Hong Kong holds one of the world’s largest foreign exchange reserves. As of July 2022, Hong Kong’s official foreign reserves stood at US$455 billion. This massive accumulation of reserves highlights Hong Kong’s importance as an international financial center and provides confidence in the Hong Kong dollar peg.
Introduction
Hong Kong’s reserves are managed by the Hong Kong Monetary Authority (HKMA) and held primarily in US dollars. The size and growth of reserves over the years reflect Hong Kong’s rise as a major trading hub and key gateway between China and the global economy.
Hong Kong’s reserves serve several purposes. They back the Hong Kong dollar currency peg, ensuring monetary and financial stability. They also provide a buffer against capital outflows and external shocks. Additionally, reserves allow Hong Kong authorities to intervene in markets during periods of volatility.
This article will examine the background, composition, purposes, and outlook for Hong Kong’s substantial war chest of foreign exchange reserves.
Background
Hong Kong’s accumulation of reserves began in earnest in the 1980s and 1990s. As an entrepôt economy integrating with China’s economic rise, Hong Kong experienced strong trade surpluses. This allowed reserves to grow rapidly.
The 1997 Asian Financial Crisis was a key turning point. To defend the Hong Kong dollar peg and prevent speculative attacks, the HKMA purchased large amounts of USD. This expanded reserves significantly.
In the 2000s, closer integration with mainland China drove further accumulation of reserves from strong capital account inflows. China-Hong Kong trade settlement and investment flows added to the war chest.
Reserves got a more recent boost during 2020-2021 due to weakness in Hong Kong’s domestic economy from COVID-19 and political factors. Import compression and resilient financial account inflows grew reserves to new highs over $450 billion.
Composition of Reserves
The HKMA does not provide a detailed breakdown of the composition of Hong Kong’s reserves. However, it is believed that around 60-70% is held in US dollars, consistent with Hong Kong dollar’s peg to the greenback.
Other reserve currencies likely held include the British pound, Euro, Japanese yen, and Chinese renminbi. Some gold bullion also forms part of reserves, though its share has fallen over time.
Hong Kong’s reserves are invested conservatively in low-risk fixed income assets. This includes government bonds of reserve currency issuing countries and supranational debt. Some deposits are also held with central banks and the Bank for International Settlements.
Purposes of Reserves
Hong Kong’s considerable stash of reserves serves multiple important purposes:
1. Maintain currency stability
The most vital purpose is maintaining the peg between the Hong Kong dollar and US dollar. The HKMA uses reserves to buy and sell Hong Kong dollars on the market to stabilize the peg within a band of 7.75-7.85 HKD/USD. Reserves provide confidence in this 36-year old currency peg.
2. Defend against speculative attacks
Reserves are war chest to deter speculative attacks on the Hong Kong dollar and resist sudden capital outflows. The large size of reserves makes it extremely expensive for speculators to bet against the peg.
3. Cushion against external shocks
Reserves provide an important buffer for Hong Kong’s externally-oriented economy against global crises and volatility in financial markets. They allow authorities to smooth out liquidity strains.
4. Maintain financial stability
The HKMA can use reserves to provide liquidity to banks facing cash shortages and systemic risks. This prevents bank runs and turmoil in interbank lending markets.
5. Fund fiscal reserves
A portion of reserves backs Hong Kong’s substantial fiscal reserves held in the Exchange Fund. These support government spending and operations.
Reserve Adequacy for Hong Kong
Hong Kong’s reserves are assessed to be more than adequate currently. Traditional metrics suggest ample coverage.
Reserves/GDP
Reserves now stand at over 2 times Hong Kong’s annual GDP. This high ratio indicates strong reserve adequacy. Most benchmarks assess reserve/GDP ratios above 20% as sufficient.
Reserves/Imports
With reserves around 5 times greater than annual imports, Hong Kong also has ample import coverage. The international standard is three months import coverage, or 25% of imports.
Reserves/M2 money supply
Reserves also represent over 2 times broad money supply (M2). Ratios above 20% are seen as adequate for pegs like Hong Kong’s.
Reserves/Short-term external debt
A high level of coverage is also indicated by reserves being around 30 times greater than short-term external debt obligations. Ratios above 1 are generally seen as adequate.
So by traditional metrics, Hong Kong has a very strong reserve buffer befitting its role as an international financial center. This provides confidence in policies and stability.
Outlook for Hong Kong’s Reserves
Looking ahead, Hong Kong’s reserves seem likely to remain large, with a few factors at play:
- Continued integration with the mainland Chinese economy will support the accumulation of reserves. Settlement flows and financial account inflows should continue.
- Weaker domestic demand in Hong Kong may compress imports and generate trade surpluses that add to reserves.
- Persistent political tensions may motivate the HKMA to hold higher precautionary reserves.
- An unwinding of global QE and rising US interest rates should provide gains to reserves invested in USD fixed income assets.
However, some potential drains on reserves include:
- A normalization of global trade and economies after COVID-19 may expand imports.
- Higher US interest rates could motivate some capital outflows.
- Drawdowns are possible if reserves are deployed to support banks or fiscal authorities.
Barring more extreme circumstances however, Hong Kong seems poised to maintain its very sizeable stash of official foreign exchange reserves for the foreseeable future.
Key Factors That Determine Size of Reserves
Several important factors account for the massive size of Hong Kong’s reserves:
1. Current account surpluses
Historically, Hong Kong has run substantial current account surpluses due to strong exports of goods and services. These added significantly to reserve accumulation over time. Surpluses have moderated but persist.
2. Financial account inflows
Capital inflows into Hong Kong’s financial markets and institutions have added to reserves, especially from mainland China trade settlement and investing.
3. Exchange rate policy
Hong Kong’s long-running peg to the USD requires heavy purchases of USD by the HKMA at times to maintain the peg. These interventions accumulated in reserves.
4. Precautionary demand
HKMA holds higher reserves as a precaution to protect the peg, in case of capital flight or speculation. Reserves are like an insurance policy.
5. Fiscal reserves
Transfers from reserves help the government build its own substantial fiscal reserves through the Exchange Fund. This drains reserves from the HKMA.
6. Valuation changes
Gains or losses on the US dollar and dollar-denominated securities like Treasuries impact the market value and size of reserves.
So Hong Kong’s combination of chronic surpluses, financial inflows, and exchange rate policy drove the accumulation over decades to a very large stockpile. Reserves beget more reserves.
Factors That Decrease Reserves
On the other side, factors that can drain or decrease the level of reserves include:
1. Current account deficits
If Hong Kong were to run sustained trade and services deficits, it would eat into reserves accumulated from past surpluses. But deficits have been rare.
2. Financial account outflows
Outflows of capital, either long-term like direct investment abroad by Hong Kong firms or short-term speculative outflows, deplete reserves. Major outflows occurred during periods of financial turmoil.
3. Currency market intervention
When the HKMA sells Hong Kong dollars to maintain the peg, the related USD outflows reduce the size of reserves. Intervention varies over time.
4. Fiscal reserves transfers
If the government draws down on the Exchange Fund reserves, it requires transfers from the HKMA’s reserves. These have been large in some years.
5. Valuation changes
Losses on US dollar and dollar securities reduce the nominal value of reserves, as was seen in 2018.
So while inflows have dominated, outflows do diminish reserves periodically. Outflows also raise questions around the optimal size of the reserves stockpile.
Costs of Holding Large Reserves
While reserves provide confidence and stability, there are also costs:
- Fiscal costs – reserves are borrowed by the government, so building them has meant higher public debt for Hong Kong.
- Sterilization costs – the HKMA mops up local dollar liquidity from intervention, which requires issuing bills and notes. This raises interest costs.
- Opportunity costs – reserves invested in low-yielding USD assets means lost returns relative to higher returning investments.
- financial risks – reserves still have market risk. Valuation changes can lead to large paper losses, as HKMA manages a USD portfolio.
So authorities must balance the benefits of reserves against their financial and opportunity costs. There are trade-offs involved.
Hong Kong’s Reserves Relative to Singapore
Hong Kong and Singapore both operate exchange rate-centered monetary regimes and accumulated substantial reserves. But some differences stand out:
- Singapore’s reserves of around US$300 billion are smaller in absolute terms. But relative to GDP, they are proportionally larger.
- Singapore does not have a hard peg, rather a monitoring band around a trade-weighted exchange rate. This requires less active reserves management.
- Singapore’s current and financial accounts are more balanced, reducing the need for sustained accumulation of reserves.
- Singapore holds a larger share of its reserves in non-USD currencies, especially Asian ones. This provides more diversification.
- Hong Kong’s reserves partially back the Exchange Fund and fiscal reserves, whereas Singapore’s are wholly for monetary purposes.
So both cities hold ample reserves, though Singapore’s reserves accumulation has been relatively less aggressive and more diversified.
Reserves Give Confidence in Hong Kong’s Institutions
The substantial size of Hong Kong’s reserves provides confidence in key institutions and policies:
- The currency peg remains sacrosanct, with reserves to defend it. There is no fear of running out of ammunition.
- The HKMA has ample firepower as lender of last resort if liquidity strains hit banks. Depositors are reassured.
- Hong Kong’s fiscal reserves are also sized at prudent levels, backed in part by transfers from foreign exchange reserves. Taxes can remain low.
- The Linked Exchange Rate System and currency board rules are proven resilient over decades. Reserves provide credibility.
- Hong Kong remains an attractive hub for global trade, finance and investment given reserves provide economic stability.
So reserves are a keystone of Hong Kong’s economic model and reputation as a stable financial center. They represent an insurance policy bought over decades.
Conclusion
Hong Kong’s mountain of foreign exchange reserves accumulated from current account surpluses, financial inflows, and the linked exchange rate system. Reserves provide confidence in the Hong Kong dollar peg and support overall monetary and financial stability.
Though costly to hold, reserves remain vital for Hong Kong’s future. The HKMA seems intent on maintaining a high level of reserves as insurance against economic and financial volatility. This prudence will sustain confidence in Hong Kong as a global financial center.
