As the Chinese economy continues to shows signs of a slowdown in growth, the autonomous territory of Hong Kong has been receiving more than its fair share of the pain. This fear has caused Chinese capital outflows to rise significantly over the last year, and Hong Kong has largely been caught in its tide. To make matters worse, the Hong Kong dollar is pegged to the U.S. dollar and held in the interval between $7.75 and $7.85. As the United States has begun to tighten its monetary policy, Hong Kong is seeing exports decrease as prices in the territory become more expensive relative to international peers.
This has lead some to believe that the Hong Kong Monetary Authority (HKMA), the de-facto central bank of the economic zone, will abandon the peg to stop it's ill-effects from further slowing the economy.
Click to enlargeDespite this dramatic scenario clearly having gained traction in the market, with the USD/HKD shooting upwards in the last few days, it remains extremely unlikely that it will actually materialize.
Hong Kong's peg to the greenback adds a great deal of credibility to the currency which would immediately be lost if the peg was abandoned. Taking its place would be a great deal of exchange rate risk as the currency's value shoots up and down, trying to find equilibrium. This would significantly effect trade and foreign investment, with the volatile exchange rate would bringing significant risk to foreigners whose base currency would be constantly fluctuating in value against the HKD.
This effect would not go away quickly, either. After losing the stability of being pegged to the U.S. dollar, the Hong Kong dollar would be seen as having significant exchange rate risk for years to come. This would hurt trade and foreign investment long into the future.
In an effort to calm markets, the Hong Kong Monetary Authority has announced that it has no plans to change the peg, as well. This provides even more credibility to the common sense reasoning for why the peg should stay.
As markets panic about the unlikely peg abandonment, it has created an investment opportunity. The closer the rate gets to $7.85, the more one can gain from betting on a reversal. History shows, as can be seen in this Zero Hedge chart going back to 2000, momentum will eventually shift and the rate will head back in the other direction. By waiting for an entry very near the limit, it is possible to achieve a very strong risk/return profile on this trade.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in USD/HKD over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.