• Tensions between the U.S. and China have been escalating for months
  • US have criticized China's new security laws in Hong Kong
  • The Hong Kong dollar has been pegged to the US dollar since 1983

Some aides to U.S. Secretary of State Michael Pompeo have suggested that Washington could punish China by compromising the Hong Kong dollar’s peg to the U.S. dollar.

Tensions between the U.S. and China have been escalating for months, worsened by Beijing’s imposition of new security laws in Hong Kong that some think will eliminate the city-state’s autonomy.

Bloomberg reported that one way to undermine the Hong Kong dollar peg would be by restricting the ability of Hong Kong banks to purchase U.S. dollars. The matter has been discussed with Pompeo but not yet with senior members of President Donald Trump’s White House staff.

Hong Kong has linked its currency to the U.S. dollar since 1983 and has generally performed well trading within a narrow band.

The proposal would also face obstacles among other U.S. government officials who fear it would just hurt Hong Kong banks and not mainland China itself.

Last month, Hong Kong’s financial secretary, Paul Chan said that if the US slapped sanctions on the city-state, then China’s central bank could supply it with American dollars.

Eddie Yue, chief executive of the Hong Kong Monetary Authority, Hong Kong’s de facto central bank, said that the 36-year old dollar peg predates the 1992 U.S-China Policy Act which features a provision permitting the U.S. dollar “to be freely exchanged” with the Hong Kong dollar.

Yue suggested that the unlikely event of Trump blocking Hong Kong’s access to U.S. dollars would amount to an “apocalyptic” scenario that could backfire on Washington.

“With Hong Kong’s financial system closely integrated with the global economic and financial systems, any move that hits our financial system would also send shockwaves across the global financial markets, including the U.S.,” he said. “Confidence of international investors in using the [U.S. dollar] and holding U.S. financial assets could also be undermined.”

Yue further noted that the dollar peg is supported by about $440 billion of foreign-exchange reserves, which is more than double the size of the city-state’s money in circulation.

Other analysts also criticized the proposal.

Xia Le, chief Asia economist at BBVA Hong Kong, called the measure a “nuclear-like weapon” which could completely decouple China from the U.S. “It’s technically difficult to impose, and it’ll hurt U.S. a lot,” he said.

Ding Shuang, chief economist for Greater China and North Asia at Standard Chartered in Hong Kong, warned that if the U.S. sought to limit American banks from selling U.S. dollars to Chinese lenders, it would be “self-defeating.”

It “sounds quite radical and will have profound and unpredictable implications not only for China’s banks, but also the U.S. banks and the global financial market,” Ding said. “I see a low likelihood for the U.S. to resort to such a potentially self-defeating approach, before options that cause more problems for China than for the U.S. are exhausted.”

David Qu, economist at Bloomberg, commented that Hong Kong “appears to have the will -- and it certainly has the means -- to keep the peg. Any move by the U.S. to try to force a decoupling strikes us as extremely unlikely, given the prohibitively heavy costs.”

Stephen Innes, chief global market strategist with AxiCorp, said that if the Trump administration tried to get the U.S. Treasury to restrict American banks from providing dollar funding to banks in Hong Kong and Chinese banks, that would drive the costs for such funding “exorbitantly” higher.

But Innes noted this is unlikely to happen since China could respond by taking measures against U.S. assets including Treasuries and stocks, possibly resulting in the destabilizing of currency pegs in other parts of the world, including the Middle East.

“The unthinkable instability that it would trigger in the [U.S. dollar]-based global financial ecosystem could drive a selloff in U.S. equity markets --- an outcome abhorrent to the White House ahead of the November presidential election,” Innes wrote in a note.

Innes added that “U.S. banks don’t want to give up access to China markets.”

Bloomberg also reported that some senior Trump officials, including Pompeo, want to punish Hong Kong-based banks like HSBC Holdings (HSBC), which have endorsed China’s security laws.

Pompeo specifically criticized Peter Wong, HSBC’s Asia Pacific chief executive officer, for supporting “Beijing’s disastrous decision to destroy Hong Kong’s autonomy.”