Latest Thoughts on the HKD Peg

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The Hong Kong dollar has steadily weakened this year.  Yet there is no threat at all to the peg, which we see being maintained for the foreseeable future. 

POLITICAL OUTLOOK

Carrie Lam was elected Chief Executive in March.  Lam has been active in Hong Kong politics for years, and so she is seen as the status quo.  She won with 777 votes from the 1200-member Election Committee.  However, the structure of the Election Committee ensures that the candidate preferred by Beijing will always win.

In the 2016 elections for the 70-seat Legislative Council (Legco), pro-Beijing seats fell to 40 from 43 in 2012.  Traditional pro-democracy seats also fell, to 23 from 27 in 2012.  Filling these 7 lost seats were the so-called “radicalists.”  Still, the opposition remains basically toothless but we would expect sporadic protests on some of the signature issues that include greater democracy and self-determination for Hong Kong.

ECONOMIC OUTLOOK

The economy is picking up, helped by an improving mainland outlook.  GDP growth is forecast by the IMF to accelerate to 2.4% in 2017 and 2.5% in 2018 from 1.9% in 2016.  GDP rose 3.1% y/y in Q4, the strongest since Q2 2015.  Monthly data for Q1 suggest further acceleration.  As such, we see some upside risks to the growth forecasts.

Price pressures are easing, with CPI decelerating to 0.5% y/y in March.  Excluding distorted January and February readings, this is the lowest rate since September 2009.  However, base effects from 2016 are low and so the y/y rate should resume climbing.  The Hong Kong Monetary Authority (HKMA) does not run an independent monetary policy due to the HKD peg to USD.  Indeed, it has raised the base rate three times since December 2015, in lockstep with the Fed.

Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Bank Rate.  Indeed, the Prime rate has been kept at 5% despite the 75 bp of Fed tightening seen since December 2015.  Loans and advances are rebounding, up 11.6% y/y in March vs. the trough of -1.4% y/y in March 2016.  M3 also grew double digits y/y in March.  Macro-prudential measures have been used to contain potential risks from the property boom.

Fiscal policy has remained prudent.  Indeed, accumulated budget surpluses will likely boost the Fiscal Reserves to an estimated HKD952 bln ($122.5 bln) by March 2018.  This is enough to cover over two years of expenditures.  The budget surplus came in at an estimated 3% of GDP in 2016, up from about 2% in 2015.  It is expected to fall back to 1% in both 2017 and 2018.

The external accounts remain in solid shape.  Hong Kong has run a current account surplus since 1998.  The surplus is expected to come in around 3% of GDP in both 2017 and 2018.  Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP.  HKMA foreign reserves stood at a record high $395.6 bln at the end of March.  Clearly, Hong Kong has very low external vulnerability across most metrics.

HKD PEG OUTLOOK

We can’t put it any better than the IMF did in its annual Article IV consultation from January:  “The Linked Exchange Rate System (LERS) remains the best arrangement for Hong Kong SAR, backed by the credibility built up over three decades and tested through crises. The LERS is underpinned by the flexible economy, ample reserves buffers, and strong financial regulation and supervision. Wage and price flexibility allows the economy to adapt quickly to cyclical conditions and structural change. The external position is broadly in line with medium-term fundamentals and desirable policies.”

The HKD peg to the USD was put in place in 1983, when prospects for the 1997 handover of Hong Kong from the UK to mainland China disrupted Hong Kong markets.  The negotiations for the handover unsettled markets.  With HKD freely floating then, it weakened from less than 5 per USD in 1980 to almost 9 per USD in 1983 before the peg was introduced.

Under the initial 1983 peg arrangement, HKD could not trade on the weak side (above) the 7.8 peg rate, but could appreciate without limit to the strong side (below 7.8).  A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate that prevented appreciation beyond 7.75.  The Hong Kong Monetary Authority (HKMA) is obliged to buy and sell USD to prevent the HKD from breaching either side of the band.

Since the peg was put in place, it has really been tested only once, during the Asian Crisis that started in 1997.  Interbank rates soared in 1998, as foreign reserves fell and the domestic money supply shrank.  The HKMA also took some unorthodox steps, such as buying Hong Kong stocks as the Hang Seng plunged.  Ultimately, the HKMA prevailed then and we would expect similar success if the HKD were to come under greater pressure.

The HKMA runs a strict currency board.  In essence, this means that every HKD in circulation is backed by an equivalent amount (at the official exchange rate) of USD.  When run correctly, such a peg cannot be broken.  Argentina’s peg was broken because it violated several of the basic tenets of a currency board.

We continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future (perhaps in 10+ years?).  It seems that if conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan.

This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware.  China authorities will manage market expectations in order to minimize potential turmoil and disruptions from such a game-changing move.  For now, we see no change to the HKD peg.

INVESTMENT OUTLOOK

USD/HKD last week traded at its highest level since February 2016.  It has since fallen back a bit, but to keep things in perspective, the current rate of 7.7820 remains well below the 7.8 peg rate.  The last time it was above the peg rate was in January 2016, when the pair traded as high as 7.83 as EM came under severe pressure.  As local interest rates spiked then, the pair quickly moved back below the 7.8 area.

Hong Kong equities have done better after a poor 2016.  In 2016, MSCI Hong Kong was -2% vs. +7% for MSCI EM.  So far this year, MSCI Hong Kong is up 18% YTD and compares to up 15% YTD for MSCI EM.  This outperformance should continue, as our EM Equity model has Hong Kong at a VERY OVERWEIGHT position.

Hong Kong bonds have outperformed.  The yield on 10-year local currency government bonds is about -50 bp YTD.  This compares favorably to the best performers Brazil (-115 bp), Indonesia (-88 bp), Colombia (-87 bp), Turkey (-86 bp), and Russia (-77 bp bp).  With inflation likely to climb again, we think Hong Kong bonds will start underperforming.