Explainer: Dollar peg is critical to Hong Kong amid U.S. threats, China worries

By Noah Sin

HONG KONG (Reuters) - China's plans to impose a national security law on Hong Kong and moves by the United States to begin withdrawing privileges enjoyed by the city under U.S. law have unsettled investors. They have also raised fears about the stability of the Hong Kong dollar's <HKD=D3> (HKD) 36-year old peg to its U.S. counterpart, prompting local officials to issue several reassurances.

HOW THE PEG WORKS

The HKD is pegged in a narrow range of 7.75-7.85 to the U.S. dollar. The Hong Kong Monetary Authority (HKMA) buys and sells the currency at either limit to maintain the range. Buying HKD boosts it by reducing its availability and raises the costs of betting against the currency. Sales do the opposite.

To maintain the peg, official Hong Kong interest rates track U.S. monetary policy. The currency's movement within its trading band is influenced by differences between market interest rates in both. Hong Kong interbank rates <HIBOR=> are higher than their U.S. equivalents <LIBOR=>, helping keep the HKD strong in spite of concerns about outflows related to the national security law.

For a graphic on HKD peg HIBOR:

https://fingfx.thomsonreuters.com/gfx/mkt/bdwvkdkdepm/HKD%20peg%20HIBOR.jpg

For a graphic on HiLi spread HKD monthly change:

https://fingfx.thomsonreuters.com/gfx/mkt/qzjpqjnjyvx/HiLi%20HKD.jpg

HOW VULNERABLE IS THE PEG?

There are fears that escalating U.S.-China tensions could result in the United States potentially limiting Hong Kong banks' access to U.S. dollars, thus putting an end to the peg.

Eddie Yue, chief executive of the HKMA, said on Tuesday the peg predates by nine years the 1992 U.S. Act which grants Hong Kong special status - whose provisions Washington is currently reconsidering.

"For the past 36 years, the (peg) has withstood the test of various market shocks and has been operating smoothly," Yue wrote in a blog post on June 2. "It is a pillar of Hong Kong's monetary and financial systems and will not be changed because of any shift in foreign policies towards Hong Kong."

Hong Kong also has $440 billion in reserves - six times the currency in circulation. The HKMA can also call on China's central bank for U.S. dollars, the city's top finance official said this week.

WHY THE HKD MATTERS

Hong Kong's economy has shrunk in its importance relative to the mainland since the territory's 1997 handover to China but its financial significance has grown. Any real threat to the peg risks undermining that.

With China maintaining tight capital controls, Hong Kong acts as a key financing conduit, hosting one of the largest stock markets in the world and acting as the biggest gateway for international investment in mainland stocks and bonds. It has also become one of the world's biggest currency trading centres and ranks third globally for U.S. dollar trading.

China's wealthy have put faith in the city too, with more than half of Hong Kong's estimated private wealth of more than $1 trillion coming from mainland individuals.

For a graphic on HK reserves:

https://fingfx.thomsonreuters.com/gfx/mkt/nmopakwkypa/HK%20reserves.jpg

(Editing by Jennifer Hughes and Jacqueline Wong)