Hong Kong has all but abandoned the dollar peg

Shuli Ren, Bloomberg

Interest rates in Hong Kong have been eerily low, raising the question of whether the city’s dollar peg is now in name only.

Hong Kong surrendered its monetary autonomy decades ago, thanks to a unique mechanism that restricts its currency fluctuation to a narrow band of 7.75 and 7.85 per dollar. That means the city’s borrowing costs move in lockstep with those in the US, which are dictated by the Federal Reserve’s rate policies.

Lately, though, currency traders have been staring at an anomaly. The one-month Hong Kong interbank offered rate, or Hibor, has collapsed since early May. The gap with the US secured overnight financing rate, or SOFR, is at an unprecedented level of more than three percentage points. Investors are now asking what caused this divergence and whether Hibor will stay lower for longer.

The first part of the story is well understood. Last month, the Hong Kong Monetary Authority purchased the greenback amid a global dollar rout to prevent its currency from strengthening beyond 7.75. HKMA’s balance sheet ballooned while a flood of new local money pushed down Hibor.

But such glaring bifurcation from SOFR should only be temporary. When local funding costs are significantly lower, traders can borrow Hong Kong dollars and sell them against the higher-yielding US counterpart. This, in turn, will lift the city’s currency and rates over time.

The fact that this rate gap has not narrowed shows there’s little appetite to earn dollar carry trades. Wall Street banks are reinforcing their calls that the dollar will weaken further. In addition, there’s talk of an Asian Financial Crisis in reverse, marked by a violent rally in local currencies such as the one Taiwan witnessed in early May. What if HKMA all of a sudden decides to move the currency peg to a stronger range? Gains from the carry trade would be instantly wiped out.

Investors are right not to lose sight of the big picture. After all, Taiwan dollar’s 8% melt-up last month proved painful for under-hedged insurers and exporters.

On an economic level, this trend can be a huge boon for a financial hub that is trying to regain its footing. In recent years, businesses have complained about the dollar peg, saying that Fed rate hikes unnecessarily tightened the city’s financial conditions and hamstrung its economic recovery.

Hong Kong’s anemic residential real estate, for one, could see a rebound if the current trend continues. The prevailing new mortgage rate would be only 2.1%, versus 3.5% in early May. For a 30-year loan with a 70% loan-to-value ratio, monthly payments could be cut by about 15%, according to Bloomberg Intelligence. The value of underwater mortgages would fall as well.

A persistent rate gap reveals two things: First, the “Sell America” trade is real. Second, the city has practically moved on from a waning reserve currency, tearing itself from an interest rate trajectory mapped out by central bankers thousands of miles away. This peg is too archaic.

Courtesy Bloomberg/Shuli Ren