The fate of Hong Kong and, by extension, of Chinese economic stability hangs in the balance.
According to a recent Reuters report[1]: “The wide yield spread between US government debt and [Hong Kong’s] equivalent has forced the monetary authority in the special administrative region of China to repeatedly intervene to prevent the currency from crossing the weak end of its official trading band of between 7.75 and 7.85 per dollar. In the short term that’s manageable, but it highlights investors’ deeper concerns about the city’s economic future.
In the process of maintaining the defense, the Hong Kong Monetary Authority’s aggregate balance—a key gauge of cash in the banking system—has plunged from HK$458 billion ($58 billion) to below HK$50 billion since September. That is the lowest level since 2008, and the steepness of the slope is striking; the last comparable decline took nearly four years. In the past 12 months, the de-facto central bank has stepped in to buy Hong Kong dollars from the market roughly 40 times.” (italics mine)
The primary concern is that Hong Kong depends on the performance of the Chinese Mainland, which in the past four years was sunk by Covid restrictions. Then as constraints have been lifted, the Mainland economy should be primed, and this will be reflected in the Hong Kong market index and, thus, in the HK dollar results.
Still, investors have other, broader worries and question more fundamentally the sustainability of the peg, introduced in 1983 by the British authorities and kept all along by Beijing. If the peg is not long-term defensible, what about the future of its stock market and, more widely, of the territory’s economy, society, and politics?
Believing that a sudden financial attack would break the peg is naive. In 1997 and 1998, when China’s economy was much smaller, Beijing managed to stave off assaults against the peg. But there are two reasons for long-term concern: 1. Sudden tension in China could kindle US sanctions similar to those hitting Russia and thus break the peg. 2. Long-term US-China tensions are wearing down the peg’s rationale.
The apparent reason for Beijing to keep the peg was to link Hong Kong and China’s economy to the American and foreign economies, producing all of China’s surplus.
Then if the general direction is the full convertibility of the RMB, using the peg as a temporary measure makes sense. The fully convertible HK dollar and the territory’s stock exchange are doomed if it is not the direction.
More generally, the peg makes sense if Hong Kong is a bridge between the world and China. If Hong Kong depends entirely on China’s political whims, why peg the currency to the US dollar?
If China promotes a non-fully convertible RMB, then what is the use of an HK dollar pegged to the US dollar? Promoting the non-fully convertible RMB contributes to undermine the fundamentals of the HK dollar and its peg. People in Beijing may think that Hong Kong could be replaced by a bigger role given to Shanghai and investors would flock in attracted by perspective high returns.
But actually markets may decide not to follow Beijing’s wishes. Markets need long-term political and legal stability, if Beijing dumps Hong Kong now, it could also dump Shanghai in a few years. The possibility could scare them for good.
It’s different from the 1997-98 crisis. The strain on the peg comes during significant international volatility and growing political tensions with Beijing.
Then Asian countries supported China’s defense of the Hong Kong peg. Now other Asian countries could feel they have much to gain from the breakdown of the peg and, by extension, greater economic difficulties for China.
We have seen a lackluster performance by Hong Kong’s economy and market recently. It raises long-term concerns that the whole existence of Hong Kong as a different entity from the Mainland is under a heavy shadow. It also raises question marks about the future of China that investors may not like.
The slide could continue for years or suddenly blow up because of any event. In the past 40 years, Hong Kong has served as a fundamental financial bridge and guarantor of international trust in Beijing.
It is also naïve to think that Mainland China can be insulated from a crisis starting from the territory. It could be just the opposite. A highly uncertain situation in Hong Kong would trigger a deeper problem in the Mainland. China can survive overall, but the damage could be pretty significant possibly denting the welfare of its bulging middle class.
A Hong Kong market crash could also impact global markets, which are jittery because of the ongoing war in Ukraine, and it could create a political and financial backlash in China.
Beijing needs a comprehensive response, whatever direction it chooses to take.
[1] https://www.reuters.com/breakingviews/hong-kongs-dollar-stress-gets-more-fundamental-2023-04-24/
