The Hong Kong dollar is tied closely to the US dollar. Monetary policy made in Washington therefore applies directly in Wan Chai and Kowloon. In recent months, the Hong Kong Monetary Authority has been obliged to shrink its balance sheet rapidly to maintain the fixed exchange rate. This serves as a real-life policy experiment of the effects of quantitative tightening in a financial system. So far, nothing has blown up, but Hong Kong equities have been under pressure as financial conditions have tightened.
The Hong Kong dollar has been pegged to the US dollar since 17 October 1983. Under the so-called Linked Exchange Rate System, the Hong Kong Monetary Authority (HKMA) has a standing commitment to buy US dollars when the Hong Kong dollar weakens excessively and sell US dollars when the Hong Kong dollar strengthens excessively.
But what does 'excessively' mean? Today, the system operates with a 'convertibility zone' from 7.75 to 7.85 Hong Kong dollars per US dollar. Inside that range, the authorities allow market forces to determine the exchange range. At the boundaries of that range, the HKMA has an explicit commitment to intervene known as the 'convertibility undertaking'.
The Hong Kong Monetary Authority has a standing commitment to buy US dollars when the Hong Kong dollar weakens excessively and sell US dollars when the Hong Kong dollar strengthens excessively
In recent months, the Hong Kong dollar has been bumping up against the weak end of the range. The HKMA has therefore been obliged to sells some of its ample US dollar reserves, and they have been obliged to do so aggressively to maintain the value of the exchange rate.
In return for selling US dollar assets, they receive Hong Kong dollars. In so doing, they automatically reduce the stock of Hong Kong dollars held by the private financial sector. In other words, they have tightened liquidity conditions through a very aggressive programme of quantitative tightening (QT).
This is what makes Hong Kong so interesting to monitor for global investors. Markets are fretting about the fallout from the gradual reduction in the US Federal Reserve’s balance sheet and the associated destruction in interbank liquidity. However the contrast is with Hong Kong is telling…
The type of quantitative tightening seen in Hong Kong is unequivocally more rapid, aggressive and interventionist than that which has been seen in the US.
If you're worried about the impact of US quantitative tightening on US dollar assets, you should be terrified about the impact of Hong Kong quantitative tightening on Hong Kong dollar assets
So what has been the impact so far? As shown in the charts below, the system is creaking but not collapsing. The drop in interbank liquidity (panel 1) has had a clear impact on Hong Kong dollar interest rates (panel 2) but done little to the exchange rate (panel 3). Equities have been on the back foot (panel 4), although the latest salvoes in the US-China trade wars are a significant contributory factor.
US QT could undoubtedly have broader ramifications. As the global reserve currency, the US dollar is the cornerstone of global capital markets. However, quantitative tightening is a step into the unknown so we are well advised to look for any global pointers as to its impact. In the Hong Kong policy petri dish, there has been remarkably little monetary mayhem thus far.
Having said that, we believe Hang Seng stock market weakness will continue and interest rate differentials between the US and Hong Kong will contract further.
Given our longer-term views around the structural challenges facing the global economy, we struggle to see how inflation can rise meaningfully for any prolonged period of time. That said, while cyclical improvement does not override secular forces, a period of synchronised global growth is challenging the consensus narrative that inflation ‘volatility’ is dead.