Report: Hong Kong Monetary Policy Outlook

Executive Summary:

Hong Kong (HK) adopted the Linked Exchange Rate (LER) system in 1983, and it has been operating successfully for more than three decades. However, the maintenance costs for the LER system have grown exorbitantly and could outpace the costs of an exit, especially under the combined influence of a slow-down of the Chinese economy and a possible interest rate hike in the U.S. The HK government currently holds much more foreign reserves than it did preceding the 1997 Asian Financial Crisis. The HK government is also facing political unrest and growing anger of low income residents towards wealth inequality. This opposition could eventually force the HK government to abandon the Currency Board System. At present, the cost of exiting the LER ­system is small thanks to a strong HKD sustained by large capital inflows from mainland China. However, the time frame for such a low-cost exit is short.

There are two ways in which investors can speculate on HK’s exit from the Currency Board System. One is to speculate on a de-pegging strategy at present and betting on a strengthening HKD. Investors consider this strategy to be the “politically correct” option, as they would face less hostility and possibly acquiescence from the HK government. The other option is a “double down” strategy to capitalize on the depreciation of the HKD when the Chinese economy hits a hard landing.

Background: HK’s Adoption of the LER System

HK adopted the current LER system in 1983 after an “unfavorable” discussion between Margaret Thatcher and Deng Xiaoping concerning the transfer of HK sovereignty from the UK to China in 1997. The uncertainty generated by the transition talks drove capital out of HK at a time when HK used a floating exchange rate. Since HK lacked a central bank, the HKD depreciated quickly against the USD, and inflation skyrocketed. In order to control inflation and restore discipline in the financial market within a short period of time, the HK government adopted the LER system. In essence, this is a Currency Board System[1]. The HK government also announced that it would peg the HKD to the USD at the rate of 7.80[2]. Since then, the LER system has proved to be resilient to several financial crises, including the 1997 Asian Financial Crisis and the more recent 2008 global financial crisis. The HK government has claimed that its currency arrangements are the cornerstone of HK’s prosperous economy, and it argues that as a small open economy, the Currency Board System is the best choice for HK. However, as the external environment changes, even the best functioning system may reveal its weaknesses. In the next section, we examine the arguments made by the Hong Kong Monetary Authority (HKMA) in favor of maintaining the LER system.

The HKMA claimed that “the Linked Exchange Rate remains the best monetary option for Hong Kong and no other monetary policy would provide the stability and confidence necessary for an extremely open and externally oriented economy like Hong Kong.”[3]

In the introductory document to the current currency system, the HKMA acknowledges the weakness of the LER but argues that the LER is still the best choice for HK after comparing it to alternative options including dollarization, free float, link to a basket of currencies, link to another currency, and link to the US dollar but at another rate[4]. Although the HKMA’s argument has some merit, it does not discuss the option of adopting the monitoring band mechanism used by Singapore, another small, open and highly successful Asian economy.

Several researchers argue that adopting a monitoring band system would be a better option for HK. Professors Rajan and Siregar argue that Singapore’ monitoring band system has “outperformed” HK’s Currency Board System overall[5], especially on flexibility. The ability to use discretionary policies to mitigate the effects of negative economic shocks seen in Singapore’s system is missing in HK’s Currency Board System.  As a result, costly adjustments such as lowering labor costs are required to boost the economy. A failure to undertake the necessary adjustments will lead to HK’s loss of price competitiveness in international markets and a build-up of trade imbalances. This also encourages a negative reaction from financial markets, which only exacerbates the problem. Also, if the HKMA adopts some discretionary monetary policy under the current LER system, it would undermine the credibility and concomitant benefits of the hard peg. Hong Kong took some discretionary actions in the late 1990s after the Asian Financial Crisis, but it resulted in a sustained attack on the HKD in the midst of the crisis.[6]

Professors Tse and Yip’s research on interest rate behavior in the two economies also shows that the monitoring band system in Singapore not only allows a greater flexibility in the choice of the exchange rate, but also a greater autonomy in the choice of interest rates to mitigate a crisis, recession, or overheating. The loopholes and de-pegging risks of the currency board might imply a substantial exchange-rate risk for banks when conducting uncovered interest arbitrage. As a result, during the previous crisis period, banks refrained from performing arbitrage, despite the emergence of a huge interest rate differential between HK and the U.S. during the crisis period. [7]

HKMA also claimed that the “structure of Hong Kong economy is flexible and responsive. Markets such as the labor market, property and retail markets respond quickly to changing circumstances: this flexibility facilitates adjustments in internal prices and costs, which in turn bring about adjustments to external competitiveness without the necessity of moving the exchange rate.”[8]

However, such an assumption might also be invalid. Yip argues that, in fact, HK’s (export) price was far more sluggish than that presumed by the proponents of the current system. He concluded that the long-perceived high flexibility in HK’s economy was in fact due to a high adjustment speed in export quantity, not price. The adjustment in quantity implies a large adjustment cost in maintaining the peg in HK. This also explained why the volatility of HK’s quantity (such as real GDP or export-volume) was unusually large by international standards. Yip found that prior to the 1997 Asian Financial Crisis, HK had experienced years of inflation, and the fixed exchange rate had pushed HK’s prices and wages to extremely high levels. Even though HK experienced deflation from 1998-2002, the accumulated fall in prices and wages during the post-crisis recession was still small when compared to the accumulated rise during the 7-8 years of asset inflation before late-1997. Yip’s research suggests that the accumulated rise in HK’s Consumer Price Index (CPI) between January 1990 and December 2003 is still substantially higher than that of the US and indicated that there could still be plenty of room for HK’s prices and wages to decrease.[9]

The sluggishness associated with adjusting wages and prices might be even worse at present compared to the last decade. HK’s wealth gap is among the widest in the world, and the problem is worsening. Monthly median earnings have only increased by 30% over the last 10 years, while HK’s GDP has jumped 60%.[10] Low income residents are becoming angrier about the growing inequality and populist political sentiment makes it harder to make necessary wage and price adjustments. For example, HK dock workers organized a strike against Hutchison Whampoa Group and asked for a 23% pay increase, which resulted in a 9.8 % pay rise backdated to 2013.[11] It is hard to imagine that low income workers would accept pay cuts or high unemployment when another crisis breaks out. It is this social and political pressure that could be “the last straw that breaks the camel’s back” in terms of the HK government maintaining the Currency Board System. However, if the HK government decides to act prior to a worst-case scenario, such factors could drive the HK government to abandon the LER system.

The Worst-Case Scenario

As monetary policies among the major central banks diverge and the Chinese economy slows down, the HKMA recently conducted research on the “worst case” scenario in order to determine the combined impact.

Quantitative easing (QE) by the European Central Bank (ECB) and the Bank of Japan (BoJ) reinforces appreciation pressures on the HKD and somewhat neutralizes capital outflows caused by a tightening in US monetary policy, resulting in a slower real GDP growth and higher unemployment rate for HK. To make things worse, with shocks emanating from the economic slowdown in the Mainland, HK’s real GDP growth falls further and unemployment rises by more. [12] Although HKMA’s research suggests that the current financial system can again sustain such shocks, it is likely that the social and political pressures would spark the exit from the current System.

Exit Timing

Yip notes that although the exit cost is unknown, a stronger HKD can mitigate the destabilizing effect of the exit and prevent the loss of confidence in the currency. He argues that if HKD is unpegged during a period when the USD is under substantial depreciation, then the exit costs will be very small (or even negative) with HKD up against USD-related currencies and relatively stable against other currencies.[13]

At present, although the timing of an exit from the currency peg is not at its best, it is also not at its worst. Thanks to capital inflows from mainland China, the HKD is currently in a strong zone.


(US Dollar (USD) to Hong Kong Dollar (HKD))

In its half-year monetary and financial stability report, the HKMA notes that after the PBOC depreciated the RMB against the USD last August, investors converted their offshore RMB into HKD. Consequently, strong-side Convertibility Undertakings (CUs)[14] were being triggered repeatedly between 1 September and 30 October 2015. The strong inflow totaled HKD 155.7 billion.[15]


However, the slowing down of the Chinese economy might be a double edge sword for the HKD FX rate. In January, the HKD dropped by as much as 0.28 percent, its biggest intra-day fall since October 2003, and speculation mounted in the options market that the city’s 32-year-old currency peg would end as investors lost confidence in Chinese assets[16].

Two Ways of Speculating on an Exit from the Currency Board System

  1. Betting HKD to Depreciate

 This strategy can be applied in the case where the HK government fails to de-peg the HKD when the currency is still strong. The economic slowdown in China and the possible interest rate hike in the U.S. would eventually push HK’s economy into recession. The rising unemployment rate is likely to trigger social unrest and drive investors out of the HK market, causing a depreciation of the HKD.

The following is an explanation of how investors applied a “double down” strategy in 1997.

Step 1: Preparation

Speculators borrowed substantial amounts of medium-term (6-12 months) HKD through the swap market or bought HKD forward in the forward market. In the stock futures market, they built up large short positions.

Step 2: Formal attack

Speculators sold their pre-funded HKD dollars in the spot market. In order to maximize the impact of their attack, they sold the HKD in the relatively thin offshore markets. When the HKMA attempted to support the HKD through purchasing the HKD, interbank liquidity was squeezed, which, in turn, caused a surge in the interbank rate. In addition, speculators also sold large amounts of HKD in the forward market. As banks usually did arbitrage between the swap market and the interbank market, the forward selling of HKD would also bid up HK’s interbank rate and this would create a sentiment that the HKD was under attack, therefore attracting more speculators to follow.

Step 3: Profit taking

After bidding up the interbank rate and pushing down the spot and futures stock indices, speculators took their profits by closing the short positions in the stock futures market. They also bought back the shares and returned them to the custodian. In the foreign exchange market, they closed their short positions in forward HKD and lent out any surplus HKD (at a shorter maturity), previously borrowed from the swap market.[17]

However, this strategy might not be as effective now as at the time. During the attack in 1997, the HK government was predisposed to “positive non-interventionism,” and it was not until the limit of tolerance had been breached that the government chose to fight back. Even so, the HK government’s intervention in the stock market still shocked and dismayed many observers on the grounds of principle[18]. After the financial crisis, the HK government implemented 7 technical improvements to the system. The HKMA has already undertaken full preparation for a similar attack and according to their report: “Any attempt to sell HKD short and push up the HKD interest rates, as in 1997–98, is very difficult now under a much larger Monetary Base and the Discount Window mechanism.”[19]

Betting on the HKD at the weak side has its pros and cons. One advantage is that the HK exchange rate can only move in one direction. The best strategy for the HK government might be to maintain the exchange rate at its legitimate weakest level at 7.85. The conclusion is that investors face literally no risks in betting in the wrong direction.

However, there are also several weaknesses of this strategy.

First, investors have to face the fact that the HK government owns huge foreign reserves, totaling HKD 3,085.3 billion, which are also backed by the Chinese government. The HK government’s ability to maintain the current Currency Board System might be much stronger than investors expect.

Second, it is politically unacceptable for the Chinese and HK governments to exit the Currency Board System when the HKD is under depreciation attack, especially considering the fact that the HK government successfully weathered the 1997 Asian Financial crisis without abandoning the system.

Third, the HK economy will certainly suffer as the Chinese economy slows down, but such pain might be seen more in the long term. In the short term, the hit might not be as severe as investors have imagined. With tighter trade linkages between HK and the Mainland, the headline trade figures suggest that the share of Hong Kong’s merchandise and services exports to the Mainland increased to 51% in 2012, while the US share declined to 21% compared to a much larger share from a decade ago. However, He, Liao, and Wu suggest that the headline figures are only informative about export destinations, rather than the origin of final demand for exports[20]. Their research shows that the share of merchandise exports to the Mainland in value-added terms was about 22% in 2012. The US share, though having declined from a decade ago, was still around 25% in 2012. In contrast to the general misconception that the demand for financial services in HK is largely Mainland-driven, within the category of HK’s exported financial services, US demand accounted for 33% of the total in 2012, whereas the Mainland’s share was merely 4%. They suggest that the US transitory shocks have remained a dominant force in driving HK’s business cycle fluctuations, and that transitory shocks from mainland China have played a less important role. However, when it comes to permanent shocks, the picture is the opposite: permanent shocks from the Mainland have a greater impact on HK’s real GDP growth than those from the US.[21] At the same time, investors are concerned about the quality of HK’s banking assets and their exposure to the Mainland. In fact, the HKMA’s report suggests that HK banking has limited direct Mainland exposure. During the last six months, the classified loan ratio of Mainland-related lending only rose to 0.94% from 0.78%.[22] As a result, it might take a relatively long period of time to see the impact of the economic slowdown in China transmitted to Hong Kong and drive up local non-performing loans (NPLs).

It is not easy to replicate a double down strategy now and gamble on the HKD depreciating. HK and Chinese governments would very likely intervene when faced with a weaker HKD. Also, speculators must consider the fact that HK might be able to withstand the economic slowdown in China for a much longer period of time than expected.

  1. Betting HKD to Appreciate

As the slowing Chinese economy puts the RMB under pressure, investors are transferring their wealth into HK to hedge the depreciating RMB. In the near term, there is an opportunity for investors to speculate on the HKD strengthening, and thus the HKMA can take advantage of this opportunity to exit the Currency Board System.

Similar to betting on the HKD depreciating, there are several pros and cons to such a bet. The biggest advantage is that it is the “politically correct” option. At present, the HK government needs a strong reason to exit the Currency Board System. Investors driving up HKD combined with the chaotic global environment appear to be a reasonable excuse. The Chinese government also has to consider the possibility that the Chinese economy might experience a hard landing, and its own massive foreign reserves might not be large enough to withstand the impact, not to mention supporting HK. In addition, if the HK government decides to exit the system right now and keep the HKD strong for a period of time, it seems such a decision would be wholly based on the HK government’s own will, making the exit less politically embarrassing. As a result, by speculating on a stronger HKD, investors are in essence helping the HKMA, so they could encounter much less resistance or even acquiescence from both the HK government and the Chinese Central Government, which could, in turn, lead to a much greater chance of success.

However, investors might still adopt a double down strategy and push the HKD into its weaker zone when the hard landing of the Chinese economy finally comes.  At present, the forward price and volatility of the HKD suggests that investors are still betting on the HKD to stay strong. However, this indicator could be misleading if HK government decides to exit the Currency Board System. If the HKD is no longer pegged to the USD, HK might suffer from capital outflows, and the attitude of investors towards the HKD might change overnight.

Second, even though it is the best time for the HK government to exit the Currency Board System, it is still out of their comfort zone. The government might act too slowly and miss a good opportunity.

Third, successfully betting on a stronger HKD requires a large number of investors to work together, and their concerns over the Chinese economy might mean there are not enough participants to make the HK government feel comfortable with exiting the Currency Board System.


(Hong Kong Dollar 12 months Forward Discount.  Source:Wind Info)

However, just as Mishkin suggests, “It is exactly when things are going well that smooth transition out of the currency board is feasible. On the other hand, this is when the political will to exit from the currency board may be the weakest, even if the country would be better served by a different monetary regime.”[23] There are several other elements investors have to consider including the current political environment, the impact on different sectors and their political influences, the impact on the financial industry, the change of capital flows into Hong Kong, and especially how the HK government monitors these capital flows. Although the HKMA has revealed that they are monitoring several indicators, including spot exchange rates, aggregate balances, net spot foreign currency positions, and BOP and market survey data, their detailed models are still not clear.[24]


The maintenance cost of the Currency Board System in HK has become too large, and the government should exit the system and adopt a monitoring band currency system similar to Singapore in preparation for economic slowdown in China and an anticipated interest rate hike in the U.S. The growing number of angry low income residents and the populist political environment might be the “the last straw that breaks the camel’s back” to end the currency system. Compared to adopting a double down strategy when the HKD is weak, investors could bet on a stronger HKD at present and speculate that the HK government will exit the system in the near future. Such a strategy is “politically correct” and might have a greater chance of success.



[1] Prof. Steve Hanke argues that the Hong Kong Government has “deviated from orthodoxy (Currency Board System) because they wanted the monetary authority to take on the features of a typical central bank.” On Dollarization and Currency Boards: Error and Deception, Steve Hanke, Policy Reform, 2002, Vol. 5(4), pp. 203–222

[2] Hong Kong’s Money The History, Logic and operation of the Currency Peg, Tony Latter, Hong Kong University Press, pp.55

[3] HKMA Background Brief No.1  Hong Kong’s Linked Exchange Rate System

[4]  Ibid.

[5]  Choice of Exchange Rate Regime: Currency Board (Hong Kong) or Monitoring Band (Singapore)?, Ramkishen Rajan and Reza Siregar, IPS Working Papers

[6] Ibid.

[7] Exchange-Rate Systems and Interest-Rate Behavior: The Experience of Hong Kong and Singapore, Y k Tse and Paul S l Yip, SMU Economics & Statistics Working Paper Series

[8] HKMA Background Brief No. 1  Hong Kong’s Linked Exchange Rate System

[9] On the Maintenance Costs and Exit Costs of the Peg in Hong Kong, S. L. YIP, Economic Growth Centre Working Paper Series

[10] Hong Kong’s growing wealth gap fuels protests, CNN,

[11]  Hong Kong dock workers end strike after pay deal, Financial Times,

[12] The Impact Of U.S Monetary Policy And Other External Shocks On The Hong Kong Economy :  A Factor-Augmented Var Approach, Hongyi Chen and Andrew Tsang, HKIMR Working Paper No.09/2016

[13] On the Maintenance Costs and Exit Costs of the Peg in Hong Kong, S. L. YIP, Economic Growth Centre Working Paper Series

[14] “Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85.”

[15] Half-Yearly Monetary And Financial Stability Report March 2016

[16]  HKD Drops Most Since ’03

[17]  The Impacts of Hong Kong’s Currency Board Reforms on the Interbank Market  Y.K. Tse Paul S.L. Yip Journal of Banking & FinanceVolume 27, Issue 12, December 2003, Pages 2273–2296

[18] Hong Kong’s Link to the US dollar-Origin and Evolution, John Greenwood, Hong Kong University Press, pp. 279-280

[19] Half-Yearly Monetary And Financial Stability Report March 2016

[20] Hong Kong’s Growth Synchronization with China and the U.S.:  A Trend and Cycle Analysis,  Dong He, Wei Liao, Tommy Wu, HKIMR Working Paper No.15/2014

[21] Ibid.

[22] Developments in the Banking Sector, Hong Kong Monetary Authority Quarterly Bulletin June 2016

[23] Monetary Policy Strategy, Frederic Mishkin, The MIT Press, pp. 456

[24] How do we monitor Hong Kong dollar fund flows? Hong Kong Monetary Authority Quarterly Bulletin December 2012