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1 More Big Challenge for Hong Kong In 2019 (And Years to Come)

This is part two in our series on the three biggest economic challenges facing Hong Kong in 2019.

For the past three decades, Hong Kong’s dollar (HKD) has been pegged to the US dollar (USD) – first at a fixed rate, then within a trading band. The previous article in this series noted worsening global trade activity and rising dependence on tourism spending as two big obstacles for Hong Kong in 2019. But unlike those problems, the currency peg will remain a perennial challenge for this year and the foreseeable future.

Letting another country drive domestic monetary policy

Effectively, the peg relies on a de facto central bank in the Hong Kong Monetary Authority (HKMA). For political and economic reasons, the arrangement is unlikely to change, given few alternatives. Despite close links to China, a peg to the renminbi is impractical, particularly since Beijing has kept the country’s capital account closed.

The challenge, then, for the HKMA is navigating domestic pricing conditions within the confines of an overseas financial institution. While the HKMA is able to buy and sell local Hong Kong dollars to drain liquidity from the market (via the Hong Kong Inter-bank Offered Rate, or HIBOR), this effort faces challenges as the Federal Reserve (Fed) interest rate policy responds to inflation expectations in the United States.

Lower interest rates in the US increase liquidity into Hong Kong’s financial system – so if inflation rates between the United States and Hong Kong diverge, Hong Kong has a problem. Since September of 2018, Hong Kong’s headline inflation has been higher than in the United States, with the spread growing for three consecutive months. With Hong Kong’s inflation expected around 2.5% in 2019, this would be higher than Fed Chairman Jerome Powell’s estimates of 2% for the year in the US. And Powell has already warned of downward revisions to that number.

Two very different housing situations

For both Hong Kong and the United States, housing accounts for the largest component in the consumer price index. However, Hong Kong is currently more susceptible to higher home prices because of chronic short supply and rising demand. Should the US inflation rate remain soft and allow the Fed to keep interest rates lower for longer, this could push Hong Kong home prices higher, creating social pressure and eroding purchasing power for Hong Kong citizens.

For Hong Kong, a rising HIBOR helps address asset bubbles in the world’s most unaffordable housing market. However, with Hong Kong’s debt-to-GDP ratio at over 400%, rising interest expenses weigh on corporate profits at a time when the economy is already susceptible to a slowdown.

Challenges for Hong Kong beyond 2019

Because of the currency peg, Hong Kong effectively imports US monetary policy. If the gap between HKD and USD interest rates remains, carry trades – when investors borrow money at a low interest rate to invest into higher-yielding assets —  will likely take place. In the current scenario, the HKD will probably grow weaker.

Reserves have increased over the past decade, with ample capacity to defend the USD and HKD range. According to the HKMA, total foreign currency reserve assets of US$434.5 billion represent about seven times the currency in circulation, or 46% of Hong Kong dollar money supply and highly liquid assets.

This should provide some reprieve amid the current trade war between the United States and China. But should Washington and Beijing fail to reach any compromise, the Federal Reserve and the People’s Bank of China are likely to keep liquidity conditions loose, creating pressure for the HKMA.

Low inflation rates will benefit holders of Hong Kong dollar assets (like property and equity), since such rates discourage savings. Previously, the HKMA tightened liquidity to stem the rise of property prices in the world’s most unaffordable housing market. Those efforts were unsuccessful then, and they’re unlikely to produce different results now.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.