The Hong Kong dollar has been pegged at a fixed rate of HK$7.8 to the U.S. dollar since 1983. The link has brought much-needed stability to East Asia's financial hub. But there now is the prospect that the peg may break after one-third of a century, which would be a financial disaster for the city.
The administration of U.S. President Donald Trump is exploring the nuclear option of forcing the issue. It correctly is looking for ways to punish Beijing for implementing its ridiculously broad treason-and-sedition law in Hong Kong. The legislation punishes citizens of any nation, wherever they are - and yes, that includes you - for saying, well, pretty much anything critical of the Chinese and Hong Kong governments.
Hedge fund manager Kyle Bass engages in wishful thinking that the peg will fall. Bass, a frequent China critic who has blasted Beijing for crushing pro-democracy demonstrations in Hong Kong, would love nothing better than the collapse of the peg. Bass has advised all investors with Hong Kong assets to sell out of them and shift the money directly into U.S. dollars before it's too late.
Bass has been betting against the Hong Kong dollar since May 2019. Now he has offered investors in his Hayman Capital hedge fund the opportunity to do the same.
Bass is using 200 times leverage via options to offer investors a one-way bet. Should the Hong Kong dollar depreciate by 40% within the next 18 months, investors will make 64 times their money. If the peg remains, they lose everything they've invested.
Hong Kong's central bank, the Hong Kong Monetary Authority (HKMA), buys and sells U.S. and Hong Kong dollars as necessary to maintain the peg. The possibility of limiting the HKMA's access to U.S. dollars has been elevated as high as the desk of U.S. Secretary of State Mike Pompeo, according to Bloomberg.
Bad bets of the past
Hedge fund manager George Soros attempted to torpedo the Hong Kong dollar peg in 1997-98, at the height of the Asian financial crisis. The man who is said to have broken the Bank of England took out billion-dollar bets against the currency, only for the HKMA to rush into the market and buy a large chunk of Hong Kong stocks to prop them up. Soros lost millions, money he more than made up for with successful wagers against the Thai baht and Malaysian ringgit.
"They actually did a very good job defending the Hong Kong dollar," Soros admitted in 2009.
More recently, Crispin Odey, another high-profile hedge fund manager, took out a series of bets against the Hong Kong dollar. But after two years of begging against the currency, he sold out of the trade, unsuccessfully, in 2018.
The issue facing Pompeo and the China hawks in the Trump administration is that breaking the Hong Kong dollar peg would hurt Hong Kong banks, its financial system and the U.S. financial system without directly targeting the Chinese government. So other tariff and sanction actions seem more likely.
A string of foreign currency analysts has said, with little evidence, that it's unthinkable the Hong Kong dollar peg would break.
Commerzbank is the latest among them. "Only someone who believes that the U.S. President might start flailing without considering the risks in an election campaign that is increasingly moving in an unfavorable direction might allocate any significant likelihood to this scenario," the German bank's head of foreign exchange Ulrich Leuchtmann, writes in a note to clients.
But Leuchtmann admits that irrational action is not beyond Trump. "Mad-Man theories are difficult to play on the financial markets," he concedes.
The United States agreed to the Linked Exchange Rate System in 1983 and signed the U.S.-Hong Kong Policy Act of 1992, which gave Hong Kong its special trade status and said the United States will allow the U.S. dollar to be "freely exchanged" against the greenback. But the Trump administration is now looking at ways to revoke Hong Kong's favorable trade designation, judging it has lost its autonomy from China.
A strong and stable U.S. dollar has enabled the United States to run permanent trade deficits for more than 40 years. The U.S. government does not have to worry about any run on its bonds and credits because international investors are confident it will always have the ability to back them.
China's ace in the hole
China also has a nuclear option up its sleeve. It holds US$1.1 trillion in U.S. debt as of the end of last year, or about 5% of the total US$23 trillion owed by Uncle Sam. Should China seek to sell those holdings, particularly all at once, it would blow up the U.S. dollar, and of course the value of its own investment.
There appears to be less speculation in the options market that the Hong Kong dollar will suffer than there was last year, at the height of the pro-democracy demonstrations. The Chinese government, with its US$14 trillion economy and a deep pool of US$3 trillion in foreign currency reserves, is far better poised to defend the HKD against all comers, though in the long run it would make more sense for the Hong Kong dollar to be pegged to the Chinese yuan.
However, the Chinese government would not want to be seen as breaking the Hong Kong dollar peg due to U.S. pressure, so this may be a long-term goal rather than a short-term reality.
The HKMA this month has been selling Hong Kong dollars to prevent the currency gaining too much ground on its U.S. counterpart. It has spent at least US$13.5 billion since the start of 2020 to avoid the Hong Kong dollar breaking out of the upper end of its band limit, with mainland money flooding into Hong Kong stocks via the Stock Connect linking Hong Kong's cheaper stocks to the pricier markets in Shanghai and Shenzhen.