The Hong Kong Dollar, the next black swan?

• Tradewars between the US and China picking up in the headlines. 
• Macro instability in Hong Kong is coming to the fore as a major risk for financial markets. 
• The debasement of the HKD peg would be a nuclear type of option for global financial markets.

Markets are on standby for what soon could become a blood-bath. On Friday, on the first day of its annual week-long session, the National People's Congress (NPC) unveiled a draft of legislation called "Decision on Establishing and Improving the Legal Systems and Implementation Mechanisms for Safeguarding National Security in the Hong Kong Special Administrative Region." This is a national-security law that will allow China to significantly tighten its grip on Hong Kong, a law which has drawn swift condemnation from US officials:

US Secretary of State Mike Pompeo has condemned the proposed national security law. Pompeo is warning that the passage of the legislation would be a "death knell" for Hong Kong's autonomy. The US stands "with the people of Hong Kong," Pompeo proclaimed. 

The United States strongly urges Beijing to reconsider its disastrous proposal, abide by its international obligations, and respect Hong Kong's high degree of autonomy, democratic institutions, and civil liberties, which are key to preserving its special status under US law,

The passage last year of the Hong Kong Human Rights and Democracy Act, which US President Donald Trump had no choice but to sign given overwhelming, bipartisan support for the bill, gives Pompeo more flexibility in what countermeasures he can take.

“I think President Trump is going to be at the end of his goodwill with Xi here,” said Stephen Bannon, a former top Trump strategist and  China’s Communist leadership hardliner. “It’s an outrage,” he said of Beijing’s proposed new security powers over Hong Kong.

Pushed for comment on Thursday on reports that the NPC’s announcement about the legislation was coming, he said: “I don't know what it is because nobody knows yet. If it happens we'll address that issue very strongly.”

An immediate response has come from Hong Kong's own Confederation of Trade Unions who has called from a general strike on Wednesday, 27th, a day before the law is due to be presented at the National People's Congress on the 28th. "Once the Hong Kong version of the National Security Law is implemented, it will inevitably threaten the freedoms and rights that Hong Kong people have always cherished," the Confederation of Trade Unions said on the matter. 

Meanwhile, the world has reacted with disbelief to China's action. This violates both the Joint Declaration and Hong Kong's Basic Law which is the region's mini-constitution, adopted by the NPC in 1990.

It is therefore not just HK protestors and non-conformant entities and the US, but also Britain, together with Canada and Australia, who have all issued various statements in unity, along the lines of, "we are deeply concerned by this undermining of Hong Kong's guaranteed high degree of autonomy." Such an alliance with the US will only give Washington more motivation to see through appropriate responses. 

Hong Kong dollar peg in jepordy? 

As for markets, an interesting yet concerning turn of events could come from all of this. It is something that has been brewing for months, dating back to last year's protests. We are talking about the Hong Kong dollar, its peg to the US dollar and Hong Kong's fragile existence as a whole. 

The South China Morning Post, last November, wrote:

• Sharp deterioration in city's economic health could force Hong Kong to sever peg to the US dollar, Chinese economist Yu Yongding has warned.
• The government has stressed its commitment to the linked exchange rate system, which is underpinned by massive forex reserves.

"If Hong Kong’s current account were to fall into deficit, and the government intervenes by using its foreign exchange reserves, then a crisis could occur due to a shortage of foreign reserves", the prominent Chinese economist and former central bank adviser Yu Yongding has warned.

However, in the same article, The South China Morning Post quoted Ding Shuang, chief Greater China economist for Standard Chartered Bank, who disagreed with Yu’s view, arguing that the chances of an end to the Hong Kong dollar peg were close to zero.

“Economically speaking, HKMA [Hong Kong Monetary Authority] has a strong base of foreign exchange reserves, which are larger than a lot of other country’s foreign exchange reserves,” he said.

Kyle Bass, a hedge fund manager who’s been shorting Hong Kong’s currency, said the former British colony faces a banking crisis in 2020, mirroring the struggles of Iceland and Ireland a decade ago.

“It takes about a year for a full-fledged banking crisis to hit, and you’ll see a full-fledged banking crisis in Hong Kong now,” Bass, founder of Hayman Capital, said.

The Hong Kong dollar is currently trading near 7.7545 per dollar, after rallying to a three-year high of 7.7487 per dollar last month, testing its trading band of 7.75 to 7.85 per US dollar, set in 2005, which has neven been fully broken. George Soros tried and failed to break its peg to the US currency during the Asian financial crisis in 1998 and Crispin Odey also tried to bet against the Hong Kong dollar. After more than two years of failing to do so, he gave up in mid-2018.

However, the currency is now at a precarious position with these protests reigniting and the prospects for the US dollar catching another bid. Structural issues in Hong Kong’s monetary system, an oversubscribed real estate industry, domestic recession, or a potential recession in China as global consumption dries up, collateral damage pertaining to the US and Chinese trade war, could all prompt the city to abandon the peg. 

The South China Morning Post quotes Diana Choyleva, chief economist at Enodo Economics who said, "If Washington was to suspend free trading of the US dollar with the Hong Kong dollar, it would cause the local currency to plunge, likely leading to a sharp outflow of funds from the city and denting its reputation as a financial hub."

This could get into a nuclear type of option for global financial markets – that is the significance of Hong Kong for global financial markets, –

said Choyleva.

If you want a 10-year forecast, this is the end of the beginning of the demise of Hong Kong as a global financial centre.