Stablecoins.

They’re a hot topic. Are they sustainable? Is the mechanism sound? Will it work?

Lucky for us, HKMA just performed the 32nd open market operation of 2022 in order to defend the HKD currency exchange peg. This brought an idea to mind:

A fixed exchange currency is effectively a stablecoin. They face mostly analogous economic pressures and challenges.

Hong Kong dollar, a US$400B market cap stablecoin, allows us to glimpse under the hood of how such currencies respond to shocks. 

Last three years are a treasure throve of data on the interplay of a limited monetary policy of fixed exchange rate and relaxed fiscal policy rooted in abundance of the past. It's the perfect natural experiment.

First things first, however:

What makes a fixed exchange rate currency, a stablecoin if you will, maintain its value?

Stripping aside the mystical arts of finance on which so many jobs depend, there really is one single relationship that matters:

Do people want to use your token?

If people want to use your token to pay for services, commerce, settle bills, travel, invest, save value in, and participate in your culture, then your stablecoin has an easy job of maintaining its peg to another currency.

They give you their money which becomes your reserve, and you issue them a nice shiny token to participate in your world.

If people don’t want to use your token, then you have to keep buying it up in order to maintain a 1:X relationship of foreign reserve to circulating local currency tokens. This can escalate quickly due to confidence bust and you become Venezuela.

By definition of a fixed exchange rate regime, you do not get to print new local money in absence of foreign inflows.

TLDR: the way you keep your stablecoin stable is by maintaining a reserve at 1:X ratio. This job is easy if people want your token. It is not easy if people want to cash out. 

Now, back to the Hong Kong Dollar.

HKMA just performed their 32nd open market operation this year alone. This brings us up to a -US$27.39B reserve drain representing a 6% decrease of USD reserves in only 9 months. Important to note that HKD M1 supply has not decreased proportionally.

The pandemic has created an unique set of factors placing the peg under pressure:

• Social: One of the largests population emigrations in recent history - 1.6% decrease in a single year - means mass withdrawals of MPF and local bank deposits, and consequent downward pressure on reserves due to redemptions out of local economy.

• Local Economy: Longer than average pandemic measures caused for many local businesses to shut down permanently, business owners to move out, and property prices to plummet.

• Global Profile: Reduced global competitiveness due to extended pandemic measures. About 30% of MNCs are contemplating departing. This leads into investment capital departing, and further downward pressure on reserves due to redemptions out of local economy.

• Inflationary Pressures: Issuing mass consumption stimuli while keeping local businesses like restaurants, bars, cinemas, live venues closed or limited means that the money went towards imported consumer goods like iPhones. This means a bunch of stimuli went straight into import under CA, which is largely settled in USD. Further downward pressure on reserves.

• Fiscal Spending: Parabolic increase in spending on public services created more disposable income in the middle-upper income bracket, more HKD liquidity, and potentially higher redemption as USD is still the preferred saving vehicle for the well-off.

• Monetary Policy: Keeping local interest rates low relative to USD means HKMA had to keep performing open market operations to offset the Fed hikes. Under fixed exchange rate, you either move the local supply, or match interest rates of the currency you peg to. Keeping local rates low meant further burn of the reserves.

Now what can be done under all these above pressures? Each path yields danger at the extreme:

• Hiking Interest Rates - aggressively matching the Fed runs into the possibility of effectively suppressing any recovery of the battered local economy.

• Keep Draining USD Reserves - keeping open market operations going faces the issue of confidence failure, leading into capital flight.

• Impose “Emergency” Capital Controls - this would be a recipe for disaster in a world city, thus unlikely.

• Abandon the Peg - although full abandonment is unlikely, it may need to be recalculated.

The HKD stablecoin project is facing unprecedented challenges now, perhaps the most dramatic set of issues since launching 39 years ago on 17 October 1983. 

What happens next will provide us with invaluable lessons in feasibility of stable coins on a global scale.

Stablecoins.

They’re a hot topic. Are they sustainable? Is the mechanism sound? Will it work?

Lucky for us, HKMA just performed the 32nd open market operation of 2022 in order to defend the HKD currency exchange peg. This brought an idea to mind:

A fixed exchange currency is effectively a stablecoin. They face mostly analogous economic pressures and challenges.

Hong Kong dollar, a US$400B market cap stablecoin, allows us to glimpse under the hood of how such currencies respond to shocks. 

Last three years are a treasure throve of data on the interplay of a limited monetary policy of fixed exchange rate and relaxed fiscal policy rooted in abundance of the past. It's the perfect natural experiment.

First things first, however:

What makes a fixed exchange rate currency, a stablecoin if you will, maintain its value?

Stripping aside the mystical arts of finance on which so many jobs depend, there really is one single relationship that matters:

Do people want to use your token?

If people want to use your token to pay for services, commerce, settle bills, travel, invest, save value in, and participate in your culture, then your stablecoin has an easy job of maintaining its peg to another currency.

They give you their money which becomes your reserve, and you issue them a nice shiny token to participate in your world.

If people don’t want to use your token, then you have to keep buying it up in order to maintain a 1:X relationship of foreign reserve to circulating local currency tokens. This can escalate quickly due to confidence bust and you become Venezuela.

By definition of a fixed exchange rate regime, you do not get to print new local money in absence of foreign inflows.

TLDR: the way you keep your stablecoin stable is by maintaining a reserve at 1:X ratio. This job is easy if people want your token. It is not easy if people want to cash out. 

Now, back to the Hong Kong Dollar.

HKMA just performed their 32nd open market operation this year alone. This brings us up to a -US$27.39B reserve drain representing a 6% decrease of USD reserves in only 9 months. Important to note that HKD M1 supply has not decreased proportionally.

The pandemic has created an unique set of factors placing the peg under pressure:

• Social: One of the largests population emigrations in recent history - 1.6% decrease in a single year - means mass withdrawals of MPF and local bank deposits, and consequent downward pressure on reserves due to redemptions out of local economy.

• Local Economy: Longer than average pandemic measures caused for many local businesses to shut down permanently, business owners to move out, and property prices to plummet.

• Global Profile: Reduced global competitiveness due to extended pandemic measures. About 30% of MNCs are contemplating departing. This leads into investment capital departing, and further downward pressure on reserves due to redemptions out of local economy.

• Inflationary Pressures: Issuing mass consumption stimuli while keeping local businesses like restaurants, bars, cinemas, live venues closed or limited means that the money went towards imported consumer goods like iPhones. This means a bunch of stimuli went straight into import under CA, which is largely settled in USD. Further downward pressure on reserves.

• Fiscal Spending: Parabolic increase in spending on public services created more disposable income in the middle-upper income bracket, more HKD liquidity, and potentially higher redemption as USD is still the preferred saving vehicle for the well-off.

• Monetary Policy: Keeping local interest rates low relative to USD means HKMA had to keep performing open market operations to offset the Fed hikes. Under fixed exchange rate, you either move the local supply, or match interest rates of the currency you peg to. Keeping local rates low meant further burn of the reserves.

Now what can be done under all these above pressures? Each path yields danger at the extreme:

• Hiking Interest Rates - aggressively matching the Fed runs into the possibility of effectively suppressing any recovery of the battered local economy.

• Keep Draining USD Reserves - keeping open market operations going faces the issue of confidence failure, leading into capital flight.

• Impose “Emergency” Capital Controls - this would be a recipe for disaster in a world city, thus unlikely.

• Abandon the Peg - although full abandonment is unlikely, it may need to be recalculated.

The HKD stablecoin project is facing unprecedented challenges now, perhaps the most dramatic set of issues since launching 39 years ago on 17 October 1983. 

What happens next will provide us with invaluable lessons in feasibility of stable coins on a global scale.