Think about this if you own Hong Kong dollars

On January 20, 1841, after delivering a series of military defeats to Imperial China in the First Opium War, British forces landed in Hong Kong and took control of the island.

Hong Kong was hugely important for the British economy because it ensured access to the Chinese market. And they went to war multiple times to keep control of the island.

In 1898 the two empires signed a lasting peace treaty whereby Britain agreed to turn the island over to China in 1997. And Hong Kong prospered for decades under British rule.

But by early 1980s, Hong Kong started experiencing more turbulent times.

International businesses, bankers, and traders were becoming concerned about the Chinese handover that would take place 15 years later.

And when China’s Deng Xiaoping expressed his desire to hit the gas pedal on Hong Kong’s return to China, investors panicked.

Between September 1982 and September 1983, the Hong Kong dollar lost 25% of its value against the US dollar.

Within a week, by early October, it had lost another 15% of its value. And it continued losing ground by the day.

The currency was in free-fall. So in mid-October 1983, the Hong Kong government stabilized the currency by fixing the exchange rate to the US dollar.

It has remained that way for the past 36 years.

This ‘pegged’ exchange rate provided a lot of benefit to Hong Kong back then, helping cement its status as an international financial center.

And I’ve been writing about this for years: the pegged exchange rate means that the Hong Kong dollar has all the benefits of the US dollar, without any of the baggage.

The US dollar has international recognition and stability. Hong Kong’s currency is pegged to the US dollar, so it shares those benefits too.

But while the United States is drowning in debt with $50+ trillion in unfunded pension liabilities, Hong Kong has massive financial reserves, positive cash flow, and a healthy current account surplus.

For the past months we’ve watched Hong Kong’s most dramatic political turmoil in decades.

Millions of people have protested, and it’s becoming a full-blown revolution.

Just this morning the Chinese government asserted its right to declare a state of emergency– pretext for sending armed troops into Hong Kong to quell rebellion.

Does this mean Hong Kong’s pegged exchange rate is finished?

Throughout financial history there are a examples of central banks that tried, and failed, to maintain a pegged exchange rate.

The most notorious example is the UK in the 1990s, which had pegged the British pound to the German Deutsche Mark at minimum level of 2.773.

The market did not believe that Britain could maintain the peg. And they were right.

In 1992, a group of speculators (including George Soros) bet so heavily against the British pound that the central bank spent all of its cash reserves defending the exchange rate.

With an insolvent central bank, the British government finally capitulated and devalued the pound.

In the case of Hong Kong today, though, that scenario is highly unlikely.

Hong Kong’s Monetary Authority (HKMA) has an absurd amount of firepower to maintain the exchange rate indefinitely.

HKMA is, by far, one of the most well-capitalized central banks in the world.  For every Hong Kong dollar in circulation, the HKMA has TWO dollars of foreign currency in reserve.

In other words, the HKMA could fend off speculators and defend the pegged exchange rate to the very last Hong Kong dollar… and STILL have hundreds of billions of dollars left over.

And HKMA will still have those cash reserves even in a nightmare scenario where Chinese tanks and millions of people are in the streets.

This is a political issue. A MAJOR political issue. But it’s not a financial one.

It’s also important to remember that Hong Kong’s pegged exchange rate has survived plenty of apocalyptic events before.

There was the Asian Financial Crisis in 1997, the dot-com crash in 2000, the Global Financial Crisis in 2008, plus plenty of other non-financial crises like swine flu, bird flu, and, of course, the handover to the Chinese.

The peg has always survived.

But here’s a VERY critical point: just because the HKMA is ABLE to maintain the peg, and just because they have done so for decades, doesn’t mean they will continue to do so.

At the end of the day, Hong Kong’s pegged exchange rate needs to make sense for Hong Kong. And for China.

It’s becoming more clear that this is no longer the case.

Back in the 1980s, the US was Hong Kong’s primary trading partner. Having a dollar peg was incredibly convenient.

It was also a convenience for mainland China, because the peg gave Chinese businesses (through their Hong Kong subsidiaries) easy access to foreign markets and US dollars.

Today those things are no longer necessary.

Hong Kong is now a first-world economy that no longer requires US economic support.

Hong Kong’s primary trading partner today is China, not the US. And China has so much economic power that its businesses don’t need US dollar convertibility through Hong Kong.

The biggest issue is that maintaining the peg requires Hong Kong to mirror US interest rate policy, essentially sacrificing part of its economic sovereignty.

That’s something that definitely doesn’t make sense, for Hong Kong, OR for China– especially with a trade war looming.

It’s worth noting that HKMA’s CEO, Norman Chan, a long-time defender of the currency peg, is retiring this month.

And it remains to be seen whether his successor will share the same enthusiasm to spend hundreds of billions of dollars maintaining a peg that might not make sense anymore.

Bottom line– Hong Kong will unlikely be ‘bullied’ by speculators into dropping its currency peg.

But it’s entirely possible they may choose to willingly do so… simply because the US dollar peg doesn’t make as much sense as it did in 1983.

So if you’re holding Hong Kong dollars, please do bear this possibility in mind.

About the Author

Simon Black is an international investor, entrepreneur, and founder of Sovereign Man. His free daily e-letter Notes from the Field is about using the experiences from his life and travels to help you achieve more freedom, make more money, keep more of it, and protect it all from bankrupt governments.