This is the second article in a three-part series looking at the outlook for Hong Kong’s dollar peg system under the city’s current political turmoil.

US legislation that paves the way for diplomatic action and sanctions again Hong Kong could potentially threaten the city’s exchange rate peg and long-term status as a financial centre, analysts said.

The Hong Kong Human Rights and Democracy Act, which was signed into law last month by US President Donald Trump, increases scrutiny of Hong Kong’s economic and political systems, and its passage comes during a time of unprecedented unrest in the city.

Among other mandates, it allows the US State Department to suspend Hong Kong’s special trading status based on whether the city retains a sufficient level of autonomy under the “one country, two systems” principle.

The United States has treated Hong Kong as a separate entity from mainland China since 1992, granting it special economic privileges, such as the free exchange of the US dollar with the Hong Kong dollar, and access to sensitive technologies. Exports from Hong Kong are also exempt from trade war tariffs that have been applied to the mainland by Washington.

Most analysts say there would need to be a massive intervention from China for the US to revoke Hong Kong's status, given the negative impact it would have on the city rather than the mainland. But many agree it now gives the Washington another source of leverage in its escalating competition with Beijing.

“The USA is building up its geopolitical arsenal in its cold war with China,” said David Chin, managing director at consultancy firm Basis Point. “Hong Kong is one of several elements in this cold war arsenal, so Hong Kong could be collateral damage in this regard.”

George Magnus, a research associate at Oxford University’s China Centre, and the author of Red Flags: Why Xi’s China Is in Jeopardy, said the US legislation was a “classic example” of how the trade war was threatening to spill over to finance and capital markets.

“Obviously [revoking Hong Kong’s special trade status] would be a serious escalation, especially to the extent that the peg’s anchoring of financial stability might then be called into question with alarming consequences for Hong Kong, China, and global markets,” Magnus said.

Hong Kong’s dollar has been “pegged” to the US dollar since October 17, 1983, meaning its value is tied directly to that of the US dollar. The peg was originally set at 7.8 per US dollar, although it has been allowed to trade in a range between 7.75 and 7.85 per US dollar since 2005.

If the Hong Kong dollar’s value hits either end of the trading range, the Hong Kong Monetary Authority (HKMA), the city’s de facto central bank, is obliged to buy or sell the local dollar to keep it within the band.

The stability of Hong Kong's exchange rate since the peg was introduced has helped earn the city its reputation as a global financial hub. However, that has been tested over the past six months as anti-government protests, sparked by a now-withdrawn extradition bill, have roiled the city.

Many of those protesting, who are now demanding wider democratic freedoms and an investigation of alleged police brutality, support the US legislation. The bill allows sanctions to be imposed against individuals responsible for alleged human rights abuses in the city, including freezing US assets and barring them from American visas.



So far, the HKMA has not had to worry about capital flight or defending the peg during the current political crisis, even though the city has slipped into recession, with the economy shrinking 3.2 per cent in the third quarter from the one previous.

The Hong Kong dollar has proved remarkably resilient, not once reaching the weak end of its trading band since protests began in June. The HKMA has said there have been no signs of massive capital outflows from the city's banking system and the Hong Kong dollar exchange rate has remained stable.

However, the risk of violent clashes escalating between police and radical protesters remains, raising the potential for a significant deterioration in the business environment and the possible introduction of changes to Hong Kong’s legal and political systems by Beijing.

“All bets are off if the situation in Hong Kong changes dramatically in a negative way from the US perspective,” said Julian Ku, a professor of law at Hofstra University in New York.



Even without the State Department’s annual review, the US president could, by executive order, revoke Hong Kong’s special trading status, Ku said.

“The US president has broad powers over international economic activities so he could at any time refuse to allow US government entities and banks from exchanging the US dollar for the Hong Kong dollar,” he said.

After signing the Hong Kong democracy act into law, US President Donald Trump acknowledged it could complicate the signing of a “phase one” trade deal with China. But with almost unanimous US congressional support, he had little political room to manoeuvre.

He spoke of his “respect” for Chinese President Xi Jinping when signing the bill and that he hoped the “leaders and representatives of China and Hong Kong will be able to amicably settle their differences.”

Trump also indicated he had no intention of implementing the bill’s provisions, saying the act infringed on constitutional responsibilities in conducting foreign policy.

Diana Choyleva, chief economist at Enodo Economics, said if Washington was to suspend free trading of the US dollar with the Hong Kong dollar, it would cause the local currency to plunge, likely leading to a sharp outflow of funds from the city and denting its reputation as a financial hub.

“This could get into a nuclear type of option for global financial markets – that is the significance of Hong Kong for global financial markets,” said Choyleva. “If you want a 10-year forecast, this is the end of the beginning of the demise of Hong Kong as a global financial centre.”