The Hong Kong dollar strengthened to 7.75 recently. The strong-side Convertibility Undertaking (CU) was triggered repeatedly during the period from 19 October up to the present (9 November). So far, the HKMA has purchased US$4.2 billion of US dollars and the Aggregate Balance of the banking system has increased by HK$32.2 billion to HK$180.9 billion. This fresh round of fund inflows has attracted wide attention and there have also been some misunderstandings regarding the operation of the Currency Board system. I will try to address certain issues in the form of questions and answers.
Q1. There has been a continuous inflow of “hot money” into Hong Kong recently and as a result, the HKMA has to intervene in the forex market many times. How long will the HKMA be able to keep this up? Will the amount being injected into the market ultimately exceed the amount of HK$640 billion injected during 2008 and 2009?
A1. First of all, it is not entirely correct to describe what we have been doing as “intervention”. The HKMA honoured the CU (i.e. strong-side CU at 7.75 and weak-side CU at 7.85) by conducting market operations in accordance with the Currency Board system so that the exchange rate of the Hong Kong dollar will stay within the zone of 7.75 to 7.85. The HKMA buys or sells Hong Kong dollars according to the strong-side or weak-side CU passively. This is different from the active trading in the forex market by other central banks for the purpose of affecting the exchange rate of their own currencies.
It is worth noting that the strong-side CU will not necessarily be triggered even though the Hong Kong dollar has strengthened to 7.7500. It is because banks can trade Hong Kong dollars among themselves at this level. The strong-side CU will only be triggered when there are not any banks to take up the US dollars in the interbank market. Instant update of the amount of Aggregate Balance will be announced through the relevant financial information platform so as to ensure high transparency in the operation of the Currency Board system.
The net inflow of funds is expected to continue for a while but it is difficult to anticipate how long this will last. However, based on current conditions, it is likely that the size of the current net inflow of funds will be smaller than that in 2008 and 2009.
After the collapse of Lehman Brothers at the end of 2008, credit squeeze was experienced in Hong Kong and the rest of the world. Local enterprises repatriated funds from overseas and exchanged them into Hong Kong dollars to meet their liquidity needs. In 2009, active IPO activities attracted significant inflows into Hong Kong’s equity market from all over the world. As a result, demand for Hong Kong dollars from individuals, firms as well as the banking sector increased markedly. This was also one of the main causes for the exchange rate of the Hong Kong dollar to stay close to 7.75 with repeated triggering of the strong-side CU for a prolonged period of time during 2009. However, no irregularities in the supply of and demand for Hong Kong dollar have been identified in the current situation and IPOs are far less than that in 2009. Therefore, we estimate that the amount of the recent inflows will be less than last time.
Q2. A total of HK$32.2 billion of Hong Kong dollars has been sold by the HKMA from 19 October up to the present. Who have got hold of these funds and for what purpose? Will Hong Kong’s market and financial stability be affected as a result?
A2. As an international financial centre, it is not unusual to have large amounts of funds to flow freely into and out of Hong Kong on a daily basis. Nevertheless, we have analysed the funds that flow into Hong Kong and believe that these fund inflows are mainly driven by two forces:
(1) Increased allocation to Hong Kong dollar assets by overseas investors -- According to information from various market sources, overseas investors continued to reduce their holding of Hong Kong equities in 2011 but it seems that the situation has improved recently. Some market participants estimate that the net purchases of Hong Kong equities by global mutual funds in the first 10 months of this year amounted to tens of billions of Hong Kong dollars, reversing the trend of net selling as seen last year. Moreover, these funds have stepped up their purchases of Hong Kong equities in September and October. The main reason being that after the announcement of QE3 by the US Federal Reserve, US dollar funds have resumed the search for investment opportunities all over the world. Moreover, market sentiment has somewhat improved due to QE3 and the bond purchase programme introduced by the European Central Bank. There are also signs showing that the slowdown in China has come to an end and the economy began to rebound in the third quarter. All these factors have worked together to attract funds to flow into the emerging markets in Asia again. In fact, other currencies in Asia other than the Hong Kong dollar are also faced with upward pressure in general after the announcement of QE3.
(2) Issuance of foreign currency bonds by Hong Kong firms in exchange for Hong Kong dollars -- The size of the local syndicated loan market has reduced as a result of the European debt crisis. We noted that there was a significant increase in the issuance of foreign currency bonds by local firms to raise funds this year. During the first 10 months of this year, the total amount of foreign currency bonds issued by local firms has reached US$20.7 billion (around HK$160 billion), which tripled that of last year. Part of the foreign exchange proceeds from these bond issuance activities were exchanged into Hong Kong dollars in the spot market, thereby creating upward pressure on the exchange rate of the Hong Kong dollar.
The recent net inflow of funds into the Hong Kong dollar only amounted to slightly over US$4 billion so far, which is not really significant compared to the size of our capital market. In addition, funds that flowed into the Hong Kong dollar might not necessarily be “hot money” as often seen by most people. The increase in asset allocation to Hong Kong dollar assets by institutional investors and the exchange for Hong Kong dollars with foreign currencies to meet operational needs mentioned above are normal economic and financial activities. We should not overreact. As an international financial centre, it is impossible for Hong Kong to stop the inflow and outflow funds. What we should do is to ensure that our banking and financial systems are able to manage the risks associated with the significant flows of funds into and out of our economy. We have demonstrated our capability to handle the inflow and outflow of funds, since the global financial crisis in 2008.
Q3. Should funds flow into the HKD persistently, how long can the HKMA keep up with its operations in the foreign exchange market? Will changes be made to the Linked Exchange Rate [System] to contain inflation and asset price increasing pressures caused by “hot money”?
A3. Under the Currency Board system, whenever funds flow into the Hong Kong dollar, triggering the strong-side CU, the HKMA can create Hong Kong dollars to buy US dollars from the market by way of expanding the Hong Kong dollar monetary base. The HKMA’s ability to create Hong Kong dollars is limitless. So people need not worry about any shortage of Hong Kong dollars required by the HKMA to keep up its US dollar-buying action.
I would like to reiterate the firm position of the HKSAR Government that Hong Kong has neither the need nor the intention to change the LERS. We have kept under constant review the implications of the Linked Exchange Rate for the Hong Kong economy. The conclusion we have reached is that as a small and open economy, as well as an international financial centre, Hong Kong has always seen its economic growth mainly driven by external factors. In view of this economic framework, a fixed exchange rate regime can better serve the long-term interests of Hong Kong than a floating exchange rate regime. Experience shows that under the LERS, Hong Kong has weathered well through various financial crises. The LERS has also helped maintain monetary and financial stability during cyclical changes and support sustained economic growth in Hong Kong.
Inflation in Hong Kong is driven by a number of internal and external factors. The LERS is not the dominating factor. A number of our neighbouring economies in the region have all come under considerable inflationary pressures regardless of the different exchange rate regimes adopted. For example, in Singapore where a floating exchange rate system is adopted, average inflation rate was 4.8% between January and September 2012, even higher than the level of 4.2% in Hong Kong.
Movements in local asset prices are similarly subject to various factors, exchange rates being just one. Property prices can shift as a result of changes in other factors, including interest rates, demographic structure, land and housing supply, and household income prospect. While Singapore’s currency has appreciated considerably against the US dollar in the past few years, it is likewise faced with overheating in the property market. The Singapore government has thus taken repeated measures to help cool the market, including the introduction of an extra 10% stamp duty on property purchases by foreigners, with property price increases finally slowing lately.
A floating exchange rate regime is not a panacea that always works. Take a look at Switzerland, where massive fund inflows, driven by the European debt crisis, have resulted in a substantially appreciated Swiss franc. This increased the risk of deflation and reduced competitiveness of the country. Thus in 2011 the Swiss central bank decided to create a ceiling, at 1.20, for the exchange rate of the Swiss franc against the euro, and engaged in large-scale operations in the foreign exchange market. It was until then that escalation in the Swiss franc and deflationary pressures could be stemmed.
Following its Article IV consultation with Hong Kong at the end of 2011, the International Monetary Fund (IMF) gave its explicit support for Hong Kong's LERS, confirming that the LERS is a simple, credible, transparent and widely understood exchange rate system which has contributed immensely to the maintenance of monetary and financial stability in Hong Kong. The IMF concluded that arguments for abandoning the LERS in favour of other exchange rate regimes were unconvincing. Besides, Hong Kong is in every way in line with the prerequisites for the current LERS, with the existing exchange rate level of the Hong Kong dollar broadly reflecting our economic fundamentals.
In June 2012, the IMF again endorsed the LERS, citing simplicity, high credibility, transparency and broad understanding being among the system’s merits for its continued support.
Q4. Is the large amount of "hot money" flowing into Hong Kong recently looking for speculation opportunities on the Mainland? Will this affect financial stability and security on the Mainland?
A4. The offshore RMB market in Hong Kong has developed into quite a considerable scale. Average daily transactions are worth about US$2 to 3 billion, with most of them conducted in RMB against the US dollar. If overseas investors are bullish about the RMB’s potential to appreciate, they can simply buy RMB with US dollars in the offshore market, averting any costs for converting US dollars first into Hong Kong dollars and then into RMB. Thus the theory about global “hot money” entering the Hong Kong dollar and looking for speculation opportunities on the Mainland cannot hold. Besides, the financial system on the Mainland is an immense one, with total assets in the banking system alone reaching RMB126 trillion yuan. No way can the financial stability and security of the Mainland be impaired even if we are to witness huge sums, to the tune of tens of billions of Hong Kong dollars, flowing in and out of the country.
The development of the offshore RMB market in Hong Kong, to a certain extent, provides a buffer for the RMB market on the Mainland. It also provides useful market information about the external demand for RMB. When expectations are high for the RMB to appreciate, the premium of the offshore RMB exchange rate (CNH) over the onshore RMB exchange rate (CNY) goes up, for example, to as much as 1,700 pips in October 2010. In contrast, when the market turns bearish about the RMB and other Asian currencies, as was the case in September 2011, the CNH represented a discount of more than 1,000 pips. The gap between the CNH and CNY has remained narrow so far this year, only moving around positive and negative 100 pips in recent months. In other words, no significant imbalances between supply and demand are seen in the offshore market in Hong Kong.
Some worry that "hot money" under the pretense of trade transactions may try to get hold of RMB through the exchange window in Shanghai. In this connection, the HKMA has required banks in Hong Kong to verify the authenticity of trade transactions in relation to the use of the Shanghai exchange window. Operations in relation to the use of the RMB exchange window by banks in Hong Kong for trade transactions have been running in a smooth, steady and orderly manner. We believe there is little chance for any speculators to access the Shanghai exchange window via Hong Kong.
Since exchange control is implemented in the Mainland, only certain qualifying transactions and funds could flow across the border under legal channels. The relevant Mainland authorities and banks would have to decide which funds are qualified under the existing framework.
Article 112 of the Basic Law of Hong Kong stipulates that “No foreign exchange control policies shall be applied in the Hong Kong Special Administrative Region. The Hong Kong dollar shall be freely convertible. Markets for foreign exchange, gold, securities, futures and the like shall continue. The Government of the Hong Kong Special Administrative Region shall safeguard the free flow of capital within, into and out of the Region.” This has always been the cornerstone of Hong Kong’s success as a financial centre and free trade port.
Norman T.L. Chan
Hong Kong Monetary Authority
9 November 2012