The Domino that Starts in Hong Kong: Currency Crisis Ahead

Dear Reader,

The cosy relationship we have had with China for the past few decades is over.

What it will look like going forward is uncertain.

I just know it will be different.

Yesterday saw the release of a new defence white paper and an increased 10-year budget of $270 billion.

The reason behind this?

The increasing aggression of China.

From The Australian:

The new assessment comes amid a warning from Defence Minister Linda Reynolds that China’s push for greater influence in the Indo-Pacific has “deeply unsettled the region”.

Senator Reynolds will declare in a speech on Thursday that China’s actions in the region have inflamed strategic tensions.

“We have supported China where that pursuit advances ­mutual interests in security, prosperity and stability,” she will say.

However, some of China’s ­actions have deeply unsettled the region. They have not positively contributed to Australia’s, or the region’s, security and stability.

“Australia is far from alone in being troubled by this.”

No, we’re not.

Just ask Hong Kong.

As new national security laws there came into effect, protesters again bravely took to the streets. 350 were arrested, 10 under the new laws.

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Hong Kong is a flashpoint

It represents the struggle between individual freedoms championed by the West, and the growing power of the Marxist/Leninist dictatorship of the East.

Hong Kong citizens will not easily give up their freedoms. As the Wall Street Journal reports:

One 78-year-old woman among the protesters said she fled to Hong Kong in the 1970s to escape Communist Party suppression during China’s Cultural Revolution and was dismayed by Beijing extending its reach into the city.

“What we see today is this national security-law, which is much worse than what Mao Zedong did to us,” she said. “We are not scared anymore at this age. We want to oppose the national-security law.”

This is going to be quite a battle.

From an economic perspective, the indicator to watch is the Hong Kong dollar’s peg to the US dollar.

It’s been in existence since 17 October, 1983. It was put in place during a crisis of confidence and has provided stability ever since.

According to the South China Morning Post:

Under the currency board system behind the peg, Hong Kong’s monetary base is fully backed by foreign reserves, while the local interest rates move in lockstep with those in the US. The Hong Kong Monetary Authority (HKMA), the city’s de facto central bank, uses HK$4.094 trillion (US$528.6 billion) to defend the peg and to make sure it trades within the range of HK$7.75 to HK$7.85.

With China moving to gain increasing control of Hong Kong, is this peg sustainable?

An inevitable currency crisis

That is a hugely important question for global financial markets.

If the peg breaks, it could wreak havoc on global asset prices. Hong Kong is one of the largest banking sectors in the world. Trillions of dollars worth of transactions pass through there every year.

The peg to the dollar underpins these transactions.

So if China’s authoritarian tentacles continue to envelope the island, it’s inevitable that capital will want to escape its reach.

The escape route is via the pegged exchange rate. That means, if the flow turns into a torrent, there is no way the Hong Kong Monetary Authority (Hong Kong’s central bank) will be able to defend the peg.

Currently though, such an outcome doesn’t look likely.

The Fed satisfied the huge demand for US dollars following the COVID-19 panic by providing swap lines with central banks around the world, including Hong Kong.

This means that it provides access to as many dollars as necessary, providing central banks post collateral in return.

However, the Fed doesn’t extend such advantages to the People’s Bank of China. There is no swap line for the communists.

Would the US dare pull this lever down the track?

It’s definitely a weapon they have at their disposal.

But it’s not going to happen in an election year.

The thing is, if the Hong Kong peg breaks, the yuan’s peg to the dollar is likely to break too.

This would send a hugely deflationary shock around the world, as the US dollar soars and the Hong Kong dollar and Chinese yuan plummet.

There is an argument that China’s move on Hong Kong is a way for it to gain access to the US dollar, via the Hong Kong banking system and the swap lines just mentioned.

I say that because the US dollar (or the lack of them) is the Achilles heel of the Chinese economy.

China, as you probably know, continues to generate a huge amount of yuan-denominated debt. As long as it can maintain a decent inflow of US dollars via a trade surplus, it can probably sustain this debt growth for some time.

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But if the world moves its supply chain away from China, then its famed trade surpluses will dry up. US dollar inflows will dry up too.

At that point, the US$40 or so trillion worth of yuan-denominated debt sloshing around the Chinese economy will look increasingly shaky in terms of its real value.

With China moving on Hong Kong and the West moving away from China, I see a breaking of the currency pegs, and a resulting currency crisis, as all but inevitable.

Regards,


Signature
Greg Canavan,
Editor, The Rum Rebellion


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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