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Talking Points:

  • Weaker Yuan after Brexit puts pressure on the Hong Kong Dollar’s pegged FX rate regime
  • Yuan’s globalization process will be interrupted and slowed down after Brexit referendum
  • In the longer term China may develop more Yuan offshore markets in Europe vs. London

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China, Hong Kong and the UK share unique historical linkages. We have previously discussed that Brexit risk can be transferred from Hong Kong to mainland China and affect local business and equity markets. Now we will take a look at the potential impacts to the currencies in the two regions.

A Weaker Yuan and the Vulnerable HKD/USD Peg

The Hong Kong Dollar’s pegged exchange rate system to the US Dollar is under high risk after Brexit. We have discussed that the plunge in the Pound led by Britain’s departure leaves room for the Yuan to weaken further against other major counterparts. Because of Yuan’s unique FX regime, the PBOC is able to guide CNY pairs directly. They have an incentive to weaken the Yuan against the Dollar in an effort to maintaining its stability relative to a basket of currencies. This could be very bad for the Hong Kong Dollar (HKD), which is still pegged to the US Dollar. In the Tale of Two Currencies, we have discussed the increased connections between capital markets in mainland China and Hong Kong since 2015. While the gap between the two pairs continues to widen, Hong Kong will face increasing pressure in attracting tourists and investors from its most important partner, mainland China.

Also, the US Dollar is likely to appreciate against most other currencies due to its safe-haven status. In turn, the pegged Hong Kong Dollar will become more expensive versus those currencies, which will hurt Hong Kong’s trade widely. In addition, it will become harder for the Hong Kong Monetary Authority (HKMA) to hold the pegged exchange rate regime as the Hong Kong Dollar is no longer a safe haven asset on the back of UK’s departure. Hong Kong’s capital market has already taken a direct hit from Brexit because the region has strong connections with the UK which were set up over the 100 years that it was ruled by the UK. The Hang Seng Index plunged -2.92% on Friday when the Brexit referendum result came out. Global investors may sell HKD-denominated assets amid risk aversion and withdraw their funds from Hong Kong rather than the other way around. This could lead to significant capital outflows.

In order to maintain the pegged the exchange rate regime, the HKMA has to burn their foreign reserves and buy back the Hong Kong Dollar. According to the most recent data released by HKMA, Hong Kong owned US$360.3 billion as of the end of May 2016. It is not certain how long this amount of FX reserves can support the pegged system under increasing capital-outflow pressure. To use mainland China as a rough comparison, its foreign reserves dropped by US$140 billion over the past six months amid capital outflow pressure even though the Yuan had devaluated against the US Dollar. Also, as the mainland will be busy dealing with turbulence in the Yuan rates resulted from Brexit, it may not provide as much support as it used to offer to Hong Kong. Thus, the Hong Kong Dollar’s pegged exchange rate regime is at high risk.

Yuan’s Globalization

The UK plays a key role in Chinese Yuan’s internationalization process. UK leaving the EU could change the whole agenda of the Yuan becoming a global currency. London is the second largest offshore Yuan center after Hong Kong in the world and the largest center in Europe. It serves as a gateway for the Chinese currency to develop in Europe, a main part of the Western world. London’s position cannot be substituted by Hong Kong or Singapore offshore centers. The latter are main Yuan offshore centers but cover mainly the Eastern world. China has not set up a major Yuan offshore center in the North American region so far. In fact, no Yuan clearing bank has been set up in the US, only one in Canada, while the clearing bank in the UK was established as early as June 2013.

This is one of the main reasons that China would prefer that the UK stays in the EU. The PBOC has been actively promoting Yuan products in the London offshore market. Two weeks ago, the Chinese government issued Yuan-denominated bonds in London, the first time that China issues such bonds in an offshore market other than in Hong Kong. As an EU member, it would be easier for UK banks to sell Yuan-denominated products to investors in other EU countries. Choosing to leave the UK will not only slow Yuan’s development within UK, as the country will be busy dealing with its own problems caused by Brexit. More importantly, it will interrupt the Yuan’s expansion in the rest of Europe due to UK’s isolation and hurt its internationalization process.

A Bigger Picture

However, a slowdown does not mean a reversal of the Yuan’s globalization process for both external and internal reasons. The Chinese currency will be officially included in the SDR basket on October 1 this year. The PBOC has reiterated its target of promoting a more market-driven Yuan. Thus, the central bank will continue to improve the Yuan’s global role despite the Brexit interruption.

In the long term, a reduced UK role in Yuan development could be an opportunity for other European countries. In addition to London, China has Yuan cleaning banks in Germany, France and Luxembourg. These places could be the next Yuan offshore centers in Europe. The importance of the Euro/Yuan cross rate could rise as well. On June 12th, German Chancellor Merkel visited China in an effort to enhance cooperation between the two countries. In the future, cooperation between China and European countries could grow, for trade as well as for Yuan development, though it may take a longer time.

To read the full coverage of Brexit by the DailyFXteam, click here for the background information, scenarios, technical analysis and more.

Written by Renee Mu, DailyFX Research Team

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