Is the HKD peg safe? How could HIBOR move from here?

July 26, 2022 12:29
Photo: Reuters

The Hong Kong Dollar has been hovering over the weak end of its band recently, sparking concerns and questions regarding the viability of the peg to the U.S. Dollar. We don’t think the peg is at risk – not now and not any time in the near future. However, to maintain the peg, interest rates could continue to rise uncomfortably high. Compared with 2016-18, a more hawkish Fed and subdued growth in China may lead to higher capital outflows from Hong Kong, keeping USD/HKD near 7.85 and quickly lifting HIBOR in the next 2-3 months. This would benefit banks but weigh on property.

The Hong Kong dollar initially started to depreciate from 7.75 levels (the stronger side of its trading band) in 2021 when Hong Kong-listed equities saw outflows due to regulatory risks, before weakening recently and touching 7.85 (the weaker side of the band) on multiple occasions. The Hong Kong Monetary Authority (HKMA) began to intervene in May and have cumulatively bought around HKD 18 billion from the market. However, the currency pair continued to hover around 7.85 and outflows persisted. Given the challenging growth outlook for Hong Kong and mainland China, some investors have started to worry that the HKD peg is at risk.

The peg is not at risk

The exchange rate mechanism that pegs the Hong Kong Dollar to the U.S. Dollar is operated through a “currency board.” The main features of the system are that the Hong Kong Monetary Authority (HKMA) must follow U.S. monetary policy and must maintain foreign exchange (FX) reserves equal to or greater than existing money supply. Therefore, under a well-managed system every HKD banknote should be able to be exchanged into USD. Additionally, the HKMA cannot set discretionary monetary policy.

So how does it work? If HKD liquidity drains due to outflows, the money supply contracts and interest rates (HIBOR) naturally rise. This attracts money back to the system, creating a natural balance between interest rates, the exchange rate, and money supply.

The stability of the exchange rate is maintained through an automatic interest rate adjustments, where interest rates – rather than the exchange rate – adjust to the inflow or outflow of capital. The drawbacks of this system is that the HKMA cannot implement independent monetary policies, they cannot set interest rates, and they cannot expand or contract their balance sheet to reflect local conditions.

For illustration, the below chart shows the ratio of foreign reserves kept by the HKMA that are designated to defend the peg – namely the backing assets – for Hong Kong’s monetary base. While the ratio fell from a peak during 2020 as the growth of the monetary base amid Covid relief easing outpaced the growth of foreign reserves, it continues to stand comfortably over 100%.

We see Hibor meaningfully rising from here

Given the necessary linkages to U.S. monetary policy, HIBOR is set to rise at a time when the economy does not need higher rates, and it could rise sharply in coming months. The peg mechanism is the key driver. As mentioned above, interest rates adjust according to flows – when HKD liquidity drains due to outflows, Hibor will automatically go up to attract money back. This is already happening.

Hibor started to pick up in parallel with USD rates since the first Fed hike in March. However, the rise has been too slow to catch up to the rapid increase in U.S. yields due to the jump in aggregate balances amid very easy monetary conditions over the past two years, and as a result, rate differentials have remained negative.

Compared with previous Fed tightening cycles, we see a more challenging backdrop this time, given: 1) a much more hawkish Fed; and 2) China's slower growth momentum. Capital outflow pressures could thus be more intense compared with the last Fed hike cycle. We expect outflows to drive down the aggregate balance to below HKD 100 billion (vs HKD 330 billion now), potentially in August as the Fed already raised rates by 75bps in the June FOMC meeting and is poised to deliver at least 75 bps hikes at the July FOMC meeting this week. These drivers will likely eventually drain liquidity in the system and send Hibor rates sharply higher.

It would make sense to expect narrowing of USD-HKD yield differentials in 2nd half of 2022. The current spread between Fed fund rate and overnight HIBOR at 79bps seems unsustainable. Historical experience suggests that the spread between the fed fund rate and HIBOR tends to narrow significantly when aggregate balance falls below HKD 100 billion.

It is a bad time for higher interest rates, as Hong Kong’s macro environment remains challenging. The economy contracted 4% yoy in Q1, as recurring Covid restrictions heavily disrupted consumption, compounding the drag from missing inbound tourism. Growth has been bumpy for a few years. The economy printed negative growth in both 2019 and 2020. The rebound in 2021 was strong thanks to generous fiscal easing and strong exports, but was again disrupted by lockdowns earlier this year. While demand could recover as the economy reopens and a new round of cash handouts get delivered, the negative outlook of external demand, and a closed border with China, pose continued risks to growth. With tighter financial conditions going forward, a rebound in Q3 could be weaker than in 2021.

Investment implications

USD/HKD will likely continue to trade near the weak side of the band (i.e. 7.85) in the near term. We think the LIBOR-HIBOR differential will close more materially in the coming months, once liquidity starts to drain.

While the composition of the local stock market is not particularly reflective of the domestic economy, there are some segments that could see a more direct impact from higher interest rates. For example, Hong Kong banks could be a key beneficiary amid interest rate hikes, as net interest margin (NIM) has proven to be highly correlated with HIBOR and LIBOR over the past 10 years. The NIM sensitivity at HK banks is expected to be greater in the coming cycles than previous times, due to record high CASA ratios (i.e., the ratio of deposits in current and saving accounts to total deposits). We expect the underlying margin trend to improve in the coming quarters, driven by higher deposit spreads. Hong Kong developers could face headwinds amid rising interest rates. In addition to slower GDP growth, affordability for homebuyers would be impacted by higher mortgage rates, leading to a decrease in transaction volume in the property market, and potential weakness in housing prices.

From a cross-asset perspective we continue to advocate for adding to core fixed income. Although yields have come down, in our view expected returns in a soft landing scenario are on par with equities, and in a recession scenario are likely to beat equities. From a risk adjusted perspective core fixed income (corporate investment grade and U.S. Treasuries) remains our highest conviction call. Equities are pricing in about 60-70% of an average recession, so there’s certainly some pain already in the price, but we see continued downside risk to earnings and still above average positioning in equities.

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Asia Head of Investments Strategy, J.P. Morgan Private Bank