The Peg is not in danger


July 2019

 

Should we short the Hong Kong currency? Hedge fund manager Kyle Bass mentioned that “Hong Kong currently sits atop one of the largest financial time bombs in history"[1]. While the Hong Kong dollar (HKD) has been weakened recently, we believe the possibility of the currency peg to break is unlikely.

To begin with a brief background, a semi-peg system between the HKD and the U.S. dollar (USD) has begun in early 1980s. In 2005, the HKD is allowed to trade within a band of between HK$7.75 and HK$7.85 for USD 1. The Hong Kong Monetary Authority (HKMA), the de-facto central bank of the city, has the responsibility to defend the currency peg through controlling the demand of supply of the HKD. If the HKD hits the end of the trading band at HK$7.85 which means HKD is weaker, the HKMA must intervene and buy HKD to keep it within the agreed exchange rate range.

The peg, although it keeps getting tested, has never been broken. The recent weakness of HKD was due to the rate spread. The U.S. Federal Reserve raised interest rate earlier as the U.S. economy has been strengthening with upward inflation pressure, while Hong Kong’s interest rate hardly picks up as the banks are piled up with cash. The wide interest rate gaps present an arbitrage opportunity between London Inter-bank Offered Rate (LIBOR) and Hong Kong Interbank Offered Rate (HIBOR), attracting carry trade activities to sell HKD for higher-yielding USD. The liquidity tightened further as banks need to hold cash for regular checks and corporates paid dividend approaching the half year-end. If the rate spread continues, there will be pressure for capital outflow. On the contrary, the trade will be less attractive if the spread narrows, as demonstrated by the end of June when the banks in Hong Kong started to raise rates.   

 

The peg is considered an anchor for financial stability. It has a naturally built in self-adjusting mechanism that has gone through many economic cycles over the past 36 years and the HKMA has no intension to change the system. Indeed, the overnight rates jumped to 20% during the Asian financial crisis with housing prices dropped 70%, yet no single bank collapsed, and the peg still hold.   

The HKMA has deep pockets to defend the currency peg. The aggregate balance, or excess reserve referred by Bass, is currently around HK$54 billion [2]. The mechanism is that the aggregate balance has to fall before HIBOR can rise. The local borrowing cost will become more responsive to intervention unless the aggregate balance drops below HK$10 billion, which is close to the level prior to the financial crisis in 2008. If the liquidity gets tighter, the HKMA can ease the funding condition by stop rolling over its Exchange Fund bills to release liquidity back to the market. Not to mention that Hong Kong is always backed by its home country – China has over US$3 trillion foreign-exchange reserves that can inject liquidity to the market if necessary. As of now, banks in Hong Kong maintain healthy cash level, the banking system is not that easy to collapse. 

 

 

The recent extradition bill in Hong Kong has again sparked the discussion of the U.S.-Hong Kong relationship. There is a speculation that the U.S. may stop treating Hong Kong as a separate customs territory as China exploits Hong Kong’s autonomy. We believe that the issue will only be used by the U.S. as bargaining chip in the trade talk, the possibility to revise the U.S. Hong Kong Policy Act is minimal.

Hong Kong still plays a strategic role for its motherland. This city is one of the most important financial centers globally and has a reputation for valuing the rule of law and enjoys high degree of autonomy. Hong Kong is a gateway between Mainland China and the rest of the world. In recent years the Hong Kong stock exchange has become the premier fund-raising venue for Chinese enterprises to attract foreign capital. Although RMB is non-convertible in nature, Hong Kong is the first market to conduct offshore RMB business including currency exchange and remittances, RMB bond issuance, trade settlement and other related services.

 

Reference: 

[1] Bass, Kyle Bass. (2019, April 22). The Quiet Panic in Hong Kong. Retrieved from https://www.centerforsecuritypolicy.org/wp-content/uploads/2019/04/The-Quiet-Panic-in-Hong-Kong-April-2019.pdf?fbclid=IwAR3JuuwcsJoOSd6DBpbCvO3eT9hRJq55XWmDWqzKA2q8p3q_NetGKPcDGWE

[2] Bloomberg (2019, June 28)

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