For the first time since 2019, the Hong Kong dollar (HKD) has fallen to the lower end of the Convertibility-Undertaking threshold, under which the Hong Kong Monetary Authority limits the currency’s trading range against the US dollar. Chi Lo, our senior market strategist in Hong Kong, explains what is happening and discusses the mechanism in place to sustain the Hong Kong dollar peg.
For most of 2021, prior to the US Federal Reserve getting serious about policy tightening, the Hong Kong dollar depreciated (see Exhibit 1). The depreciation was due to net portfolio outflows: a decline in southbound flows from mainland China (China buying Hong Kong stocks) via the Stock Connect channels relative to northbound flows (Hong Kong-based investors buying Chinese onshore stocks).
Since late 2021, outflows have given way to currency carry as the key driver for HKD weakness. Market expectations of aggressive US Fed rate rises have pushed US dollar/HKD interest-rate differentials higher. The widening of the USD-HKD rate spread has created an opportunity for investors to borrow the low-yielding HKD and invest in the relatively high-yielding USD.
Removing excess liquidity will take time
The extent of the interest-rate differential stems from the ample liquidity within Hong Kong’s monetary system. As of 30 April 2022, liquidity totalled HKD 338 bn (USD 43.3 bn), a five-year high. The total is more than six times the aggregate balance at the end of 2019 when the HKD peg was last under speculative attack.
The HKD peg (or Linked Exchange-Rate System, LERS, as it is officially known) requires the Hong Kong Monetary Authority (HKMA) to follow in lockstep interest-rate moves by the US Federal Reserve. However, Hong Kong’ banks are under no obligation to follow the trend in US interest rates if there is a large liquidity cushion in Hong Kong’s monetary system, as there is now.
If the 2018-19 episode is any guide, and assuming current macroeconomic trends continue, it could take a few more months for Hong Kong’s liquidity to tighten to around HKD 54 bn, the level at which Hong Kong’s banks would be forced to raise their interest rates to attract capital. Under this scenario, Hong Kong’s asset markets, especially property, while not suffering any liquidity squeeze now, may face tightening liquidity by late summer or early autumn 2022.
HKMA – Formidable ammunition to defend the currency
Hong Kong has foreign exchange reserves of USD 482 bn as of March 2022, the sixth largest in the world. They amount to almost 200% of Hong Kong’s monetary base, implying that if investors wanted to exchange all their HKD for USD, the HKMA has reserves almost double the amount needed to honour the demand for USD at the exchange rate of 7.8 to the US dollar.
In a currency crisis, a country typically suffers from major capital outflows. However, Hong Kong’s foreign exchange reserves are equivalent to 23% of M2, providing it with a sizeable buffer in any crisis.
The HKD peg has survived many rounds of capital outflows and speculative attacks since its inception on 17 October 1983. It remains stable like a rock in the storm.
That firmness speaks volumes about the robustness of the LERS, the automatic mechanism employed by the HKMA to correct the weakness or strength of the HKD. When the HKD falls/rises to the weak/strong side of the convertibility range, the HKMA buys/sells HKD from the market at 7.85/7.75 as required by the LERS mechanism, leading to a contraction/expansion of the aggregate balance.
The resultant tightening in HKD liquidity pushes up HIBOR, narrowing the gap with USD interest rates, reducing capital outflows, and stabilising the HKD exchange rate just as required under the currency board rule. Hence, during speculative attacks or periods of significant capital outflows, HIBOR typically rises significantly. For example, during the Asian Financial Crisis, 3-month HIBOR shot up to 15.7% in August 1998, more than 1 000bp above USD LIBOR.
No change in sight
Despite the significant economic and financial market integration with mainland China, we believe the time is not yet ripe for pegging the convertible HKD to the renminbi (which is inconvertible on the capital account). Until China liberalises its capital account significantly, it makes sense for Hong Kong to keep the currency pegged to the USD by anchoring Hong Kong’s monetary policy to a global hard currency run by a historically credible and transparent Federal Reserve.
The ability of the HKD-USD peg to come through global economic and financial shocks unscathed, with manageable negative consequences for local markets, highlights the credibility of the LERS.
High interest rates and economic volatility seem a manageable price to pay for anchoring international confidence and eliminating foreign exchange risk in Hong Kong’s small open economy, upon which domestic macroeconomic policy does not necessarily have any significant effective influence.