In December, the US Congressional-Executive Commission on China issued its annual report, accusing Hong Kong of eroding freedoms and aiding Russia in its war against Ukraine. These allegations sparked speculation about potential United States sanctions, including disconnecting Hong Kong from the SWIFT worldwide banking system, which could trigger a depegging of the Hong Kong dollar (HKD) from the US dollar (USD). However, such extreme measures are unlikely, as they would require support from the European Union and other allies and could destabilize the global financial system. In fact, depegging the HKD from the USD would more likely be triggered by a significant dwindling of reserves in Hong Kong rather than a drastic US policy shift.
To mitigate the risk of depegging, Hong Kong must develop a proactive strategy to minimize the financial risk by stimulating its economy, boosting foreign direct investments, and securing healthy reserves.
The post-pandemic economic recovery in Hong Kong has been slower than expected. As of the third quarter of 2024, its economy grew by 1.8 percent year-on-year, down from the 3.2 percent growth observed in the previous quarter. Several factors have contributed to this decline, including the political demonstrations in 2019, quarantine measures during the COVID-19 pandemic, and the relocation since 2020 of some foreign firms’ Asian headquarters to other cities in the region.
Due to reduced tax revenues and increased expenditure on various infrastructure projects, such as the Northern Metropolis megaproject, Hong Kong has experienced consecutive fiscal deficits in the post-pandemic era. The deficit hit HK$139.8 billion ($18 billion) in the 2022-23 fiscal year, HK$101.6 billion in the 2023-24 fiscal year, and is projected to reach HK$100 billion for the 2024-25 fiscal year.
These consecutive fiscal deficits have caused Hong Kong’s foreign currency reserves to fall from $499.4 in November 2021 to $425.1 billion in November 2024.
Hong Kong needs to maintain its reserves above a certain critical level because, to sustain the peg, every Hong Kong dollar issued must be backed by an equivalent US dollar in reserve. The peg, introduced in October 1983 at a rate of HK$7.80 to $1, was a measure to stabilize the currency, restore investor confidence, and ensure financial stability as Hong Kong prepared for its 1997 handover.
The peg to the USD has several advantages for Hong Kong. In addition to affording a stable and predictable exchange rate, the peg ensures Hong Kong’s integration into the global financial system, as the USD is the world’s primary reserve currency. This integration facilitates easier access to global capital markets and reinforces Hong Kong’s position as an international financial hub.
Depegging the HKD from the USD could lead to unpredictable market volatility and a loss of investor confidence, similar to Argentina’s experiences in 2002 after it depegged its peso from the USD. The predictability of the exchange rate has been a cornerstone of Hong Kong’s financial stability for over 40 years, and abandoning the peg could undermine this stability.
Without the peg, the HKD could experience significant fluctuations, leading to uncertainty in trade and investment. Also, Hong Kong’s monetary policy is susceptible to decisions by the US Federal Reserve. Depegging would require the Hong Kong Monetary Authority to develop an independent monetary policy, which could be challenging given the city’s small and open economy.
Regardless of whether to continue to peg with the USD, Hong Kong needs to develop a proactive strategy to maintain healthy reserves. In doing so, the city can have the flexibility to continue its peg with the USD or switch to other currencies in the future
Some have suggested pegging the HKD to the Chinese yuan (CNY) to enhance economic integration with the Chinese mainland. While this could facilitate smoother trade and investment flows between Hong Kong and the mainland, it also introduces new risks. The CNY is not fully convertible and is subject to capital controls, which could limit Hong Kong’s financial flexibility and attractiveness as an international financial center. Despite its size, the mainland economy is still developing and can be more volatile than the US’. Additionally, pegging to the CNY could introduce new uncertainties and affect investor confidence.
Instead of speculating on potential US actions, it is crucial for the Hong Kong Special Administrative Region government to focus on improving its fiscal health. Maintaining strong reserves is essential for defending the currency peg and ensuring economic stability. The government should consider measures to increase revenue and reduce expenditure.
Recognizing that Singapore’s top marginal tax rate of 24 percent is higher than Hong Kong’s top rate of 17 percent for high-income individuals, there is room for the HKSAR government to increase the marginal tax rate. Also, Singapore charges a standard goods and services tax rate of 9 percent. Therefore, a case could be made for Hong Kong to establish a sales or capital gains tax during an economic downturn.
Moreover, the SAR government should reevaluate and prioritize capital projects to reduce expenditure. Examples include delaying noncritical infrastructure projects and optimizing public services to improve efficiency. For instance, the government hosted 110 mega events in the first half of 2024 and attracted 550,000 visitors, which is dwarfed by the approximately 3.5 million regular visitors per month over the same period. By considering the returns on investments, Hong Kong can afford to scale back nearly 100 mega-events planned for 2025 to reduce unnecessary expenditure.
Issuing bonds is another mechanism for raising funds. Still, the latest offering of HK$20 billion-worth of infrastructure bonds was undersubscribed in early December, signaling that the returns on these bonds are considered underwhelming. It indicates that the government needs to offer bonds with higher yields, though this would increase the cost of borrowing.
Regardless of whether to continue to peg with the USD, Hong Kong needs to develop a proactive strategy to maintain healthy reserves. In doing so, the city can have the flexibility to continue its peg with the USD or switch to other currencies in the future.
The author is a distinguished professor at the UCLA Anderson School of Management.
The views do not necessarily reflect those of China Daily.
