Index > Briefing
Tuesday, April 27, 2021
Hong Kong's Monetary System under Geopolitical Competition

In the past two years, Hong Kong's economic and social development has been hit hard by internal and external shocks such as social unrest and the COVID-19 pandemic. With the implementation of the National Security Law and the widespread vaccination, a new turning point is emerging. On the one hand, the pandemic is gradually brought under control, and Hong Kong now begins in attempting to reopen its borders. On the other hand, after the passage of the National Security Law, the situation of the political unrest has been greatly improved and social stability has been enhanced. However, as far as Hong Kong's economy is concerned, under the increasingly fierce geopolitical competition between the U.S. and China, it is no longer possible for Hong Kong's economy to simply "restart" in the post-pandemic era as it did after the end of the SARS outbreak. In the context of this geopolitical pattern, Hong Kong is bound to further integrate into the development of Mainland China, while drifting further away from the Western countries like the United States. There is also the possibility that the Western markets will marginalize Hong Kong in the future. Under this trend, strategic consideration and a new layout are needed to position Hong Kong's development space and direction.

Maintaining its status as an international financial center, which has been the foundation of Hong Kong's past prosperity, remains a major challenge for the city. Hong Kong's linked exchange rate system, the status of the Hong Kong dollar, and the Hong Kong financial market are all likely to change. It is fair to say that under the new geopolitical situation, Hong Kong's financial and monetary systems have once again come to a crossroads.

Historically, the linked exchange rate system, which is the core of Hong Kong's financial system, is not immutable. Hong Kong's monetary and financial systems have certainly undergone many changes in the past. Some Hong Kong scholars pointed out that in the beginning Chinese cash coins were used to circulated in Hong Kong; the Hong Kong dollar was backed by silver and used alternately with the silver dollar. In addition, the Hong Kong dollar is freely convertible into foreign currencies such as the British pound sterling. In 1935, the Chinese currency abandoned the silver standard, while Hong Kong established the Exchange Fund and shifted its reserves from silver to pounds sterling. The Hong Kong dollar was pegged to the pound sterling to implement the linked exchange rate system and began to be formally pegged to international currencies. After World War II, under the Bretton Woods system, the exchange rate system of the Hong Kong dollar began to be linked to the U.S. dollar under the gold standard. It was not until the 1980s, under the background of negotiations between China and the UK, that the current U.S. dollar-based linked exchange rate system was formed in order to stabilize the market.

It can be seen that in addition to geographical advantages, the linked exchange rate system that pegged Hong Kong dollar with major international currency is indispensable for Hong Kong to become an international financial hub. Unlike in the past, the influence of RMB on Hong Kong is becoming stronger as Hong Kong becomes increasingly integrated into the development of the Guangdong-Hong Kong-Macao Greater Bay Area and has closer economic and trade ties with mainland China. At present, the establishment of Shanghai-Shenzhen-Hong Kong Stock Connect, Bond Connect, and Wealth Management Connect has not only made Hong Kong the main channel for overseas funds to enter the Mainland's capital market, but also as an "outlet" for Mainland's funds to flow overseas. This means the Hong Kong market is exposed to the influence of the two major geo-currencies, i.e., the U.S. dollar and the RMB. This is something that has not occurred in the past, and it is also the main problem plaguing Hong Kong's current financial situation.

According to two Hong Kong scholars, Dr. Victor Zheng and Roger Luk Koon-hoo, the free-floating of the RMB exchange rate after the reform and the internationalization of the RMB have brought both gains and losses to Hong Kong. On the one hand, Hong Kong's RMB offshore market has become the largest overseas RMB trading market, dominating the overseas RMB pricing and bringing incremental space to the Hong Kong market. On the other hand, the former "iron triangle" of the exchange rates of U.S. dollar, RMB, and Hong Kong dollar is disintegrating. The exchange rate of Hong Kong dollar against the RMB becomes floating, while the exchange rate of Hong Kong dollar against the U.S. dollar remains fixed, leaving the Hong Kong dollar exposed to the influence of two major currencies and no longer stable. It is for this reason that Hong Kong's linked exchange rate system currently adopts an unchanging stance in response to such changes.

However, this may be a measure in case the RMB is not freely convertible. As the internationalization of the RMB continues to advance, the Hong Kong dollar will continue to face choices in the long run. This is especially true when there is the absence of any improvement in the financial "decoupling" between China and the U.S., if the U.S. takes aggressive sanctions to exclude Hong Kong dollar from the U.S. dollar system, the space of Hong Kong's current linked exchange rate system with the U.S. dollar will be further narrowed.

Both Victor Zheng and Roger Luk Koon-hoo, pointed out that Hong Kong is now facing the dilemma of geo-currency competition. They believe that the Hong Kong dollar, which was derived from Chinese cash coins, will eventually revert to the RMB. When the RMB is freely convertible, it makes sense for the Hong Kong dollar to be pegged to the RMB. However, they also pointed out that the process of achieving free convertibility of RMB would take time, and are worried about the impact and instability on Hong Kong during the transition. This issue is probably a concern and perplexity among many financial professionals and government departments in Hong Kong. In fact, as the U.S. dollar likely to remain the dominant international trading and settlement currency for a long time to come, and even if the RMB becomes freely convertible, the pegging of the Hong Kong dollar to the RMB may not solve Hong Kong's problems, but rather will further diminish its role in financial markets. As a matter of fact, the need for the existence of the Hong Kong dollar was questioned at the time of the handover of Hong Kong back to the Mainland, but it the suggestion to ditch the Hong Kong dollar was not accepted by the central government that time. The central government still wanted to maintain Hong Kong's unique status, and believed that this unique status had its own significance and necessity.

However, this does not mean that Hong Kong's linked exchange rate system should remain as it is. The pegging of the Hong Kong dollar to a freely convertible international major currency that makes Hong Kong a free port and financial center does not mean that maintaining a fixed exchange rate with the U.S. dollar is the only way to go. Small economies in the world, such as Switzerland and Singapore, did not adopt the fixed exchange rate system, but they have taken their place in the international financial markets with their own merits. The Monetary Authority of Singapore has operated a managed float regime for the Singapore dollar since 1981. The Singapore dollar is managed against a basket of currencies of its major trading partners and competitors and maintains a somewhat flexible exchange rate regime. The weights of the currencies in the basket are determined according to Singapore's trade dependence on the country, and the composition of the basket is revised periodically as Singapore's trade situation changes. This mechanism of pegging the Singapore dollar to a basket of currencies with limited floating has not affected Singapore's status as a regional trade and financial center. Therefore, a mechanism that allows the Hong Kong dollar to maintain its free convertibility to major currencies with a certain degree of flexibility can be regarded as a solution to the future reform of Hong Kong's linked exchange rate system.

Over the past two decades since the handover of Hong Kong, the role of Hong Kong in Mainland China's opening up to the outside world has been in decline. However, in the context of future geopolitical competition and China's further opening-up, Hong Kong will continue playing an important role in connecting Mainland China with the outside world. Even if the Western countries actively marginalize Hong Kong, under the "Belt and Road Initiative" and the "dual circulation" pattern, Hong Kong still plays the role of a connecting hub between Mainland China and the outside world. Relying on the geo-monetary advantage of RMB, Hong Kong can make use of the Hong Kong dollar and its own monetary policies as policy adjustment tools to create a new market space.

Final analysis conclusion:

In the post-pandemic era, Hong Kong is facing the impact of the competition between two geo-currencies, i.e., the U.S. dollar and the RMB. It is then necessary for Hong Kong to establish a relatively independent monetary mechanism and monetary policy system so as to play its role as a hub of exchanges between Mainland China and overseas, and consolidate its position as an international financial center.

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