Question

1. (a) Explain whether exchange rate risk of Hong Kong dollars is zero as it is pegged with the U.S. dollars.

2. (b) Explain how the U.S. government intervenes exchange rate indirectly to its boost economic growth.

Answer 1

a)

[The peg’s days are numbered and the idea of Zero currency Risk if the HKG is pegged to the US$ is misplaced].

Hong Kong has pegged its currency to the U.S. dollar for decades, helping make life more predictable for the city’s many trading houses and financial firms.

The trade-off is that this effectively forces Hong Kong to track U.S. interest rates even if, for example, tighter monetary policy might help cool local asset prices.

Since 2005, the Hong Kong dollar has been allowed to trade at between 7.75 and 7.85 to the U.S. dollar.

The Hong Kong Monetary Authority, the de facto central bank, buys U.S. dollars if the local currency is too strong, or sells them if it is too weak.

It has intervened dozens of times since April 2018, spending a combined US$16 billion to support the Hong Kong dollar, including some that took place in March.

As of December 18^th, the Hong Kong dollar traded at 7.79.

Interest Rates Help Even Things

Currencies respond to interest rates, as capital flows to where it can get the best returns. When the monetary authority sells U.S. dollars to buy the local currency, this drains Hong Kong dollars from the market.

That pushes up borrowing costs, which can in turn increase foreign appetite for Hong Kong dollars.

However, for the past year the Hong Kong dollar is weak even as local rates outstrip U.S. ones.

This points to persistent capital outflows.

Derivatives Prices Suggest Some Unease

The peg’s days are numbered and the idea of Zero currency Risk if the HKG is pegged to the US$ is overstated.

Derivative Data of One-year risk-reversals, a measure of the difference in price between bullish and bearish bets on the currency, have reached highs last seen in 2016.

A higher level indicates greater bearishness, and only makes sense if there is a chance the peg could break. Theoretically, Hong Kong could change the peg’s level, or anchor the currency against the Chinese yuan or a currency basket.

Liquidity in Part of the Banking System Is Running Low

The aggregate balance measures the funds parked by banks in clearing accounts at the monetary authority. As the HKMA has propped up the currency, draining Hong Kong dollars from the banking system, this measure has fallen to the lowest in more than a decade.

The rapidly shrinking aggregate balance indicates that Hong Kong sits atop one of the largest financial “time bombs” in history, and the peg could break.

Authorities Have Way More Reserves than they let on

More broadly, for every dollar of local currency, Hong Kong keeps more than twice as much in its forex reserves, which total more than US$400 billion. This calculation looks at all the cash in circulation in Hong Kong, plus the aggregate balance, and money parked in exchange-fund bills.

There’s no risk of insufficient foreign-exchange reserves to replace Hong Kong dollars if we need to Some aver, “Barring a complete collapse in confidence, I don’t think the currency peg will easily break.” This is not a distant possibility as political tensions rise in the South China Sea and China is forced to show a force of strength and crush democracy protestors in Hong Kong.

The question, instead, might be what level of collateral damage a stubborn defence of the peg could cause. As I recall, during the Asian financial crisis in 1998, Hong Kong fought off a speculative attack but the resulting spike in interest rates sent asset prices plunging. A growing reliance on floating-rate mortgages would make that more dangerous this time around.

It’s not a question of whether the peg will survive but a question of at what cost.

Summary

At the near end, it appears the Hong Kong Central Bank has sufficient reserves to maintain the peg. But it is very possible that the Hong Kong Central Bank may shift it peg to the Chinese Yuan as trade tensions between the US and China escalate.

The China Central Bank is accused of currency manipulation and the Yuan may not be a sufficient hedge for US$ denominated cash flow. If trading houses have most of their Balance Sheet derived from Chinese Yuan, it is possible that the currency of Honk Kong may become dual or even shift entirely to Yuan as Firms are forced to resort to Chinese metrics.

Risk managers who peg their metrics agains the Hong Kong$ will do well to review their weightages in the event of a crash.

B)

Unlike China that intervenes in the exchange rate directly the US intervenes indirectly. The US Government arms allow three levers to impact the US$ and in turn effect the demand of US Goods and Services. i.e. THE ECONOMY:

1. Exchange rates,
2. Treasury notes, and
3. Foreign exchange reserves

The Federal Reserves indirectly changes exchange rates when it raises or lowers the fed funds rate.

if it lowers the rate, that also drives down interest rates throughout the U.S. banking system and reduces the supply of money . If it raises rates it would make the dollar stronger relative to other currencies. That's because U.S. dollar-denominated credit has become more expensive. At the same time, dollar-denominated assets generate a higher return.

• The Federal Reserve sets interest rates, which determine what banks charge each other to borrow money, what the Fed charges banks to borrow money and what the consumer has to pay to borrow money.

The laws of demand and supply assures that less supply and more demand drives up the price of any commodity. True with any currency

The Treasury Department also indirectly affects the exchange rate. It prints more money.

This increases the supply and weakens the dollar. It can also borrow more money from other countries. That's done by selling Treasury notes. That not only increases the supply of money, it also increases the debt and both will send the dollar's value down.

The third government tool is expansionary fiscal policies. They weaken the dollar by increasing the money supply.

• More money flowing through the economy corresponds with lower interest rates, while less money available generates higher rates.
• Interest rates also reflect risk premium—how much risk both borrowers and lenders are willing

Combined, these policies can also improve US economic growth. That often makes investors demand more dollars as a haven. It's like a vote of confidence in the economy. Sometimes this demand is so high that investors overlook the low interest rate they are getting by investing in dollars or U.S. Treasurys.