As China moves closer to imposing a national security law in Hong Kong, fears have arisen that the Trump administration might break the 36-year-old peg system that fixes the currencies' exchange rate at 7.8 Hong Kong dollars per US dollar.There is concern US President Donald Trump might revoke the city's special trading status, or even slap sanctions on the city. In a worst-case scenario, the US could ban Hong Kong from accessing the US dollar clearing pool or add more restrictions on its trading of the US currency, curbs similar to those placed on Iran.But Hong Kong government officials and bankers played down these worries, while the exchange rate remained stable as of Friday, as all believed Trump would not go to such an extreme.Hong Kong adopted a fixed exchange rate against the US dollar on October 17, 1983. It was established at a moment of crisis in confidence, with the British and mainland Chinese governments discussing the 1997 handover of Hong Kong.John Bremridge, the city's financial secretary at that point, announced the peg after a sharp fall in the exchange rate to HK$9.5 per US dollar from about HK$6 that month. The peg has remained unchanged since then.Under the currency board system behind the peg, Hong Kong's monetary base is fully backed by foreign reserves, while the local interest rates move in lockstep with those in the US. The Hong Kong Monetary Authority (HKMA), the city's de facto central bank, uses HK$4.094 trillion (US$528.6 billion) to defend the peg and to make sure it trades within the range of HK$7.75 to HK$7.85. In 1998, the government spent HK$118 billion to buy stocks and futures to drive away currency speculators who wanted to break the peg.No. The peg was established almost a decade before the US gave Hong Kong special trading status under the US-Hong Kong Policy Act of 1992.Bremridge is reported to have informed the US when the city first established the system, but did not need to seek approval. The Hong Kong dollar is not the only currency pegged to the US dollar."The Hong Kong government, or any government, can determine what currency to peg to, and at what exchange rate they would like to fix it. As long as the government has the ability and enough reserves to defend the exchange rate, it can keep the system going," said Wilson Chan Fung-cheung, a former trader who witnessed the birth of the peg and is now an associate director of City University of Hong Kong.The US can ban the HKMA or other lenders from trading US dollars, but traders widely believe this will not happen, which is why the exchange rate remains stable, according to Bruce Yam, currency strategist at Everbright Sun Hung Kai."The US has banned financial firms from trading with Iran. But Hong Kong is no Iran. If Trump goes to the extreme of banning Hong Kong from getting the US dollar, the nuclear option, it will destroy the global financial markets," Yam said. "It may trigger a global market slump, and will endanger Trump's re-election. That is why nobody believes he will take this risk."As of Friday, the Hong Kong dollar remained at the strong end of its peg, at 7.7521 per Us dollar, a level it has been trading at since mid-March. The HKMA, as well as local banks and investors, can buy and sell the US dollar in the open market around the world.Moreover, a temporary repurchase agreement introduced by the US Federal Reserve in March has made it easier for Hong Kong's and other central banks to get US dollars. The arrangement, to last six months, is part of efforts aimed at combating the economic crisis triggered by the Covid-19 pandemic.The HKMA introduced a US$10 billion liquidity facility in April to provide all 162 banks in Hong Kong with access to the currency made available by the Fed. What next for American banks, as US says Hong Kong no longer autonomous?Should the Trump administration decide to ban the HKMA from accessing this swap mechanism, it will affect the ability of Hong Kong to get US dollars, but it will also harm the Fed's efforts to combat the economic crisis the pandemic has unleased.Hong Kong was the fourth-largest foreign currency trading hub worldwide, as of April last year, ahead of Japan but after Britain, which ranked top, the US and Singapore, according to the 2019 BIS Triennial Central Bank Survey.The city traded US$632 billion in foreign currencies every day on average in April 2019, representing 7.6 per cent of the worldwide total. Britain traded 43 per cent, the US 16.5 per cent and Singapore also about 7.6 per cent. Hang Seng Index falls as Trump signals China actions, markets fear reprisalThe US dollar was a dominant currency in all this trading, representing 88 per cent of all trades against other currencies. Based on this calculation, Hong Kong traded about US$556 billion of US dollars every day.The peg "will remain the bedrock of our financial system. This is underpinned by a strong foreign reserves position of over US$440 billion, which is more than two times our monetary base," Eddie Yue Wai-man, the HKMA's chief executive, said in an insight article published on the authority's website this week.The HKMA declined to comment any further.After the handover of Hong Kong in 1997, there was talk in the markets of the peg being linked to the yuan. The Chinese currency, however, was not freely convertible, which made this difficult to achieve.Chan, the former trader, said if Hong Kong opts for a peg against another currency, technically it could work. But since the US dollar is the dominant currency, there is no advantage in shifting to another currency, which will be trading in a much smaller pool than the US currency.This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2020 South China Morning Post Publishers Ltd. All rights reserved. Copyright (c) 2020. South China Morning Post Publishers Ltd. All rights reserved.
Hedge funds may have just weeks left to make good money from the long Hong Kong dollar carry trade.Local interest rates, which have remained stubbornly high relative to those in the US, will fall at a faster pace once a measure of the city's liquidity pool exceeds HK$100 billion (US$12.9 billion), according to Bank of America. At HK$94.7 billion from Wednesday, that threshold is soon approaching. The result would be a narrowing of the Hong Kong dollar's yield advantage over the US dollar, which has persisted since November.Selling the greenback and using the proceeds to buy Hong Kong dollars had delivered Asia's highest Sharpe ratio " a measure of returns adjusted for price swings " earlier in the year. Now, the Hong Kong dollar carry trade ranks just fifth in the region over the past three weeks. Any unwinding that is too rapid, however, could lead to a sell-off and send the currency all the way to the weak end of its trading band."We are already starting to see some of the long-Hong Kong dollar carry trade lose its charm," said Claudio Piron, co-head of Asia foreign-exchange and rates strategy at BofA. He predicts the currency will drop to the weak end at 7.85 per greenback by year-end. "When the aggregate balance rises above HK$100 billion, the funding pressures will ease."The Hong Kong dollar last month climbed to the strong end of where it can technically trade with the greenback at HK$7.75, for the first time since 2016 on investor appeal with the carry trade. The city's aggregate balance has soared from HK$54 billion over the past three weeks, as authorities sold local dollars and reduced debt issuance to defend the foreign-exchange peg.A richer cash supply is also good news for a city mired in a record economic slump and with liquidity pressures arising later this year ahead of planned large stock listings.While the intervention has helped to lower borrowing costs, it's not yet aggressive enough to damp the carry trade altogether. Hong Kong's one-month interbank interest rates " known as Hibor " were more than 60 basis points higher than their US counterparts as of Monday, even though they are about a third of the level seen at the start of April. The gap reached a two-decade high of more than one percentage point last month.The liquidity pool will peak this quarter at HK$110 billion, said Samuel Tse, an economist at DBS Bank, forecasting the Hong Kong dollar will weaken to 7.8 per US dollar when the gap between Hibor and US Libor contracts to around 20 basis points.The city's currency, which is allowed to trade in a range of 7.75 to 7.85, was trading at 7.7510 per US dollar on Tuesday morning, a few pips from the strong end of its trading band.To be sure, bullish bets on the currency could become attractive from time to time in the second half of 2020, according to Becky Liu, head of China macro strategy at Standard Chartered Bank. Then, stock listings of Chinese companies in the city may drive demand for the Hong Kong dollar, potentially sending local interest rates higher.But for now, Liu says, "The room for long-Hong Kong dollar arbitraging is getting smaller."This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2020 South China Morning Post Publishers Ltd. All rights reserved. Copyright (c) 2020. South China Morning Post Publishers Ltd. All rights reserved.