Abstract

Hong Kong (HK) adopted the Linked Exchange Rate system in 1983 and it has been operating successfully for more than three decades. However, the maintenance costs of the system have become huge and they might outpace the exit costs, especially under the combined influence of a slow-down of the Chinese economy and an interest rate hike in the U.S. Compared with the Asian Financial Crisis in 1997, the HK government owns much larger foreign reserves at present than it did then. The HK government is also facing a much more severe populist political environment and the anger of low income residents towards wealth inequality. The anger of low income residents could be “the last straw that breaks the camel’s back” in terms of the HK government maintaining the Currency Board System. At present the cost of exiting the Linked Exchange Rate system is small thanks to capital inflows from Mainland China. However, the time horizon for the existence of such a good exit opportunity is short. There are two ways in which investors can speculate on an exit from the Currency Board System but political reasons weigh the most heavily. If investors speculate on a de-pegging strategy at present and bet on a strengthening HKD, their actions are “politically correct” and they might receive less hostility or even acquiescence from the HK government. Consequently, investors have a much greater chance of success compared to adopting a “double down” strategy to capitalize on the HKD depreciating when the Chinese economy experiences a hard landing.

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