For most of 2021, before the US Federal Reserve took policy tightening seriously, the Hong Kong dollar depreciated (see Exhibit 1). The depreciation is due to net portfolio outflows: a decline in southward flows from mainland China (China buying Hong Kong stocks) via Stock Connect channels compared to northward flows (Hong Kong-based investors buying onshore Chinese stocks).
Since late 2021, capital outflows have given way to currency carry as the main driver of HKD weakness. Market expectations for aggressive rate hikes from the US Fed pushed interest rate differentials between the US dollar and the HKD higher. The widening USD-HKD spread has created an opportunity for investors to borrow the low-yielding HKD and invest in the relatively high-yielding USD.
Eliminating excess cash will take time
The magnitude of the interest rate differential stems from the abundance of liquidity within Hong Kong’s monetary system. As of April 30, 2022, liquidity stood at 338 billion HKD (43.3 billion USD), a five-year high. The total is more than six times the aggregate balance at the end of 2019, when the HKD peg last came under speculative attack.
The HKD peg (or Linked Exchange-Rate System, LERS, as it is officially called) requires the Hong Kong Monetary Authority (HKMA) to closely monitor the US Federal Reserve’s interest rate movements. However, Hong Kong banks are not bound to follow the trend of US interest rates if there is a large cushion of liquidity in Hong Kong’s monetary system, as there is currently.
If the 2018-19 episode is any guide, and assuming current macroeconomic trends continue, it could take a few more months for Hong Kong’s liquidity to tighten to around HKD 54 billion, the level at which banks in Hong Kong would be forced to raise their interest rate. rate to attract capital. Under this scenario, Hong Kong’s asset markets, particularly real estate, although not currently experiencing any liquidity shortages, could face a liquidity crunch by the end of the summer or the early fall 2022.
HKMA – Fearsome ammunition to defend the currency
Hong Kong has foreign exchange reserves of $482 billion in March 2022, the sixth largest in the world. They make up nearly 200% of Hong Kong’s monetary base, implying that if investors wanted to exchange all their HKD for USD, the HKMA has reserves almost double the amount needed to meet the demand for USD at the rate exchange rate of 7.8 per US dollar. .
During a currency crisis, a country usually suffers from large capital outflows. However, Hong Kong’s foreign exchange reserves are equivalent to 23% of M2, which provides it with an important buffer in the event of a crisis.
The HKD peg has survived numerous capital outflows and speculative attacks since its inception on October 17, 1983. It remains stable like a rock in a storm.
This firmness speaks volumes about the robustness of the LERS, the automatic mechanism used by the HKMA to correct for weakness or strength in the HKD. When the HKD falls/rises on the weak/strong side of the convertibility range, the HKMA buys/sells HKD in the market at 7.85/7.75, as required by the LERS mechanism, resulting in a contraction/ expansion of the aggregate balance.
The resulting tight HKD liquidity pushes HIBOR higher, narrowing the gap with USD interest rates, reducing capital outflows and stabilizing the HKD exchange rate as required by the fund rule resignation. Therefore, during speculative attacks or periods of large capital outflows, HIBOR usually rises significantly. For example, during the Asian financial crisis, the 3-month HIBOR soared to 15.7% in August 1998, more than 1,000 basis points above USD LIBOR.
No change in sight
Despite the significant integration of economic and financial markets with mainland China, we believe that the time has not yet come to peg the convertible HKD to the renminbi (which is inconvertible on the capital account). Until China significantly liberalizes its capital account, it makes sense for Hong Kong to keep the currency pegged to the dollar by anchoring Hong Kong’s monetary policy to a global hard currency managed by a historically credible and transparent Federal Reserve.
The ability of the HKD-USD peg to weather global economic and financial shocks unscathed, with manageable negative consequences for local markets, highlights the credibility of the LERS.
High interest rates and economic volatility seem a manageable price to pay to anchor international trust and eliminate currency risk in Hong Kong’s small open economy, which is not necessarily influenced by national macroeconomic policy. significant effective.
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