In December 2024, anticipating Trump’s takeover of the US presidency, Lan Kwai Fong Group’s chairman Allan Zeman called on the Hong Kong government to reform its Hong Kong exchange rate system. Being shackled to an inflationary US dollar was going to put extreme pressure on the HK dollar, he argued.

Under Hong Kong’s linked exchange rate system, the HKD is pegged within a narrow band of 7.75 Hong Kong dollars and 7.85 Hong Kong dollars to 1 US dollar, with all HKD-based currencies backed by 100% foreign exchange reserves. As the US dollar strengthens, Hong Kong‘s monetary policy must follow suit, keeping its interest rates elevated and the HKD strong.

Yet a strong currency will not help an economy on the rocks. From January to November 2024, Hong Kong’s CPI was as low as 1.4%, falling from its 2022 and 2023 levels of 1.9% and 1.7%, respectively. Since prices are already low, it is of no surprise that voices in the market are calling for the Hong Kong government to reform or quit the linked exchange rate system holding it back.

Today, Hong Kong’s economy is deeply integrated with that of mainland China making it more susceptible to the economic dynamics of mainland China’s economy than to that of the U.S. As such, Hong Kong’s economic cycle is more consistent with that of mainland China. Therefore, low prices in Hong Kong are connected to low prices in mainland China.

However, as the Hong Kong dollar appreciates along with the US dollar, it will strengthen against the RMB, exacerbating the problem of low prices and weak growth.

Despite these challenges, on January 9, 2025, Yu Weiwen, Chief Executive of the Hong Kong Monetary Authority, wrote an article stressing that “we have no intention and no need to change the linked exchange rate system,” fulling backing the government’s continued use of it.

The “Impossible Trinity”

A fixed exchange rate system eliminates exchange rate risks, promoting stability in trade and cross-border capital flows. But this comes with a loss of autonomy over monetary policy, taking away a government’s capacity to even out a fluctuating economy and put public funds where they are most needed.
The dilemma is encapsulated by the “impossible trinity” – the concept that an economy can only maintain two of the following three conditions: autonomous monetary policy, fixed exchange rate and free capital flow. Governments must choose between them, inevitably sacrificing one.

Some economies, like that of mainland China, choose autonomous monetary policy and fixed exchange rate (including similar fixed exchange rate systems), and implement capital control.

In contrast, Hong Kong has chosen to maintain fixed exchange rate and free capital flow, and abandon autonomous monetary policy.

If Hong Kong and the United States have the same economic cycle, then the fixed exchange rate policy is just right, but if Hong Kong’s economic cycle is different from that of the United States, then this means that Hong Kong’s monetary policy cannot make corresponding changes to the economic status of Hong Kong.

Yet, because Hong Kong’s economy is much smaller than that of the United States, the current policy forces it to passively implement the same monetary policy as a large economy.

For Hong Kong, when its economy is sluggish and the Federal Reserve maintains a tight monetary policy, Hong Kong can do little but watch as its citizens spend across the border in mainland China, and mainland residents stay away from costly Hong Kong, a doubly negative impact on the economy.

The “impossible triangle” shows how Hong Kong’s current choice seriously restricts its government’s ability to regulate economic development, so there is a view that the Hong Kong government should reconsider the reform of the linked exchange rate system.

Experience in the UK

History can however help inform a decision on whether Hong Kong should bin its linked exchange rate. Britain’s withdrawal from the European Exchange Rate Mechanism in 1992 is a useful example.

The UK joined the ERM in 1990, pegging the pound to the group’s anchor currency, the German mark, 1 to 2.95. However as the unification of Germany two years later led to the overheating of the German economy on the back of large-scale German fiscal support to its Eastern entity, the mark strengthened.

The UK economy was too weak to support the higher interest rates required to maintain the peg. From 1090 to 1992, the UK economy saw negative growth, high unemployment and a fall in CPI growth.

Speculators, led by George Soros, quickly identified that the pound was overvalued, anticipating that the British government would eventually be unable to defend it, launching powerful short-selling attacks.

The British government spent more than 6 billion pounds shoring up the exchange rate, before it caved in, withdrawing hastily on September 16, 1992. Dubbed “Black Wednesday”, the pound fell sharply.

Soros became the “man who defeated the Bank of England.” According to the British Treasury’s estimate in 2005, the UK paid a price of 3.3 billion pounds in this exchange rate defense war.

The UK may have lost against speculators, but it regained fiscal autonomy. The government soon began to cut interest rates sharply. Looser monetary policy meant the British economy soon ushered in a recovery, employment levels improved, and inflation was kept in check.

Implications for Mainland China

Hong Kong’s linked exchange rate system, initially established in 1993 as an emergency arrangement to ensure stability, has now been in place for over four decades. While the linked exchange rate system has seen Hong Kong through multiple economic shocks over the years, including the Asian financial crisis, it has often come at significant cost to the broader economy.

Hong Kong’s current system is beneficial to those in the import and export industry and the financial industry, but not to most ordinary citizens.

Mainland China has plumped for an independent monetary policy, which means it has said no to free flow of capital and implemented capital controls.

However, there are three problems with capital control:

• First, China has one-way control only, and welcomes inflows but not outflows;
• Second, over time, the efficiency of capital control diminishes;
• Third, capital control distorts fiscal policy, limiting national welfare.

Considering the various problems of capital control, it is hard for China to maintain its independent monetary policy, and it is clearly affected by other monetary policies, especially that of the United States.

At present, China’s economy faces sluggish growth and deflationary pressure, while the US economy is overheated, prone to inflation. The interest rate gap between the two is very large.

Both Hong Kong and mainland China can learn from what the British did in 1992 and take a small loss for a big reward. Only in this way can the Chinese economy develop in a better and more sustainable way.