The Coming Hong Kong Currency Crisis
No two crises are the same.
But yet they all have similar traits.
One of those similarities, is that each crisis begins in the most strangest places.
The 1997 Asian Currency Crisis was triggered when a property developer defaulted on some bonds.
The 2008 Great Financial Crisis actually triggered 18 months earlier, when a London based subsidiary of AIG was heavily exposed to the US subprime housing sector.
Both of these events triggered near catastrophic stock market collapse.
Today, I hand the reins over to Jim who will share with you his analysis on the Hong Kong dollar.
Nobody thinks the Hong Kong dollar could be at the heart of an international market crisis. It’s a major city, with a modern financial system and a free market.
At least it was.
Hong Kong has been under China’s control now for almost 30 years. And the cracks are beginning to show.
As Jim reveals below, Hong Kong needs to decide which central bank they are going follow. The Fed or China’s central bank? Although, it’s not like Hong Kong will have a choice.
Chances are, Hong Kong elites will be coerced into following China’s central bank. If that happens, there could be a loss of faith in the Hong Kong dollar…something that will have wide implications for currency markets.
Read on for more…
Until next time,
The Coming Hong Kong Currency Crisis
Jim Rickards, Strategist
Jim Rickards, Strategist
I’ve been visiting Hong Kong for over 35 years.
My first visit was in 1982 and my most recent was last May.
All large cities change over time. New districts are developed.
New buildings are erected and some old ones torn down.
Cities on the water like Hong Kong can use landfills to build more land and transform colourful (if dangerous) dockside alleys into sleek convention centres and hotel districts.
None of that is unexpected, especially in dynamic cities like Hong Kong.
Under new management
In the 1980s and 1990s, I routinely described Hong Kong to friends as the most energetic city in the world after New York.
Yet in addition to physical infrastructure (which changes), cities have a kind of soul or zeitgeist, which is less susceptible to change. St Mark’s Square in Venice, the Louvre in Paris and Parliament in London are all defining and, if not eternal, at least help to keep a place rooted over time.
Hong Kong has ‘The Peak,’ a steep hill that dominates views of the island from all directions and provides that same kind of continuity.
Your strategist in Hong Kong last spring with a section of ‘The Peak’ visible in the background of the photo. I was there to deliver an address at the Asia Society. During that visit, I had a lengthy one-on-one discussion with a former head of the IMF and conversations with various local elites and billionaire property magnates. There was a definite chill in the air compared with visits over 35 years. China no longer hides its ambition to suppress freedom in Hong Kong.
Yet Hong Kong has changed, and not for the better.
At midnight on 30 June 1997, the island of Hong Kong and the adjacent New Territories were handed over to Communist China upon the expiration of a 99-year lease and ancillary negotiations in anticipation of that expiration.
Hong Kong began a new life as a ‘Special Administrative Region’ (SAR) of China.
The guiding principle for Hong Kong SAR was to be ‘one country, two systems.’ In other words, China would claim sovereignty, but Hong Kong would be allowed to govern its own affairs and preserve autonomy, freedom of speech and other human rights.
Hong Kong was to be China’s window on the Western world while China continued its internal transition in cities like Shanghai, Wuhan and Guangzhou (formerly called Canton).
At first, not much changed.
My visits to Hong Kong in the late 1990s and early 2000s were characterised by the same energy and dynamism I had encountered decades earlier.
The ‘two systems’ seemed to work well together.
Yet as China’s growth ‘miracle’ gathered steam from 2002–2007, a legal heavy hand and gloomy administrative culture directed from Beijing descended on Hong Kong. You could feel it in the air…
Hong Kong no longer a free market
At first, I noticed the lack of energy.
The city was still rich and active, but there was a ‘business as usual’ attitude that was less driven than the energetic venue I had always known.
Then I noticed a more depressed attitude among the bankers, investors and event planners I associated with.
They still made money, but the typical upbeat smile had been replaced with a more worried look.
This was accompanied by a rise in street protests against the heavy hand of Beijing on matters such as free speech, government autonomy and the relative importance of Hong Kong in the Chinese master plan.
Clearly Shanghai had come into its own as the financial centre of China and Hong Kong’s special role had been greatly diminished.
The most stark evidence of change came during my last visit.
I was presenting to a group of elite policymakers and property developers at the prestigious Asia Society local headquarters.
At one point, one of the local elites took me aside, looked over his shoulder and at a near whisper said, ‘Be careful what you say. Chinese agents are everywhere’.
The importance of these cultural and political developments goes far beyond the fate of individual citizens.
Global investors are accustomed to treating Hong Kong as a bastion of free markets and fair dealing.
Those assumptions are no longer true as Beijing begins to treat Hong Kong as just another piece on a chessboard of market manipulation and geopolitical ambition.
How will the ‘new’ Hong Kong that’s losing its autonomy, liberty and energy affect investors?
What developments can we expect in stocks and the currency now that the freewheeling Hong Kong we knew from 1960–2005 has come to an end?
Running out of options
The single most important factor in the forecast is the impact of a theory called the Mundell-Fleming Trilemma on the Hong Kong dollar (HKD).
The Mundell-Fleming trilemma (named for Nobel Prize-winning economist Robert Mundell) says that a country cannot maintain a fixed exchange rate, an open capital account and an independent monetary policy at the same time for more than a very brief period. Any attempt to do so will result in failure of one of the three legs.
The reason for this has to do with arbitrage opportunities.
If a country has an interest rate lower than the country to which its currency is pegged, capital will flow from the low-rate country to the high-rate country in order to get the higher yield.
This will deplete the capital account of the low-rate country. Eventually the low-rate country will run out of foreign exchange and face a currency crisis.
At that point, the only solutions are to raise interest rates (thus giving up independent monetary policy), close the capital account to prevent outflows or revalue the currency (to offset the impact of higher rates abroad).
Another solution is to devalue the currency, which causes huge losses at home but eases pressure on the capital account because the feared damage is already done.
There are other policy responses to the Mundell-Fleming trilemma, including combinations of the foregoing.
The point is that some response is needed because the initial conditions are unsustainable.
China controls Hong Kong dollars now
Most countries facing the Mundell-Fleming trilemma will give up their independent monetary policy.
If the country they peg their currency to raises rates, they will raise rates in lockstep to avoid capital outflows.
This has been Hong Kong’s approach — the Hong Kong Monetary Authority (the central bank) simply mimicked the Federal Reserve.
Other countries (notably China) have closed the capital account, thus locking down private savings while continuing to pursue monetary ease even as the Fed tightens.
Devaluation is a popular response, especially in Latin America.
Chart 1 below shows the relationship between the Hong Kong dollar (HKD) and the US dollar (USD) over the past 10 years. The USD/HKD cross rate appears volatile, but it’s not.
The exchange rate has moved in a narrow band between a high (inverted scale) of 7.75 in November 2009 and a low of 7.85 today.
That’s only a 1.3% trading range over 10 years.
A range that narrow for that long is as close to a fixed exchange rate as exists in the world today.
Hong Kong Dollar versus US Dollar (Chart 1)
Source: Thomson Reuters Eikon
Hong Kong’s path to a fixed exchange rate was straightforward and consistent with the principles of the Mundell-Fleming trilemma.
Hong Kong gave up independent monetary policy and moved its interest rates in sync with the Fed.
This removed any arbitrage between the two sets of interest rates and removed pressure from the capital account.
Global investors simply treated Hong Kong dollars as substitutes for US dollars.
Hong Kong built up its reserves through capital inflows, tourism and financial services.
This equilibrium is now under threat.
The primary reason is that Hong Kong is being required by Beijing to maintain a soft peg between the HKD and the Chinese yuan (CNY).
The rise of the ‘quad-lemma’
This is not a trilemma but a quad-lemma, because Hong Kong maintains two pegs: an open capital account and it follows Fed monetary policy.
This comes at a time when the USD/CNY exchange rate is under stress because of the China-US trade wars and because the People’s Bank of China is easing while the Fed is tightening (through balance sheet normalisation if not rate hikes for the time being).
In effect, Hong Kong is caught between a slowing Chinese economy that needs to ease and a stronger US economy that is still looking for ways to tighten despite a temporary ‘pause’ in rate hikes.
Even if Hong Kong agrees to surrender independent monetary policy, which central bank should it follow?
Hong Kong is proud of its open capital account, but if the currency is overvalued, investors will sell HKD and buy USD or CNY.
Moreover, Beijing’s intervention in the formerly autonomous affairs of Hong Kong will push it in the direction of monetary ease in order to help with the slowing of the core Chinese economy.
As Mundell accurately predicted over 50 years ago, the situation is unsustainable, and something will break.
Hong Kong is unlikely to close its capital account because it is too important to China as a window on the Western world.
Hong Kong cannot peg to two currencies at once and follow two central banks — the Fed and the People’s Bank of China (PBOC) — when they are moving in opposite directions in a financial war with each other.
Something has to give, and the something is the peg to the US dollar.
This break in the peg is presaged by the current USD/HKD cross rate at a 10-year low for HKD.
When the break in the peg comes, it will not only shock foreign exchange markets but cause a crash in Hong Kong equity markets as well.
All the best,
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