The Linked Exchange Rate System (LERS) – introduced in 1983 to maintain “a stable exchange value of the currency of Hong Kong” through an official peg to the US dollar – has come under public scrutiny as the Hong Kong dollar weakened to a four-year low against the US dollar in what became the biggest intra-day loss since October 2003. Despite market speculations on a potential de-peg, it is no cause for concern, according to the Hong Kong Monetary Authority
By Kenny Lau
The Hong Kong dollar, unlike the currency of most other developed economies, is rarely under the spotlight of the international foreign exchange markets. That’s because it is relatively free from sharp market swings as a result of a peg to the US dollar at the rate of HK$7.80 to US$1. The Linked Exchange Rate System (LERS), modified in 2005 allowing Hong Kong’s local currency to trade between HK$7.75 and HK$7.85 for every US dollar, has been instrumental in maintaining “a stable exchange value of the currency of Hong Kong” since 1983.
The big news recently, tough, is that the Hong Kong dollar has depreciated by the largest amount within the price band in more than 10 years, dropping “as much as 0.29 percent – its biggest intra-day loss since October 2003 – to a four-year low of HK$7.7817 versus the US dollar in Asian trading on [January 14],” as reported by Bloomberg. “Options prices indicate there’s a 29 percent chance the currency will weaken beyond its permitted trading range of HK$7.75-HK$7.85 by the end of this
year, up from 9.5 percent on Dec 31.”
While the exchange rate hasn’t reached the limits of LERS, market volatility, once again, has reignited the debate on the merit of the currency peg at a time of massive capital outflows in a shaky global market. Some have compared the current financial turbulence with the Asian financial crisis of 1997/98, and others have speculated that Hong Kong would put an end to the 32-year-old currency peg. Regardless of the causes for concern and anxiety, Hong Kong’s monetary base – backed with US dollars in reserve – is far stronger than it has ever been.
One key reason for the “sudden and rapid slide” of the Hong Kong dollar against the US dollar: market capital are always attracted to higher yields, and in this case have moved towards US-denominated assets amid a stronger US dollar following a hike in US interest rates in December (although less so after a cautious outlook by the US Fed in mid-February about further hikes for 2016). It is a case in which Hong Kong dollars are sold in exchange for other forms of asset – be it another currency or funds – in hope of a better return on investment.
This is a normal and unavoidable phenomenon, according to Norman Chan, Chief Executive of the Hong Kong Monetary Authority (HKMA), Hong Kong’s de facto central bank. “The US rate hike last December kick-started the process of interest rate normalization. There have been some outflows from the Hong Kong dollar, driving up Hong Kong dollar interbank rates and narrowing the spreads between Hong Kong dollar and US dollar interest rates.”
“However, we believe that the pace of further US rate hikes should be gradual,” Chan says in a statement released in early February explaining the inner workings of the HK-US dollar peg. “With fund outflows from Hong Kong, we should be prepared that the Hong Kong dollar will eventually weaken to 7.85, the weak-side Convertibility Undertaking.”
According to the automatic adjustment mechanism of the currency board arrangement, HKMA will buy Hong Kong dollars from and sell US dollars to banks whenever the Hong Kong dollar weakens. It is to keep the Hong Kong dollar exchange rate within the convertibility zone of 7.75-7.85, but it also leads to a contraction in Hong Kong’s monetary base and an increase in the Hong Kong dollar interest rates.
“[Despite] worries about the stability of Hong Kong’s financial systems…there are no causes for anxiety as our financial systems now are way more robust,” Chan reassures. “[With] a sizable monetary base – some US$130 billion have flown into the Hong Kong dollar since 2008, with the monetary base now standing at HK$1.6 trillion – we have large buffer to withstand outflows. Therefore, we believe that adjustments in local interbank rates should not be too rapid.”
Locally, a forecast of a slowdown in economic growth, moderation in credit expansion of banks with signs of deterioration in their asset quality, uncertainties in the property market and volatility in the financial markets are also contributing factors driving down the demand for the Hong Kong dollar, Chan points out. “Compounded by the easing growth rate of the Mainland China economy and weakening Renminbi exchange rate, some investors turned bearish on the prospects of the Mainland and Hong Kong economies.”
In the financial market, a security, a commodity or a currency has a price tag based on a “spot” rate and a “forward” rate – a spot rate is the current price at the moment for the purpose of immediate settlement, and a forward rate refers to the price agreed upon between parties for future transactions at a later time. The two rates can be different from one another at a given time, and they widen or narrow based on market sentiments, indicating the current and future demand of a particular financial asset.
Under the arrangements of LERS, the strong-side and weak-side Convertibility Undertakings (which together form upper and lower limits of fluctuation of the Hong Kong dollar relative to the US dollar) are only applicable to the Hong Kong dollar “spot” exchange rate. The “forward” exchange rate, on the other hand, mainly reflects the demand and supply of Hong Kong dollar in the forward market, explains Howard Lee, Executive Director (Monetary Management) of HKMA.
Likewise, as the Hong Kong dollar “forward” exchange rate has weakened to below 7.85 while trades in Hong Kong dollar options have increased significantly, there are questions whether market speculators have essentially forced the Hong Kong dollar to de-peg. The answer is: the weakening of the Hong Kong dollar forward rate does not mean the market is speculating on an imminent de-peg of the Hong Kong dollar with the US dollar, Lee points out.
“More investors have recently hedged the currency exposures for their Hong Kong equity portfolios, leading to an increase in supply of Hong Kong dollars in the forward market and putting downward pressures on the Hong Kong dollar forward rate. As liquidity in the forward market is lower, the price is more volatile,” he says. “Similarly, the increase in turnover in the Hong Kong dollar foreign exchange options is also caused by the increase in hedging activities.”
As a matter of fact, volatility of the Hong Kong dollar forward exchange rate has always been greater than that of the spot exchange rate since LERS was implemented more than three decades ago, Lee stresses. “While the forward rate traded beyond the prevailing convertibility undertaking rate from time to time, it had not affected the stability of the spot rate. We should not read too much into the fluctuations in the Hong Kong dollar forward exchange rate.”
The ripple effect
With the rise of the Hong Kong Inter-bank Offered Rates (HIBORs), which are interest rates charged on lending between banks and are closely correlated with interest rates at the retail level, consumers are now more concerned that banks will raise interest rates on their existing loans imminently. However, an increase in local interest rates, if any, will depend on the timing, speed and size of fund outflows.
“Recently, HKD HIBORs have risen slightly, but they remain at relatively low levels. The rises were largely driven by market expectations,” Lee points out. “Banks, in determining their deposit and lending rates, will take into account other factors affecting their funding cost such as changes in deposits and loan demand, in addition to interbank interest rates.”
Although the Hong Kong dollar interbank rates have risen to a seven-year high, they have been rising from near-zero levels. The one-month and three-month HIBORs as of late January are at 0.4 percent and 0.7 percent, respectively. Any increase is not expected to be as drastic as what happened during the 1997/98 Asian financial crisis even if HIBORs in Hong Kong dollar continue to rise due to outflows of funds.
This is largely because of Hong Kong’s current monetary base of over HK$1 trillion, of which the aggregate balance accounts for HK$390 billion, much higher than the level of only several billion Hong Kong dollars in 1997/98, Lee notes. And it will be very difficult for speculators to “squeeze” interest rates higher by betting against the currency.
Moreover, banks in Hong Kong have had access to overnight liquidity in Hong Kong dollar since 1998 through repurchase transactions using their holdings of Exchange Fund Bills and Notes (EFBNs) in what’s known as the “Discount Window.” The Exchange Fund is a vehicle managed by HKMA to “provide full backing to the Monetary Base as required under the Currency Board arrangements…by holding highly liquid US dollar denominated assets.”
The amount of outstanding EFBNs at the moment is about HK$850 billion – and banks are holders of a large majority of it. In effect, banks in Hong Kong – which are already stress-tested regularly on their ability to manage liquidity risks and to deal with outflows of funds – can easily swap between the Hong Kong and US dollars for the purpose of liquidity management. Hence, the ability of local banks to “dampen excessive volatility in interest rates” is greatly enhanced.
Could the recent fall of the local currency be a result of market manipulation similar to the massive “short” positions taken against the Hong Kong dollar during the Asian financial crisis in 1997/98? Was it a repeat of the infamous double-play attack in which “speculators shorted stocks and Hang Seng Index futures and then short-sold Hong Kong dollar to push up interest rates, with a view to creating panic in the market such that they could make huge profits from their short positions in stocks/index futures and the Hong Kong dollar?”
Not likely, according to Lee. “The recent [simultaneous] decline of the Hong Kong dollar exchange rate and Hong Kong equities was a result of some investors reducing their Hong Kong equity holdings on the back of their bearish sentiment towards the prospects of the Hong Kong and Mainland economies and converting [their] Hong Kong dollar proceeds into US dollar. This caused the Hong Kong dollar exchange rate and Hong Kong equity prices to decline at the same time.”
While market speculative interests in the Hong Kong dollar are always a possibility, they are also a much more difficult proposition to apprehend today than in previous years, simply because the aggregate balance of Hong Kong’s monetary base and the local banking sector as well as foreign assets of the Exchange Fund have grown exponentially since 1997, Chan explains. “Speculators will have to mobilize hundreds of billions of Hong Kong dollars to short-sell the Hong Kong dollar in order to push up interest rates.”
“Technically, speculators shortselling the Hong Kong dollar will have to take huge short positions in the Hong Kong dollar forward market. However, the forward market is thin,” he says. “If speculators were to make drastic moves in the forward market, the Hong Kong dollar forward exchange rate would drop quickly due to scanty trades, driving up the cost of short-selling. As such operation is not discreet, coupled with the escalating costs involved, it can rarely be successful.”
Hong Kong’s banking sector is also “robust,” with abundant liquidity and its overall capital adequacy ratio exceeding international standards, and is therefore much more able to withstand market volatility as some seven rounds of counter-cyclical and other prudential measures have been put in place since 2009 by HKMA, Chan notes. “Banks are less likely to lend large amount of Hong Kong dollar funds to speculators” as a result of financial reforms and tightening supervision, including Basel III, following the financial crisis of 2008.
The financial standings of Hong Kong are indeed very different in 2016 from where they were 20 years ago: foreign reserves totaling some US$360 billion now vs US$70-90 billion in 1998; a monetary base of about HK$1.6 trillion now vs HK$190 billion in the late 1990s. The price-to-earnings ratio of the Hong Kong stock market, moreover, is only eight times today as opposed to 19 times in 1997, thereby limiting the scope of profiting from short-selling Hong Kong stocks or
“There are always scaremongers spreading anxiety, pessimism and even panic whenever markets rattle. They do this in order to make gains during a market downturn,” Chan cautions. “Vigilance is one thing, but panicking is another. And we must get a full grasp of the situation and stay calm, especially when referring to the Linked Exchange Rate System. HKMA’s determination and ability to maintain the System are beyond doubt.”