The HKMA is therefore being forced to raise interest rates, despite the recession. To keep the economy afloat, Hong Kong has no choice but to resort to the fiscal weapon, i.e. a massive increase in public spending. At the risk of being penalised one day by the financial markets. 

Hong Kong is facing structural problems that are not likely to reassure international investors. China's political interference is only increasing. A part of the working population, in particular the high earners in the financial sector, is leaving the island. Hong Kong's tax base is thus being eroded even though Hong Kong is a massively indebted economy. 

Indeed, while the government's debt ratio is close to zero (as published by the IMF), the private sector's is much higher. According to some economists, the external debt is almost $500,000 for every person working in Hong Kong. Domestic debt levels have doubled since 2007, according to the World Bank. Real estate debt has been rising at a staggering rate, despite a decline in prices that appears to be accelerating (-8% year-on-year according to the latest figures), even though Hong Kong's real estate remains among the most expensive in the world.

It is this huge surge in debt, falling asset prices and the increasingly bleak outlook for Hong Kong's economy that makes defending the peg much more problematic than during the Asian crisis of the late 1990s. 

Another warning sign is that Hong Kong's foreign exchange reserves have fallen by more than 16% since the end of 2021, from $500 billion to $417 billion, the biggest drop on record.

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Hong Kong foreign exchange reserves (excluding gold)

Source: World Bank, Bloomberg

These different portfolios partly explain the decline in foreign exchange reserves in 2022. 

Firstly, the Hong Kong government had to dip into the Exchange Fund to compensate for the shortfall in tax revenues. A worsening of the economic situation in Hong Kong could therefore lead to a further decline in foreign exchange reserves. 

Another possible explanation for the drop in reserves in 2022 is the losses incurred on the investment portfolio. Although there is little or no transparency on the assets held in the portfolio, there is every indication that the decline in international markets is having an impact on the valuation of these assets. The decline in property prices is probably not yet taken into account, but could affect the future development of the Long-term Growth Portfolio. 

The composition of foreign exchange reserves highlights the risk of a vicious circle faced by the Hong Kong authorities: the island's loss of momentum will weigh on tax revenues and thus drain foreign exchange reserves. The fall in property prices could also reduce the reserves available. This drop in reserves comes at a time when the HKMA has never needed to defend the peg more than it does now. 

It is this accumulation of risks that is prompting some hedge fund managers to bet on a de-pegging of the HKD against the dollar. For example, billionaire investor Bill Ackman, manager of Pershing Square, recently said he held a large notional short position against the Hong Kong dollar through the holding of put options. For him, the peg no longer makes sense for Hong Kong and it is only a matter of time before it breaks down.

Yet China's increasing interference suggests that a yuan peg could one day make sense. Although the short and medium-term consequences could be very negative for Hong Kong. A devaluation of the HKD could further depress the property market. It would also affect the confidence of international investors in Hong Kong and accelerate talent flight. A de-pegging could also weigh on imported inflation. And trigger a competitive devaluation movement in Asia. 

As mentioned in the introduction, monetary tightening moves by the Fed have often created collateral damage beyond US borders. A pause or pivot by the Fed in 2023 would have the merit of easing the pressure on the HKD. However, Hong Kong seems to be at a turning point in its history and may have to question the wisdom of the peg.