What happens when Hong Kong’s Aggregate Balance hits zero?
Since February this year, the Hong Kong Dollar (HK$) has hit the weak side of its convertibility versus the US Dollar (US$) on multiple occasions. This has necessitated ongoing foreign exchange intervention by the Hong Kong Monetary Authority (HKMA) to support the HK$. The subsequent rapid decline of the Aggregate Balance poses potentially significant implications for market volatility and HK$ cash investors.
Figure 1: Hong Kong’s Aggregate Balance has declined to a fifteen-year low while its monetary base has grown significantly over the same period
We have been here before
The Aggregate Balance represents the total clearing account balances that commercial banks keep with the HKMA. With Hong Kong’s de-facto central bank purchasing HK$51.5bn (equivalent to selling US$6.6bn) since February this year to support the currency, the Aggregate Balance has declined to HK$44.8bn1, the lowest level since 2008 (Fig 1a) – magnifying investor and market concerns. However, this only represents a small portion of the Hong Kong’s monetary base (Fig 1b), which also includes certificate of indebtedness, notes and coins in circulation, and the Exchange Fund Bills and Notes (EFBNs); all of which help ensure the smooth operation and settlement of financial transactions in the city.
In addition, the Aggregate Balance has historically operated at a near zero level for multiple periods between 1999-2000 and 2004-2005; with the most recent period of large balances driven by unusual conditions such as the recent zero interest rate environment and a divergence in US-China economic growth. Although these periods are not directly comparable given the Linked Exchange Rate System (LERS) reforms between 1998 to 2005 which impacted the HKD’s trading band2, we still see that during these periods, the LERS still functioned properly and there were no issues with commercial banks’ day-to-day settlement activities. Moreover, if necessary, commercial banks can also use their EFBNs as collateral to obtain liquidity via intraday repo and Discount Window under the HKMA’s settlement facilities.
Figure 2: HIBORs have rebounded significantly since February 2023; compressing the HIBOR-LIBOR gap from the recent record wide levels
History does not always repeat itself
Unlike the previous Federal Reserve (Fed) interest rate hiking cycles, notably between 2015-2019, HK HIBORs have risen slowly, lagging the more rapid upward trajectory of US LIBOR yields (Fig 2a) during this rate hike cycle. The initial, elevated Aggregate Balance (peaking at over HK$462bn in January 2021) generated excess local liquidity and was a key reason for low local yields relative to its US peers. Another factor was the mismatched economic cycles between US, Hong Kong and China – which was further magnified by the Covid outbreak.
While the US economy recovered faster, Hong Kong only re-emerged from recession in the first quarter of 2023 as the city finally removed all its Covid inspired social distancing measures. Since February 2023, HIBOR yields have slowly gained traction, narrowing the 1-month HIBOR-LIBOR spread from a record wide of -246bps to less than -77bps at present (Fig 2b). The continuous compression of the HIBOR-LIBOR spread is likely to reduce the incentive for carry trades, easing the upward pressure on HK$ and lessen concerns about the viability of the currency peg (Fig 3a).
Figure 3: The HK$ has strengthened from the weak side of its convertibility , concurrently the HKMA’s has increased the Base Rate in-line with the Fed Funds Target Rate
We believe the phase of persistently low HK$ interest rates is behind us, and short-term HIBOR rates should continue to trend higher in the medium term with the HIBOR-LIBOR spread to tighten further. This presents opportunity for HK$ cash investors to achieve higher, more competitive yields. Nevertheless, given broad-based expectations that the Fed’s rate hiking cycle is approaching an end – with HKMA’s base rate in lock steps (Fig 3b), we expect interest rate volatility to remain high. Cash investors should consider maintaining a diversified approach across maturities, counterparties and instruments to balance the goal of competitive returns with adequate security and liquidity.