The US wants to retaliate against China for its recent moves to impose new security laws in Hong Kong. These laws seek to reduce the autonomy of the city.
One of the options that the US is considering is undermining the peg between US Dollars and the Hong Kong (HK) Dollar.
Hong Kong had pegged its currency to the US Dollar in 1983 at a rate of HK$7.8 = US$1. Though it has been allowed to fluctuate between a narrow range of 7.75 and 7.85 per US dollar since 2005.
Let’s take a detour to understand why these new security laws matter and why the Government of Hong Kong had pegged its currency to the US Dollars in the first place.
So, for the uninitiated, Hong Kong Island was acquired by the British empire in the year 1842 after winning the first Opium War against the Qing Dynasty of China. After winning the second Opium War in 1860, the British took over the control of the Kowloon Peninsula as well. Further, in the year 1898, Britain obtained a 99-year lease of the New Territories. Hong Kong Island, Kowloon Peninsula, New Territories are the three main regions of Hong Kong city.
Hence, Hong Kong city remained a British colony until the expiration of the 99-year lease in 1997.
Britain agreed to transfer Hong Kong to China in the year 1997 only after it agreed to protect its systems, freedoms, and way of life for at least 50 years. It meant that Hong Kong was handed over to China under the ‘one country, two systems’ principle.
But this agreement was reached after years of negotiations. During the course of these negotiations, there was a lot of uncertainty about the future of Hong Kong. Due to dwindling consumer confidence, on 24 September 1983, the Hong Kong dollar was devalued by 15% over 2 days to a historical low at HK$9.6 to US$1. Therefore, in order to stabilise the exchange rate in the city, the Government of Hong Kong had decided to peg its currency to US Dollars. We’ll discuss later how pegging works.
Coming back to the handover, Hong Kong is now a special administrative region (SAR) of China like Macau (former Portuguese colony). In theory, it retains a high degree of autonomy. It has its own constitution called the ‘basic law’ under the “one country, two systems” principle. It has its own political system, an independent judiciary, and a capitalist economy. It also has certain democratic rights like freedom of assembly and speech, unlike mainland China.
But, recently China has passed legislation that threatens the judicial independence of Hong Kong. China imposed new security laws. The law criminalises any act of secession, subversion, terrorism, and collusion with foreign or external forces. As per the critics, it curtails protest and freedom of speech. China says it will return stability. The critics are also skeptical about the unfair and opaque judiciary system in mainland China
These security laws were fast-tracked in the aftermath of months of pro-democracy protests in HK.
We know that the US is already engaged in a trade war with China since 2018. China’s inept handling of the coronavirus pandemic and its recent legislation to impose new security laws in Hong Kong further worsened the situation. The US wants to undermine the peg between the Hong Kong Dollar and US dollars.
[You may also read: What is the trade war between US and China?- Explained]
As mentioned, Hong Kong had linked/ pegged its currency to the US Dollar in 1983. It means that the Hong Kong Monetary Authority (HKMA) will allow the HK Dollars to fluctuate between a narrow band (of 7.75 to 7.85) to the US Dollars. [HKMA is the de-facto central banking authority of HK]
Therefore, HKMA buys and sells Hong Kong Dollars to maintain the exchange rate of HK Dollars between the limit. Let’s suppose the rate of HK Dollars falls to 7.75. The HKMA will buy HK Dollars (and sell US Dollars) to boost its demand so that its price increases. If the rate increases to 7.85, the HKMA will sell HK Dollars.
To maintain the peg, the Hong Kong also has to link its interest rates to the US and give up its monetary policy independence.
This peg has been backed by a whopping $440 billion in foreign exchange reserves with the HKMA.
The US can undermine the peg by restricting the ability of HK to access/ buy US dollars.
Also, the 1992 U.S. Act grants special status to Hong Kong. If the US reconsiders the Act, it could trigger massive capital outflows putting pressure on the HK currency. This was what happened to Thailand’s currency Baht in 1997.
[You may also read: The 1997 Asian Financial Crisis Explained]
But, Hong Kong has massive foreign exchange reserves and it can also ask China for US Dollars in case of any pressures on the currency.
The Hong Kong Dollar peg is significant to China and to the world economy.
Hong Kong has become a financial hub and its importance has increased since the 1990s due to the peg. It has one of the world’s largest stock exchanges and it is the world’s third-largest hub for trading in US Dollars.
Further, China has investment/ capital inflows restrictions in the mainland which are not applicable to HK. Therefore, mainland China comprises 73% of the city’s stock market value , and most of China’s top firms are listed there. Most of the international investments in Chinese bonds etc are routed through HK.
Also, the US derivate regulators provide similar treatment to HK firms like their American counterparts. The US can never even think of giving such privileges to Chinese firms. Therefore, Hong Kong serves as a conduit between China and the rest of the world
Though it is still unlikely that the Hong Kong Dollar peg will be impaired, the US considering such an option gave us an opportunity to explore the reasons behind the peg and the implications of the move.
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