Hong Kong dollar peg shows strain caught between Fed and PBOC

[HONG KONG] Hong Kong's 32-year-old currency peg is seen coming under strain, caught in a tug-of-war between tightening US monetary policy and an economic slump in China.

The linked exchange rate means Hong Kong has no choice but to follow the Federal Reserve in raising interest rates, which is forecast to happen before the end of this year. At the same time, China's slowest growth since 1990 will exert downward pressure on the city's property prices and wages, fueling public discontent towards the peg, according to BNP Paribas SA.

"It's a double whammy," Mole Hau, a Hong Kong-based economist at France's largest bank, said in an interview. "Hong Kong is more integrated with China now and so its economy could be dragged by China's slowdown. On the other hand, Hong Kong's monetary policy has to follow that of the US - that's quite a dis-coordination for the city."

The chances for an end to Hong Kong's peg jumped to a decade-high last month in the options market after a surprise devaluation of the yuan triggered depreciation across the region as well as exchange-rate regime changes in Kazakhstan and Sri Lanka. That market instability spurred demand for Hong Kong dollars, forcing the monetary authority to buy US$4.7 billion this month to keep the local currency from strengthening.

The flows reflect confidence in the resilience of a currency link that's survived a change of sovereignty in 1997, a 1998 attack by speculators during Asia's financial crisis as well as the 2008-2009 global financial crisis and almost three months of pro-democracy protests in late 2014. The Hong Kong Monetary Authority reiterated this month a pledge to maintain the stability of the local currency, which is allowed to trade in a range of HK$7.75 and HK$7.85 versus the greenback.

One-year implied volatility for Hong Kong's dollar more than doubled in August and touched 3.2 per cent on Aug. 26, the highest since December 2004. The currency reached the strong end of its permitted trading range last week for the first time in four months, prompting the HKMA to offer an unlimited amount of Hong Kong dollars at HK$7.75.

China's slowing economy and an anti-corruption drive are already hurting Hong Kong's tourism and retail sales, most notably of luxury goods. Chinese tourists accounted for 78 per cent of the city's visitors in the first seven months of the year and the local tourism board predicts growth in total arrivals will slow to 6.4 per cent in 2015 from 12 per cent last year. The city's sales of jewelry, watches and clocks dropped from a year earlier in all but one of the 18 months through July, when Jones Lang LaSalle Inc predicted high-street rents would slide 15 per cent to 20 per cent in 2015.

The city's currency link is also hurting competitiveness as exchange rates weaken across Asia excluding Japan. The Hong Kong dollar has appreciated 0.1 per cent against the greenback in the past six months, compared with a 1.8 per cent decline in the yuan and an average 6.5 per cent depreciation in regional exchange rates.

"Given that all the other countries in the region have seen their currencies fall, Hong Kong could see its competitiveness deteriorate sharply," said Gareth Leather at Capital Economics Ltd in London. "Tourists especially could start to shy away from Hong Kong."

With the challenges of a decelerating Chinese economy and bets that the US will raise rates as soon as Sept 17, UBS Group AG last week said Hong Kong is in its "black-sky scenario" and advised investors to be cautious on the city's equities market. Traders see a 28 per cent chance that the Federal Reserve will raise borrowing costs next week and 57 per cent by December, a move that would translate into higher mortgage costs in Hong Kong.

It's not just falling asset prices that heighten scrutiny of the peg. Surging home prices in 2011 prompted local lawmakers to urge a review and the chief executive of HSBC Holdings Plc, which owns two of the city's three biggest banks, suggested that any shift could be to a link against a basket of currencies. Former HKMA chief Joseph Yam in 2012 called for a review of the peg, having in 1998 conducted $15 billion of stock purchases to fend off speculative attacks on Hong Kong's equity and currency markets.

Centaline Property's Centa-City Monthly Index, a gauge of Hong Kong property prices, has risen 60 per cent since the end of 2010. Home prices may start to fall by as much as 10 per cent each year starting in 2016, according to Cusson Leung, head of Hong Kong research, conglomerates and property for JPMorgan Chase & Co.

"There will be more downward pressure on asset prices, including nominal wages and property values, adding to more popular discontent against the peg," said BNP's Mr Hau. "But Hong Kong will keep the peg no matter how painful it could be as there aren't that many alternatives."

Adjusting the Hong Kong dollar's peg to the greenback would invite speculation and harm the credibility of its financial markets, said Raymond Yeung, an economist at Australia and New Zealand Banking Group Ltd.

It's too early to consider the yuan as an anchor for the city's exchange rate because China's currency isn't fully convertible, HKMA Chief Executive Norman Chan said in 2013. Hong Kong would need almost 2 trillion yuan (US$314 billion) to back the linked exchange rate, exceeding the amount of Chinese currency available in the offshore market, he said. Hong Kong had US$340 billion of foreign reserves as of the end of July, the eighth-largest stockpile in the world.

As China opens up its capital markets, conditions for the Hong Kong dollar to be linked to the yuan will become "more ripe" in the years ahead, according to Mitul Kotecha, Singapore- based head of Asia-Pacific foreign-exchange strategy at Barclays Plc.

"Clearly, the authorities have been looking at all options," Mr Kotecha said. "That said, we do need to see some big steps in China towards convertibility for people to see any shifts in Hong Kong."

BLOOMBERG