Views On China | Cool the Hong Kong peg fever (again). It’s going nowhere

Rumors of the Hong Kong dollar peg’s impending demise have always been vastly exaggerated. This time is no different.

At 7.8321 to one U.S. dollar, the city’s currency is close to the weak end of a tightly controlled trading band that centers on 7.8, and allows for moves between 7.75 and 7.85. To extrapolate from that mundane fact that the 35-year-old anchor is about to be swept away is wishful (or fearful) thinking. 

For one thing, where’s the crisis of confidence that would force the currency board system to collapse? Yes, the city’s housing prices are bubbly, but with banks like HSBC Holdings Plc paring mortgage rates to as low as 1.25 percentage points over the interbank rate, demand for the world’s least affordable property is still intact.

Something traumatic has to happen for investors to suddenly start believing that the Hong Kong Monetary Authority’s HKD1.8 trillion (USD230 billion) in U.S. dollar assets aren’t enough to back its HKD1.7 trillion in liabilities. And before they translate those beliefs into bearish bets, they have to consider how the monetary authority bled speculators during the 1997-98 Asian financial crisis.  

Why would Hong Kong’s reaction be any less vigorous now? The local currency is weak because a glut of liquidity from mainland China has kept interbank rates relatively low and falling at the same time as expectations for the pace of U.S. monetary tightening increase. The three-month Hong Kong interbank offered rate is at just over 1 percent – half of U.S. dollar Libor. 

It’s worth noting that this situation is unusual. In a currency board system, supply and demand are reflected through changes in interest rates instead of the exchange rate. If U.S. interest rates rise and Hong Kong rates don’t, then traders can make a risk-free profit by borrowing local dollars and investing them in greenbacks (as long as they expect the peg to hold, that is).

This arbitrage activity would suck liquidity out of the Hong Kong dollar market, forcing local interbank rates higher until they are back in balance with those of the anchor currency. So the gap between Hibor and U.S. rates cannot widen indefinitely. Interest-rate parity conditions demand that they converge, eventually – unless the peg breaks. Hence the recent flurry of speculation.

The gap will close, perhaps sooner rather than later if smartphone maker Xiaomi Corp., which is targeting a valuation of as much as $100 billion, selects Hong Kong as one of the venues for its planned initial public offering. Lufax, a wealth manager owned by Ping An Insurance (Group) Co., is also hoping for a $60 billion valuation from a float in the city. 

People borrowing Hong Kong dollars to subscribe to hot IPOs would cause Hibor to rise – and discussions about the stability of the peg to stop. That’s what happened last September when ZhongAn Online P&C Insurance Co. raised $1.5 billion.

As my colleague Shuli Ren wrote back then, retail investors, who subscribed for more than 400 times their $300 million allotment, borrowed in excess of HKD50 billion from brokers when orders opened. That was almost a third of the prevailing HKD180 billion of interbank liquidity. The Hong Kong dollar climbed from a low of 7.8252 on Sept. 5 to 7.8034 on Sept. 20. 

This is the most likely, business-as-usual ending to the latest episode of currency weakness. A rarer, black-swan-type event could occur if China undergoes a credit meltdown.

If capital flight caused Hibor to rise uncontrollably, devaluation might be the only choice to avoid a depression.

Impossible? No. Highly improbable? Most certainly. With President Xi Jinping being anointed as China’s leader for life, the last thing he would want is Chinese banks going belly up in the hub of the vaunted Greater Bay area . That would do no good to a strongman leader’s reputation.

When the yuan is fully convertible, Hong Kong could voluntarily embrace it. That would make perfect sense. Until then, whichever reason you choose – Xiaomi, or Xi – a forced end to the local currency’s peg isn’t in the cards. Andy Mukherjee, Bloomberg

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