What’s Pulling at the Hong Kong Dollar’s Peg

(Bloomberg) -- Pegged to the U.S. dollar since 1983, the Hong Kong dollar is usually a dull currency. Except when it isn’t. While its trading band of HK$7.75 to HK$7.85 per U.S. dollar, set in 2005, has never been broken, it keeps getting tested. That forces the Hong Kong Monetary Authority, the de-facto central bank, to follow its mandate and intervene, raising questions about how long this can continue and the implications for Hong Kong’s wider economy.

1. What moves the Hong Kong dollar these days?

Often it’s interest rates, especially when local ones don’t move in tandem with the U.S. For example, when interbank rates on the Hong Kong dollar -- known as Hibor -- remain elevated as the Federal Reserve reduces borrowing costs, it becomes more attractive for investors to buy the Hong Kong currency against the greenback. The gap between Hibor and the U.S. currency’s Libor has been around the widest since 1999 since March, helping to push the Hong Kong dollar to HK$7.75 for the first time since early 2016. That prompted the HKMA in April to sell the city’s dollars to prevent a break of the peg.

2. Why are Hong Kong rates so high?

It’s because of tight liquidity. The HKMA bought the Hong Kong dollar in 2018 and 2019, when the popular carry trade used to be shorting the local currency against the higher-yielding greenback. The operations helped shrink the aggregate balance -- an indicator of interbank cash pool -- by 70% to the lowest level since the global financial crisis. That coincides with an increase in lenders’ loan-to-deposit ratio, leaving banks with even less money on their hands. That’s why Hong Kong’s Hibor can’t fall as quickly as the U.S. interest rates even though the city essentially imports the Fed’s monetary policy. The tighter liquidity also amplifies the volatility in interest rates, leading to dramatic spikes in borrowing costs when one-off factors, such as initial public offerings, lock up a large sum of funds.

3. Should we be worried about the peg?

No. One thing about intervention from the HKMA is that it often moves Hibor in the opposite direction. When it sells the Hong Kong dollar on the strong end of the band, the operation boosts liquidity in the financial system and lowers borrowing costs. That in turn makes the long-Hong Kong dollar carry trade less appealing for speculators. Authorities also have enough liquidity to act, with more than $430 billion of foreign reserves. There’s also another HK$1 trillion ($129 billion) of exchange fund bills outstanding, which are debt issued by the HKMA, so they could inject cash by allowing that debt to mature or reduce planned issuance. The HKMA can also expand its balance sheet by printing local currency. What could complicate matters would be a repeat of the massive speculative attack on the currency seen during the Asian financial crisis in 1997. Even then, the central bank prevailed. And of course Hong Kong has a special connection with China, which has the world’s largest foreign-exchange reserves at more than $3 trillion.

4. What are the costs of the intervention?

The HKMA may have to print money if intervention fails to bring down borrowing costs and the long-Hong Kong dollar strategy remains popular. In that case, the city risks seeing “flooding liquidity,” which could lead to higher asset prices due to inflationary pressures, according to Ken Cheung, chief Asian foreign-exchange strategist at Mizuho Bank Ltd. Then, the HKMA may need to sell exchange fund bills to withdraw cash supply, with itself shouldering the financing costs.

5. Why doesn’t Hong Kong mirror the Fed?

In many ways it does. Every time the Fed changes its benchmark rate, the HKMA adjusts its base rate, but with little effect. That’s because the base rate -- the one at which the authorities offer overnight funds to banks -- is higher than short-term Hibor even after two reductions in March. So it’s hardly relevant when lenders are able to find cheaper funding in the interbank market. The HKMA’s most recent cut to the base rate in March was 64 basis points, compared with a reduction of 100 basis points by the Fed.

6. How long will this last?

Analysts say it could last through the second quarter. The HKMA’s intervention barely nudged Hibor, with its premium over the U.S. Libor remaining wide at around 100 basis points in late April, and the Hong Kong dollar still trading near HK$7.75. This suggests the long carry trade is still appealing. The policy makers have to boost the aggregate balance to as high as HK$150 billion, a level unseen since 2018, before the interest rates fall low enough to chill the carry trade, analysts say. The gauge stood at HK$63.9 billion as of April 23.

7. Why does keeping the peg matter?

First and foremost, the currency peg is considered an anchor for financial stability and the economy. Investors park their money in Hong Kong because the currency is relatively safe. At the same time, the city’s property market, one of the world’s most expensive, is showing signs of cooling off with high borrowing costs and concerns over economic growth. A double blow of months-long anti-government protests and the coronavirus pandemic has Hong Kong’s economy bracing for another year of recession. So the potential chaos that breaking the foreign-exchange peg would bring is probably the last thing policy makers would want to see.

The Reference Shelf

• A story about HKMA’s intervention on the strong side of the band.
• Learn about how tight liquidity magnifies moves in the Hong Kong dollar.
• Bloomberg’s Fion Li recalls the peg turning 30.
• Bloomberg Opinion’s Nisha Gopalan on Hong Kong as the canary economy.

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