Weakness in HK Currency Board System and Trading Opportunities in Betting A De-Peg of the Hong Kong Dollar

Abstract

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.

In our view, the HK government is likely to maintain the current system, even at high social and economic costs, in the expectation that changing external factors, such as the rebound of the Chinese economy, will relieve the de-pegging pressure. In this report, we explore several approaches to gauge the timing and risks of a de-pegging of the HKD and the collapse of the Chinese housing bubble. At the same time, we analyze the potential impact of a de-pegging on HK’s local companies and the most vulnerable parts of the system.