The Fed Hike Could Force Hong Kong to Defend Its Dollar Peg

(Bloomberg) -- The Hong Kong dollar has never been so close to the weak end of its trading band against the greenback, and the Federal Reserve may have just given it a final push.

The currency is now 0.05 percent away from HK$7.85, a level that the city’s central bank is obliged to defend. The head of the Hong Kong Monetary Authority said the exchange rate is likely to fall to the low end of the band after the U.S. lifted borrowing costs overnight. Abundant liquidity in the Asian financial hub has meant interbank rates have lagged behind U.S. levels, making it lucrative for traders to sell the local dollar.

The Fed Hike Could Force Hong Kong to Defend Its Dollar Peg

Here’s what will happen when the HK$7.85 mark is reached:

The HKMA Starts Buying Hong Kong Dollars

HKMA operations -- disclosed here -- will begin if there’s interest from banks to buy the greenback at that level. That will shrink the aggregate balance along with the monetary base, driving interbank rates known as Hibors higher and potentially narrowing the gap with U.S. Libors -- until it is no longer lucrative to short the Hong Kong dollar.

Will This Lead to an Attack on the Peg?

In a word, no. “Don’t fight the HKMA” is the lesson investors took from the 1997 Asian financial crisis, when the monetary authority bought local equities and allowed the overnight Hibor surge to 280 percent in order to defend the currency peg. The city now has a record $443.5 billion of foreign-exchange reserves, twice its monetary base.

Implied volatility and forward points -- which surged in 2016 when the depreciating yuan fueled fears of capital outflows from Hong Kong -- are muted.

Will This End the Era of Ultra-Low Rates in Hong Kong?

You can probably expect some volatility in Hibor, but remember that Hong Kong’s aggregate balance of interbank liquidity is still about HK$180 billion ($23 billion), roughly 100 times pre-crisis levels. The HKMA may have to withdraw HK$80 billion -- which could occur within one to two months of the exchange rate hitting HK$7.85 -- before local rates start converging with U.S. ones in a more sustainable way, according to Bank of America Merrill Lynch.

In 2004-2005, the last time the HKMA had to buy the local dollar to defend the peg, such purchases ranged between HK$148 million and HK$4.5 billion a day. The central bank imposed the wider band in May 2005.

Given that the banking system is now much larger, it’s likely the aggregate balance will remain much bigger than pre-crisis levels, says MK Tang, an economist at Goldman Sachs Group Inc. He expects Hibor to converge with Libor, though it’s possible the former will remain slightly lower. Three-month Hibor will end the year at 1.75 percent, according to the median forecast in a Bloomberg survey of analysts, compared with 1.10 percent on Wednesday.

Is This Bad News for the Property Market?

Faster gains in Hibor would make mortgages pricier in the world’s least affordable housing market, where home prices reached a fresh record high just this month. As interbank rates rise, it also becomes increasingly likely banks will raise the prime rate for the first time since 2006. Because the majority of recent mortgages are based on the floating Hibor with a prime rate-based cap, an increase in the latter would further raise mortgage payments. That could happen in the six months through March 2019, Bank of America said. The chief executive of Hang Seng Bank Ltd. says such a raise is possible in the second half.

Still, few are predicting a property slump just yet. Supply is tight relative to demand, while rates have plenty of room to rise before squeezing mortgage-holders. Given earlier government measures to cool the housing market, most buyers have strong finances and aren’t too sensitive to tightening, said David Ng, a property analyst at Macquarie Group.

©2018 Bloomberg L.P.