The surprising strength of HKD – Implications for interest rates
Economic weakness, domestic unrest and concerns about the implications of the new national security laws (NSL), as well as potential US retaliation, all suggest HKD should be trading on the weak side of convertibility – as it did for most of 2019. In reality, the HKD has been trading on the strong side of its convertibility since late March (Fig 1), while the Hong Kong Monetary Authority (HKMA) has actually intervened on several occasions (Fig 2) to weaken the currency. Several factors account for this surprising reversal of fortune for the “Honkie”.
Hibor-Libor spreads: Balancing mechanism
Hibor-Libor spreads (Fig 3) started widening in mid-2019, hitting a record wide of 113bps (3-month tenor) in May 2020. Under Hong Kong’s Linked Exchange Rate System (LERS), the interest rate differential is the primary balancing mechanism for the currency – so this gradual widening already encapsulated investor concerns regarding the protests, economic slowdown and proposed NSL. With the US Federal Reserve recently slashing base rates back to their record low of 0.25%, US Libor sank to a 5-year low, triggering a global hunt for yield. The 100bps pickup on Hibor prompted renewed interest in the “carry trade”, attracting capital inflows to HKD, helping the currency strengthen. The Hibor-Libor gap has subsequently narrowed, reducing the appeal of this arbitrage opportunity, but it remains relatively attractive.
IPO demand: Returning home
The heightened US-China political tensions have impacted equity markets, with many Chinese companies unwilling to risk a US initial public offering (IPO), while companies already listed on US exchanges face the risk of delisting. These companies are pivoting to a Hong Kong Stock Exchange listing to raise funds and have the insurance of a secondary listing. Several blockbuster IPO’s for major Chinese companies have attracted large capital inflows into the city – which also supports the HKD.
Impact on HKD and HKMA actions:
As demand for HKD sky-rockets, the currency has breached the strong side of its convertibility versus the USD on multiple occasions, requiring the HKMA to intervene the spot foreign exchange (FX) markets buying USD and selling HKD to protect the peg. Since April, the HKMA has sold a total of HK$52bn (US$7bn), increasing the aggregate balance by 133% to two-year high of HK$126bn.
While the aggregate balance has increased sharply, it is still well below historic levels (Fig 5), increasing the risk of tight liquidity conditions and volatile interest rates. In contrast, the Hong Kong monetary base has continued to increase – recently reached a record high at HKD 1,737bn (Fig 6) - mainly via the issuance of Exchange Fund Notes and Bills (EFBNs), which represented 63% of the total. To correct this imbalance, the HKMA has further proposed reducing the size of some EFBN issuance to increase the interbank market liquidity.
HKD risks: Still lingering
China-US tensions remain a risk, with concerns focused on the potential for US actions under the United States – Hong Kong Policy Act of 1992. Critical among these is Hong Kong’s ability to access funding markets and avoid capital flight. While the US is highly unlikely to imperil the city’s ability to access USD markets, capital flight remains a worry until the new NSL are published and their implications clarified.
Fortunately, the HKMA remains committed to the peg and HK’s monetary base is fully backed (112%) by a portfolio of highly liquid USD assets while Hong Kong’s investment portfolio takes support for the monetary base to over 200% - more than adequate to assuage investor concerns. Finally, while Hon g Kong remains a gateway to China, banks and investors are unlikely to reduce support for the HKD.
Interest rate and market outlook
Despite the multiple HKMA interventions, the HKD continues to trade very close to the strong side of convertibility, suggesting further central bank actions may be required. Meanwhile, Hibor-Libor spreads remain wide relatively to historical levels – with local rates attractive in a zero yield world. In addition, further IPOs will keep future demand for HKD robust. All these factors imply that Hibor rates will continue to decline while HKD volatility will persist.