Fighting an 'uphill battle'

US monetary tightening has wreaked havoc on world financial markets. Though Hong Kong is confident of keeping its monetary and financial system stable, challenges and uncertainties for the economy remain amid the rate-hike cycle. Liu Yifan reports from Hong Kong.

"The dollar is our currency, but it's your problem," then-US Treasury secretary John Connally famously told the Group of 10 finance ministers' meeting in 1971. His words quite succinctly sum up today's tumultuous global financial markets.

The US Federal Reserve began raising interest rates seven months ago to rein in surging prices. However, the latest twist in the battle hasn't led to taming inflation, but caused the greenback to strengthen, with painful adjustments made worldwide. As major global currencies take a hammering, the Hong Kong dollar's appreciation in tandem with its US counterpart has offered no relief for the city. Instead, Hong Kong could be in for an even more distinct economic sting from the monetary tightening cycle in the near term.

The recently released US consumer price index, which measures what consumers pay for goods and services, rose 8.2 percent in September from the same month a year ago. Although the reading was down from 8.3 percent in August and 8.5 percent in July, it's still a far cry from the US target of 2 percent.That pushed the Fed's officials to sanction a fourth straight 75-basis-point raise at their policy meeting this week.

With a contrasting outcome, the US currency has been turbocharged. The US Dollar Index — a measure of the greenback against half a dozen major currencies — has climbed by roughly 18 percent so far this year to its highest level in nearly 20 years.

Demand for the greenback has surged for simple reasons — the Fed's aggressive rate increases have turned the US dollar into a high-yielding currency, drawing capital from global investors. Also, as a currency that powers international trade and gets the lion's share of the world's foreign-exchange reserves, the greenback is considered a safe haven in uncertain times.

The flip side of the mighty US dollar has wreaked financial havoc elsewhere. In Britain, the sterling has taken a breathtaking dive; the euro has plummeted to a two-decade low against the greenback; while Japan, India and Thailand have intervened to prop up their respective currencies. The impact of these ructions on them has brought no good news — recession risks, unbridled inflation and debt woes.

With the US dollar gaining strength on foreign-currency exchanges, the Hong Kong dollar has also climbed against other major currencies because of the city's 39-year-old Linked Exchange Rate System. Under the dollar peg, the Hong Kong Monetary Authority — the special administrative region's de facto central bank — is obliged to keep the currency trading at HK$7.75 to HK$7.85 per US dollar by buying and selling the local dollar.

This anchor of currency stability that allows free movement of capital is much needed for a small open economy and an international financial hub like the SAR, says Terence Chong Tai-leung, associate professor at the Chinese University of Hong Kong's economics department.

But it has also come at a price — the city gives up its independent monetary policy. In other words, Hong Kong has to follow suit with the US interest-rate hikes although the city's economic cycles are not perfectly aligned with those of the US.

Different situation

The US Fed's monetary tightening this year is to cool the country's red-hot economy and rising inflation as a result of too much money chasing after a constrained supply of goods and services. Obviously, that's not the case for Hong Kong, which sees few inflation concerns, but a deepening economic downturn for the year.

In the July-to-September period, Hong Kong's GDP shrank by 4.5 percent compared with a year ago, according to preliminary data released by the Census and Statistics Department on Monday. It was the third consecutive quarter of contraction and the worst drop since the second quarter of 2020. The SAR government cited a worsened external environment and continued disruptions to cross-border land cargo flows.

Meanwhile, the city's consumer price index rose 4.4 percent in September from a year earlier — a stark contrast to the 8.2 percent in the US. The underlying inflation edged up only 1.8 percent after excluding the effects of the SAR government's one-time relief measures.

What Hong Kong finds now are a stronger local currency and tighter policies than it prefers, which could pile fresh pressure on the local economy already battered by a population outflow and the COVID-19 pandemic.

In any other economy where the exchange rate is flexible, certain volatility in monetary tightening is absorbed externally through a floating currency, while the rest is reflected in lower domestic asset valuations. But for Hong Kong, the bulk of the burden is borne by asset markets. The benchmark Hang Seng Index sank below 15,000 points last week for the first time in more than 13 years as global funds retreated, bringing the decline this year to 36 percent and making it one of the worst-performing major equity indexes worldwide.

Valuations of the equity markets have come down for various reasons that are not entirely connected with the linked exchange rate. But that offers scope for discussion basically about whether Hong Kong's market is cheap enough to cash in. This has always been the case since the city's exchange rate was linked in 1983.

"The prices, wages, the valuation of the stock market, bonds and everything revolve around the fixed exchange rate and have done so throughout the last number of decades," says Philip Wyatt, macro strategist at UBS Global Wealth Management's Chief Investment Office.

Fueled by the rate-hike cycle, Hong Kong's property market has also seen the end of its long boom. "Interest rates are a very important channel by which our monetary policy is linked to that of the US," Wyatt explains. "That means the cost of borrowing and mortgages in Hong Kong have gone up, and so people will delay related activities."

Hours after the Fed's latest rate hike, the HKMA raised its base rate by 75 basis points to a 14-year high of 4.25 percent, lifting the city's cost of money for the sixth time in eight months. The one-month Hong Kong Interbank Offered Rate — a benchmark used for pricing mortgages — has risen more than 3 percentage points since late May. In September, the city's major commercial lenders have also upped their prime rates for the first time in four years.

Nevertheless, judging by the one-month US dollar London Interbank Offered Rate, Hong Kong is still way behind the normal speed of the US rate hikes, says Andy Kwan Cheuk-chiu, director of the ACE Centre for Business and Economic Research.

"We follow US interest rates because of the peg, but only partially," he says. "If you look at US interest rates, they began going up about half a year ago. In this case, we're basically far behind."

Such a differential in interest rates has sparked arbitrage activities. The HKMA has ramped up currency purchases since May 11 to defend the dollar peg system as arbitrageurs engage in so-called "carry trades", in which they short the Hong Kong dollar against the higher-yielding greenback.

The HKMA's interventions have resulted in a slump of more than 70 percent in the city's aggregate balance — the key gauge of cash in the banking system — from HK$350 billion ($44.6 billion) in May to around HK$100 billion now.

The bite on the market and the economy in the short term is still real as shrinking interbank liquidity could weaken the monetary base, and is likely to cause Hong Kong dollar interbank rates and commercial banks' best lending rates to rise further, warns Carie Li Ruofan, global market strategist at DBS Bank (Hong Kong).

"The aggregate balance would probably bottom out at HK$50 billion during this tightening cycle, and the room for declining will make banks more cautious and put a damper on business activities as well as on people's consumption," she adds.

Ray of hope

The sticky situation is Hong Kong appears to have only reactive rather than proactive approaches in response as its monetary system runs completely automatically. However, the modest upside to all the gloom is Hong Kong's battle-tested monetary and financial base.

Linus Yip Sheung-chi, chief strategist at First Shanghai Securities, believes Hong Kong's banking system is going through "normalization" of its excess liquidity created by the US quantitative easing.

Since November 2008, the US has injected billions of US dollars into the market by purchasing mortgage-backed securities, as well as government and corporate debt securities, to stimulate its economy and employment.

"Hot money has flooded into economies, including Hong Kong, since 2008, jacking up the asset bubble to a high level," says Yip. "Today is probably a good time to gradually 'normalize' some of the past 15 years."

HKMA officials hold similar views, believing that the specific level of interbank liquidity is not a concern. "Prior to 2008, when major central banks around the world implemented quantitative easing policies, Hong Kong's aggregate balance used to be quite small for a long period of time, often below HK$10 billion," Clara Chan, executive director of monetary management at HKMA, tells China Daily.

More recently, the aggregate balance had stayed as low as HK$54 billion for 12 months — from April 2019 to April 2020, Chan adds.

At the other end of the HKMA's balance sheet, there're also more than HK$1 trillion in Exchange Fund Bills and Notes when assessing the strength of the city's monetary base. These Hong Kong dollar debt securities issued by the banking watchdog were set up to mop up excessive liquidity.

"This is a source of funds as well because if you're a bank and you hold these exchange fund bills and notes, you can choose not to roll them over," Wyatt explains. "And, there is liquidity right there or facilities that are available to enable you to borrow against it with very, very short-term funds."

Financial Secretary Paul Chan Mo-po and HKMA Chief Executive Eddie Yue Wai-man have both reiterated that Hong Kong has the capability and resolve to maintain the Linked Exchange Rate System as well as its monetary and financial stability despite capital outflows and the monetary tightening cycle.

Evidence provided by them is that the SAR still has plenty of financial firepower, with $419.2 billion in its foreign exchange assets as of September, representing more than five times the value of the local currency in circulation.

The greatest unknown is still when the US can tame its domestic inflation. Most economists and bankers believe the Fed is likely to pivot away from raising rates "at some point in 2023". More precisely, if DBS Bank's prediction is to be taken seriously, it would be the first quarter of next year at the earliest.

For now, at least, it is "very premature" to be thinking about pausing, the Fed Chairman Jerome Powell said at a news conference this week after the US central bank's two-day meeting. That means Hong Kong's interest rates will continue to catch up with those of the US, and there will be a slowdown in economic activities, corrections in asset prices, and funds flowing in and out that we normally see, says Kwan.

"The rate hike pace and the greenback won't stay this strong forever," Kwan says. "But until we see compelling signs of the Fed's turnaround, Hong Kong's uphill battle continues."