With the market generally predicting that the Federal Reserve will raise interest rates by 75 basis points at the July meeting, the persistently weak Hong Kong dollar exchange rate is bound to face challenges again. Although the Hong Kong Monetary Authority (HKMA) has repeatedly stated that it will continue stabilizing the exchange rate, at a time when the international geopolitical and economic situation is constantly changing, and Hong Kong's own economic and financial positioning are undergoing transformation, it is doubtful if the HKD-USD linked exchange rate system can still be maintained.
The exchange rate of the HKD against the USD hit a ceiling of HKD 7.85 in May this year since the Fed started interest rate hikes. To this end, the HKMA intervened for the first time on May 15 by using reserve funds. In the following two months, the HKMA bought a total of more than HKD 170 billion, causing the balance of Hong Kong's banking system to decrease to HKD 165.292 billion on July 22, hitting a new low in nearly two years. This also means that Hong Kong's liquidity has shrunk by nearly 50%. Considering the upcoming round of U.S. interest rate hikes, the market generally believes that Hong Kong's ability to continue sustaining the linked exchange rate system is facing severe challenges. Mizuho Bank predicts that after the Fed's September interest rate meeting, the total balance of the Hong Kong banking system is likely to fall below HKD 100 billion. Hyman Capital even believes that, based on the current rate of decline, the linked exchange rate system's reserve will run out by the end of August.
The linked exchange rate system of the HKD began on October 15, 1983. Against the background of the stock market crash in Hong Kong and the uncertain future, in order to save the financial system and boost public confidence in the HKD, the then Financial Secretary John Henry Bremridge led the promulgation of the linked exchange rate system, which began to operate on October 17 of the same year. Since then, the HKD has been pegged to the USD, and the exchange rate is fixed at HKD 7.8 to USD 1. The system has been implemented until now. HKMA Chief Executive Eddie Yue also emphasized in a report on July 22 that the HKD-USD exchange rate linkage system has been implemented for nearly 40 years and is the cornerstone of Hong Kong's financial and currency stability. Hence, the HKMA has "no plans to change it".
However, according to researchers at ANBOUND, the necessity and practical significance of the HKD's linked exchange rate system has now weakened. On the one hand, Hong Kong's own role in China and the international economic and financial system is changing; on the other hand, the global geopolitical and economic environment has seen some shifts.
In the past, Hong Kong acted as the window connecting Mainland China's economy and the world. The trade and transactions of the two sides came in and out of Hong Kong, where international capital gathered. Under such circumstances, free trade and the linked exchange rate system became the two cornerstones of Hong Kong's development. Linking the HKD to the USD, then with the entire U.S. economic and financial systems allowed the enhancement of the international recognition and liquidity of the HKD. This was necessary for Hong Kong, which was then focusing on the development of re-exports of goods and trade in services. Hong Kong at that time positioned itself as an international financial center, and the linkage helped it to integrate with the international legal and monetary systems. However, with the development of cities such as Shanghai and Shenzhen, the role of Hong Kong as a trade channel is diminishing.
After the continuous social unrest in Hong Kong in recent years, the introduction of the National Security Law has contributed to the so-called "second return" of the region. Although this change is of great significance to maintaining Hong Kong's social and economic stability, it has also contributed to the decline of Hong Kong's status in the international economic and financial systems. With this, there is the intensification of the tendency among foreign capitals to withdraw from Hong Kong and move to Singapore or other places. According to data released by the European Chamber of Commerce in Hong Kong on March 24, 25% of the companies surveyed intend to leave Hong Kong completely within the next year, 24% said they would partially relocate, and only 17% said they would not leave within a year. The departure of these companies will inevitably bring out a large number of funds, and the HKD will then be weakened in the process.
On the other hand, by integrating into the Greater Bay Area, Hong Kong which is undergoing the "second return" is now more closely integrated with Mainland China economically and politically, and its economic operation cycle will also converge with that of the Chinese economy. However, the current linked exchange rate system requires Hong Kong to link its monetary policy to the American economy. Even without considering technical factors such as the current U.S. interest rate hike process, with it being economically dependent on Mainland China and its currency on the U.S., there is a structural divergence. At the same time, considering the current tense geopolitical relations between China and the United States, if the relationship between the two countries further deteriorates in the future, the consequences of the "dislocation" between Hong Kong's economy and financial system may become more serious. This is especially true when the economic cycles of China and the United States are different, the pressure on Hong Kong will further increase. As such, the HKD will inevitably fall into the "impossible triangle" dilemma.
There are in fact not many countries that still insist on using the linked exchange rate system. Highly open financial centers such as Luxembourg, Singapore, and Dubai, which have a similar role to Hong Kong, have basically adopted independent monetary policy systems, thus ensuring greater room for coordination and operation in the interest rate and exchange rate management. Singapore's independent monetary policy for instance makes it even more flexible in business competition and currency management, instead of reducing its international recognition.
The linked exchange rate system is the "cornerstone" system of Hong Kong's economy. From a political point of view, the basic policy of "one country, two systems" and "fifty years unchanged" may require the HKD-linked exchange rate system to continue for at least another 25 years. However, from an economic point of view, how long can Hong Kong, whose economy is now increasingly integrated with the Mainland, have its currency pegged to the U.S. dollar, and maintain the linked exchange rate system? There are indeed uncertainties from a technical and market perspective.
Final analysis conclusion:
All in all, the linked exchange rate system of the Hong Kong dollar was a necessity under specific historical background. For a long time, this system and free trade policy helped to establish Hong Kong's prosperity and unique status and enabled it to become an international financial hub. However, with the changes in the international situation and in Hong Kong's market position, the contradictions faced by the Hong Kong dollar-linked exchange rate system have emerged, and its future prospects are uncertain.
