserves of high liquidity assets, it may need to decouple its currency from the US dollar.

At the time of the Asian financial crisis in 1997, Hong Kong’s foreign exchange reserves were only $70 billion. A large part of the banking system’s assets were hit by the Southeast Asian financial crisis and suffered heavy losses. During this time, the HK dollar was most at risk for decoupling.

In contrast, Hong Kong does not currently have serious fiscal deficits and trade deficits. Since the financial crisis in 2008, under the strict supervision of the HKMA, the average capital adequacy ratio of local banks in Hong Kong in 2017 was 18.7%, a very high level compared to the rest of the world. Moreover, the banks had held more than 4 trillion Hong Kong dollars of high-liquidity US dollar assets at the end of 2017 (more than 3 trillion Hong Kong dollars as foreign currency assets), more than enough to deal with the repercussions of US rate hikes.

Therefore, in the absence of a major global financial or economic crisis, as long as Hong Kong does not have the willingness to decouple from the US dollar, the HKMA continues its stabilization policy, and the housing market remains lucrative, the exchange rate of the Hong Kong dollar can now be said to be solid, regardless of the interest hikes in the US.