June 14, 2017 10:00 pm JST

Hong Kong dollar weakens on Fed tightening, strong liquidity

Currency slips below mid-point of the peg with the greenback

JOYCE HO, Nikkei staff writer

Banks gather at the financial district in central Hong Kong. (Photo by Nozomu Ogawa)

HONG KONG - The Hong Kong dollar is hovering in the bottom half of its pegged range to the U.S. dollar, marking the first time that the currency has breached 7.8 to the greenback since January 2016 when the yuan was devalued.

The Hong Kong dollar is pegged at 7.75-7.85 to the dollar. Its weakening is widely attributed to expectations that the U.S. Federal Reserve will raise interest rates while local banks are flush with liquidity, partly driven by strong inflows from the mainland. Together, those forces have torn wider the interest rate spread between the two currencies since January this year.

Wall Street is expecting the Fed to lift its key benchmark rates by 25 basis points to a target range of 1%-1.25% from 0.75%-1% after a 2-day meeting ends Wednesday. Analysts are also expecting at least one more hike this year.

The Hong Kong dollar has been pegged to the U.S. dollar since 1983. In the 9 years before that, the currency was freely traded and discussions between Beijing and London over the future of the then British colony after its 1997 handover to China had triggered a confidence crisis that led to a sharp depreciation of the Hong Kong dollar.

The current currency board arrangement was the result of a revision of the linked exchange rate system in 2005, when repeated episodes of capital inflows, driven by weakness of the U.S. dollar as well as market speculations about a revaluation of the yuan, had pushed up the Hong Kong dollar significantly.

Hong Kong Monetary Authority, the city's de facto central bank, maintains the peg by influencing domestic money supply mechanically whenever the currency hits the margins of the convertibility zone.

To prevent a surge in capital outflow, it also seeks to match the city's lending rate in lockstep with the Fed's. The base rate, now at 1.25%, was upped in December and March following similar moves in the U.S.

Yet the lift-off has yet to be absorbed into the interbank market. The 1-week Hong Kong dollar interest settlement rates have edged lower persistently since the beginning of the year when it was quoted at 0.61929, versus 0.19729 on June 14.

Flush with cash

"The underlying [reason] has to do with a lot of liquidity in the banking system," said Christy Tan, head of markets strategy and research for Asia at National Australia Bank. "The base rate will reflect the hike in Fed funds rates quite immediately; [but] the interbank rate could well be more driven by liquidity and that may track the Fed hike or the base rate hike in a lagging manner."

The anomaly was reflected in the city's mortgage rates. In spite of a heated property market, they had been falling steadily from the end of 2015 until last month, when the HKMA stepped up capital requirements for banks extending mortgage loans.

Tan suggested that liquidity was partly supported by a buoyant local stock market, which has returned 17.51% year-to-date. Investments from the mainland through the stock-connect scheme were significant due to strong expectation for the yuan to depreciate against the U.S. dollar. The average daily turnover for southbound trading via the Shanghai-Hong Kong link jumped by 1.5 times on the year to HK$6 billion during the first quarter.

"There are definitely more inflows in the last month or so into the Hong Kong equity market, and that could well be keeping rates quite low," said Tan.

Hong Kong's monetary base stood at $1.66 trillion as of Wednesday, up 1.32% from the end of last year, HKMA data show.

The closing-in of the dividend season also prompted more liquidity to flow into Hong Kong, according to Eddie Cheung, foreign exchange strategist at Standard Chartered Bank. "A lot of companies need to bring money back to Hong Kong for dividend distribution between May to July. That also explains the low [Hong Kong dollar] rate and rich liquidity," said Cheung.

Given the influence of U.S. and mainland economies on Hong Kong, he saw a strong basis for the local currency to be on the weak side of the peg this year. "If China's economy expands steadily while the U.S. continues along the rate hike trajectory, it's not hard for the Hong Kong dollar to hit 7.8," said Cheung. The tension created by the two opposing forces will further widen the rate differential, he said.

In China's shadow

But he believed liquidity could tighten should China's economic data surprise the market on the downside. "We believe China's economic data might have probably peak out in the first quarter, eclipsing the rest of the year," said Cheung, "It's natural for China's economic growth to slow down amid the ongoing deleveraging process."

Although Hong Kong's economy and financial markets are increasingly interlinked with the mainland, the currency peg should remain in place, said Cheung, dismissing views that the yuan should also be included in Hong Kong's exchange rate regime.

"Hong Kong is still closely tied to the U.S. economically," said Cheung, adding that the Basic Law, or Hong Kong's constitution, had stipulated that the local currency could only be pegged with a freely convertible currency, a requirement that the yuan has yet to meet.

The People's Bank of China revised the yuan's fixing mechanism in late May by introducing the so-called "counter-cyclical factor" into the calculation of the yuan's daily reference rate, which is now measured against a trade-weighted basket of currencies.

The move followed another unannounced revision in February, which shortened the reference period of yuan trading against its trade-weighted basket to 15 hours from 24 hours previously, according to a report by Reuters.

Although the new fixing element came across as "opaque" to many market participants, Cheung said it is "not necessarily bad for the yuan's internationalization" if it could help stabilize the currency.

But Cliff Tan, East Asian head of global markets research at the Bank of Tokyo-Mitsubishi UFJ, criticized the move as a "domestication" of the yuan.

"The new fixing mechanism actually greatly increases the importance of the Shanghai trading hours in the determination of every day's fix," said Tan. "In a nutshell, what China did was to say 'We don't want traders in London and we don't want traders in New York to move around our yuan in a way that makes us uncomfortable the following day.' Even though they have very lofty ambitions for the [yuan] as a global currency. In practice, they are actually going the other direction."

He also said that the countercyclical measure would make the yuan fixing more difficult to forecast over time. "If it's much more difficult to forecast the fix, it means that the [yuan] will be much more difficult to hedge. If it's much more difficult to hedge, then it's attractiveness as a global currency will go down," said Tan.

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