Why Hong Kong's Currency Is Still Rock Solid

When the future of Hong Kong was hanging in the balance during Sino-British handover talks, the city's currency lost around a third of its value against the dollar in just 12 months. The Hong Kong government then decided in 1983 to peg its currency to the dollar to restore confidence. The exchange-rate system put in place then should once again weather the turmoil the city is facing.

Could the protests that have embroiled Hong Kong (https://www.wsj.com/articles/political-crisis-deepens-in-hong-kong- as-protesters-retake-streets-11568538067)for more than 100 days bring down the 36-year peg? The worries are understandable: Fixed-exchange-rate regimes fail all the time.

But Hong Kong's currency-board system (https://www.wsj.com/articles/a-dollar-peg-that-will-stay-on-the-line- 1523527777) is far more robust than an ordinary peg. Every single Hong Kong dollar in circulation is fully backed by liquid dollar-denominated foreign reserves. In fact, Hong Kong's $433 billion of foreign reserves is more than twice its monetary base, which also includes excess reserves in the banking system and short-term bills issued by the city's de facto central bank.

Unlike many governments with failed pegs, Hong Kong has been very disciplined in sticking to its rules: It cannot create unbacked money, and has to allow its monetary base to fluctuate with capital flows. Hong Kong's money-supply growth has largely been in line with the growth of its foreign reserves.

Even against a broader measure of money supply, Hong Kong's reserves still look ample: Reserves stand at nearly half of Hong Kong's local-currency M3, which includes all the Hong Kong dollar deposits in the city. It would take an unprecedented exodus of capital to push the reserves to dangerous levels.

The drawback of the peg is that it can create booms and busts in local asset prices as Hong Kong has essentially handed over its monetary policy-making to the Federal Reserve. The city's famously expensive property market is at least partly attributable to the currency arrangement, as local authorities can't tighten monetary policy on their own to rein in asset bubbles.

On the other hand, when capital flows out of Hong Kong the currency-board arrangement means interest rates should automatically rise, which may in turn drive property or stock prices much lower. This was the cost of defending the peg during the Asian financial crisis of 1997-1998.

But these costs must be weighed against the benefits. Having such a dependably stable currency has vastly helped Hong Kong in its role as an intermediary between China and the rest of the world, first as a trading port and more recently as a financial center. Abandoning the peg now, just as other questions swirl over the city's future, would put all this at risk. That is why it won't happen for the foreseeable future.

-Jacky Wong; 415-439-6400; AskNewswires@dowjones.com

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