The Hong Kong dollar peg: the beautiful self-adjusting mechanism that was
It's all getting to be rather routine, these announcements that the Hong Kong Monetary Authority has once again stepped into the market to stop the HK dollar from trading at stronger levels than HK$7.75 to the US dollar.
But while this does not impose a breaking strain on the peg to the US dollar, recent events point to conditions that no one had in mind when the peg was introduced in late 1983, and it cannot be an entirely comfortable environment for the HKMA.
The basic principle of the peg, a currency board exchange rate link, is really quite simple. It says that you pick an exchange rate to the US dollar, HK$7.80 in our case, and any time that someone wants Hong Kong dollars at that rate, you take his US dollars, stick them into the safe and print the equivalent of HK dollars for him, straight out of thin air.
When he then wants his US dollars again, you give them back to him for his HK dollars at that same HK$7.80 rate and you burn up those HK dollars. Remember the key element here - you print them out of thin air when people want them and you burn them back into thin air when people don't want them any longer.
In other words, when everyone wants HK dollars there are soon so many of them floating about that interest rates and yields fall much lower than in US dollars and then people will start to go back to US dollars again.
Similarly, when few people want HK dollars the interest rate on them will be bid up far above US dollar levels and then people will come back to the HK dollar. It's a beautiful self-adjusting mechanism.
Or rather, it was. But what happens when you have fog-brained academics in charge of monetary affairs in the US and they reduce interest rates to zero for seven years? No one thought of that in 1983 and it sticks a wrench into the workings of this mechanism. There are no longer interest rate attractions to one side or the other this way.
And what further happens when you have a very big sovereign neighbour with a supposedly closed capital account that actually springs more leaks than a wide-mesh sieve and suddenly everyone there wants out of yuan and into HK dollars for reasons that have nothing to do with the returns on either.
You then get what you see in the first chart - an exchange rate that now butts right up against the HKMA's HK$7.75 must-intervene level and that, as the second chart shows, has been kept there only by HK$366 billion of accumulated intervention.
It is not quite how the original architects of the peg expected things to work out and, while the HKMA still has plenty of thin air, it's not a happy state of affairs.
