How credible is the Hong Kong peg?

Despite speculation over the years that Hong Kong’s currency peg may be abandoned, leading the HKD to depreciate against the USD, it has remained unchanged, except for minor technical improvements, since its introduction in October 1983, almost 40 years ago. From the perspective of monetary history, that is a remarkable achievement.

While commentators have typically focussed on the risk of a weakening of the HKD, the risk is in principle in both directions, although the HKMA can sell HKD in unlimited amounts to prevent an appreciation. Sustained high growth in China coupled with the opening of its financial system may lead the HKMA at some future stage to switch the peg to the renminbi. If so, the HKD could hypothetically appreciate against the USD.

Focussing on the risk of a depreciation, some back-of-the-envelope calculations illustrate that the likelihood the peg will be overrun must be very low, at least if the past is a guide to the future. Most would probably argue that the historical evidence suggests the likelihood the peg will be overrun over a twelve-month period is at most 1%, and probably much less than that.

Assessing the credibility of the peg

To assess the credibility of the currency board, a simple technique can be used. The test involves computing the range around the USD interest rate for a given maturity that is compatible with the currency board remaining in force. Investors will only be willing to borrow or lend at HKD interest rates outside that range if they believe that the peg may collapse during the period defined by the maturity of the interest rate considered.

The perspective of 12-month interest rates

The Figure above plots the upper and lower limits of the interest rate corridor, together with the 12-month HIBOR rate for the period June 2005 (when a “strong side” undertaking of 7.75 HKD was introduced and the “weak side” undertaking was moved to 7.85 HKD) to March 2021. Between 2005 and 2010, the HKD interest rate was below the range, indicating that investors believed the HKD might strengthen above 7.75 HKD. The cause of this was the appreciation of the renminbi against the USD from the summer of 2005 onward, which fuelled speculation that the HKD peg might be switched to the renminbi and lead to an appreciation of the HKD against the USD. This illustrates the two-sided risk to the HKD peg.

Between 2010 and 2017, the 12-month HIBOR rate was generally just inside the range, implying that investors believed the peg would remain unchanged. But in February 2020, the HIBOR rate rose briefly above the upper limit of the interest rate range, implying that some investors grew concerned that the peg might collapse. However, it recovered quickly and is now well inside the range.

The perspective of 10-year yields

The following Figure shows the same calculation, but using 10-year yields. The interest rate range is much narrower in this case, for the reasons explained above.

Interestingly, the 10-year HKD yields are in this case always below the range, except in March 2020 when they are just inside the range. This suggests that market participants attached little weight to the risk of the currency board being broken. However, it is compatible with the idea that the HKMA might decide to switch the peg to the renminbi, potentially leading to an appreciation of the HKD against the USD.

Conclusion

There are two main conclusions of the analysis. First, with the currency board having remained unchanged for 38 years, it is clear that the likelihood of a collapse of the peg must on average have been very low, perhaps a fraction of a percent per annum. Had the probability been materially higher, one would have expected to see one or several episodes in which the currency board was overrun. Second, the HK dollar peg appears highly credible to market participants. If anything, a strengthening of the HKD above the 7.75 HKD seems more likely than a weakening below 7.85 HKD, as evidenced by the fact that the HKD 10-year yield has been persistently below the range implied by the analysis above.

Such an appreciation of the HKD is compatible with the peg being switched from the USD to the renminbi, and the latter appreciating against the USD. While such a switch seems unlikely in the near term, from an historical and political perspective it remains a possibility in the more distant future.

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