June 27, 2019
The recent protests in Hong Kong highlight an uneasy calm that blanketed the territory since China resumed sovereignty from the United Kingdom in 1997. The current issue is a controversial proposed extradition law. In 2014, protestors challenged the structure of elections.
As is always the case, a certain amount of sociopolitical unrest bleeds over into economics, which is sometimes the cause and sometimes the effect. Hong Kong occupies a unique place in the global trading and finance system. Even though it is part of China, the special administrative region has its own legislature, judiciary and currency. The Hong Kong dollar is pegged to the U.S. dollar. It differs from the Chinese yuan, which can actually appreciate or depreciate in very tight ranges and can take time to move. China also focuses its currency peg on a basket of currencies, rather than just the greenback.
Having that peg has been important in the last few decades in order to provide a stable environment for trade, but any peg has a downside. One of the big ones is that the economy effectively loses its monetary policy in that the anchor currency – the U.S. dollar in this case – has a high degree of influence over the economy with the peg. Pressure comes from investors that carry trades, who borrow in a low-interest economy and loan out funds in a higher interest economy.
That activity normally carries foreign exchange risk, but if a peg is in place that risk goes away. Then the question becomes how the government deals with countering pressure on currency levels. To some extent, reserves can be used, but those can run out. Harmonizing interest rates is clearly a more stable solution, but risks being the wrong monetary policy for that economy.
Hong Kong's interbank interest rates are a little above the U.S. equivalent, having been at highs not seen since 2008. The interbank foreign currency rate is midway between $7.75 and $7.85, but that is a weaker U.S. dollar from what we have seen all year. U.S. interest-rate expectations have fallen recently. That process has certainly raised some concerns out there about how long this structure will last.
My View: I am not worried about Hong Kong, at least not yet. The financial system is stable and has been somewhat insulated so far from the trade storms. Over time, it will no doubt have to adjust to whatever new trading environment arises from the current geopolitical talks.
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