HKSAR seen draining liquidity with currency near ‘84 low

Hong Kong’s central bank will probably take steps to tighten liquidity in the financial system, a survey of analysts showed, as the city’s currency approaches the weak end of its peg against the greenback. The authority denied having any such plans for now.

The Hong Kong Monetary Authority will offer extra Exchange Fund Bills this year, according to 15 of 19 analysts surveyed by Bloomberg from March 2 to 6, although not all agreed currency weakness would be a factor in the sales. Twelve respondents said the exchange rate will breach the weak end of its HKD7.75-7.85 band for the first time since it was imposed in 2005. HKMA Chief Executive Norman Chan said on Thursday afternoon the city is capable of coping with fund outflows and will ensure the exchange rate doesn’t weaken beyond its band.

As a global financial center with open capital borders and a currency peg, Hong Kong has limited options when it comes to controlling liquidity — which is currently plentiful. Extra bill sales may help slow the local dollar’s drop, but they risk undermining a monetary system in which the HKMA is not supposed to target interest rates. Once the currency reaches the limit of the band, the HKMA will be forced to buy Hong Kong dollars, thereby shrinking the monetary base and effectively raising rates.

“HKMA will act preemptively before HKD hits the 7.85 level,” said Christy Tan, Singapore-based head of Asia markets strategy at National Australia Bank Ltd.

She added that the local currency could breach the HK$7.85 level quickly as it becomes more volatile around the Federal Open Market Committee meeting on March 22 and if local interbank rates known as Hibor remain low. “HKMA may need to spend more to defend the peg system in this circumstance, as speculators may see this as an opportunity to test the peg,” Tan said.

The Hong Kong dollar reversed earlier gains on Thursday, falling as much as 0.06 percent to HK$7.8405. The move came after HKMA’s Chan said in a statement the authority had no plans to sell additional bills for now and it is not true that it doesn’t want to see a weaker exchange rate.

The market has started to show it expects higher rates. One-year interest-rate swaps jumped to the highest intraday level since 2008 on Thursday, while basis swaps – which let holders exchange floating Hibor-based payments with those based on dollar Libor – rose above zero last week for the first time since late 2016. Twelve-month forward points rose to the highest since January on Thursday.

The Hong Kong dollar has fallen 1.1 percent since the end of 2016, near its weakest level since 1984. That trend was interrupted only when monetary officials announced EFB sales totaling HK$80 billion ($10.2 billion) in August and September. Still, gains in rates proved temporary as money flowed into the stock market and liquidity remained flush after massive inflows fueled by global monetary easing. The one-month Hibor is 103 basis points below the U.S. equivalent of Libor, the biggest spread since 2008.

To be sure, the HKMA can sell EFBs regardless of currency moves. It stressed last year that the bill sales weren’t aimed at pushing up rates and only served to meet strong demand. Six of the surveyed analysts who said they expect more of the debt sales indicated the spot rate won’t be a consideration.

Still, selling EFBs now could create the impression that they are aimed at pushing up Hibor and hence the exchange rate. Many analysts say the HKMA prefers using bill sales over being forced to buy local currency when the exchange rate reaches HK$7.85 – which it has not had to do since the band was widened in 2005.

“Mopping up liquidity again and again would put the credibility of the Linked Exchange Rate System in question, which would be risky to the whole financial system,” said Iris Pang, an economist at ING Groep NV in Hong Kong. Justina Lee, Emma Dai, Bloomberg