The Hong Kong dollar has eased against the US dollar along with recent outflows of funds. While the Hong Kong dollar exchange rate has not reached the weak-side Convertibility Undertaking level at 7.85 against USD, it has aroused quite some discussions in the matter. Some commentators even compared the current situation with the Asian financial crisis in 1997-98. This article is aimed to promote better understanding by the public and market participants of our currency board system so as to avoid unwarranted concerns. The HKMA has repeatedly pointed out that the easing of the Hong Kong dollar is a normal phenomenon amid widening interest rate differentials between the Hong Kong dollar and US dollar after the US rate hike. Even if the exchange rate touches the weak-side Convertibility Undertaking rate and funds flow out of the Hong Kong dollar, this is an inevitable process for the normalisation of Hong Kong dollar interest rates. These reflect normal workings in accordance with the design of the Linked Exchange Rate System (LERS). The paragraphs below provide more explanations about the technical details of the system.
1. What are the reasons for the sudden and rapid slide of the spot rate of the Hong Kong dollar against the US dollar? Is the Hong Kong dollar being attacked?
- The Hong Kong dollar exchange rate is under the influence of the currency board system’s functioning as well as other market-related factors. After the liftoff in US interest rates, the spreads between Hong Kong dollar and US dollar interest rates have widened. So, it is expected that there will be gradual outflows of funds from the Hong Kong dollar to the US dollar and that the Hong Kong dollar exchange rate will start easing from the level of 7.75. Apart from interest rate spreads, the recent decline in Hong Kong equity prices, the volatility of the renminbi exchange rate and the less optimistic market outlook for Hong Kong and Mainland China economies have also dampened demand for the Hong Kong dollar. Moreover, the recent strengthening of the US dollar against other Asian currencies had led some international investors to conduct more currency hedging for their Hong Kong equity portfolios. Such activities further added to the downward pressure on the Hong Kong dollar exchange rate. Of course, we cannot rule out the possibility that there might be some speculative interests in the Hong Kong dollar. While the recent movement of the Hong Kong dollar exchange rate was relatively fast, its fluctuations remained well within the narrow band under the currency board system. It remains very stable when compared with other Asian currencies.
2. The Hong Kong dollar forward exchange rate has weakened to below 7.85 while trades in Hong Kong dollar options have increased significantly. Does it mean that speculators have successfully forced the Hong Kong dollar to depeg?
- Under the currency board arrangements of the Linked Exchange Rate System, the strong-side and weak-side Convertibility Undertakings are only applicable to the Hong Kong dollar spot exchange rate. The Hong Kong dollar forward exchange rate mainly reflects the demand and supply of Hong Kong dollar in the forward market. The weakening of the Hong Kong dollar forward rate to below 7.85 does not mean that the market is speculating on an imminent depeg of the Hong Kong dollar with the US dollar. Recently, more investors hedged the currency exposures for their Hong Kong equity portfolios, leading to an increase in supply of Hong Kong dollars in the forward market and putting downward pressures on the Hong Kong dollar forward rate. As liquidity in the forward market is lower, the price is more volatile. Similarly, the increase in turnover in the Hong Kong dollar foreign exchange options is also caused by the increase in hedging activities.
- The LERS has been implemented for over three decades, during which the volatility of the Hong Kong dollar forward exchange rate has always been greater than that of the spot exchange rate. While the forward rate traded beyond the prevailing Convertibility Undertaking rate from time to time, it had not affected the stability of the spot rate. We should not read too much into the fluctuations in the Hong Kong dollar forward exchange rate.
3. HIBORs have risen to its seven-year high. Will the Hong Kong dollar interest rates rise sharply? When will banks raise interest rates?
- While the Hong Kong dollar interbank rates have risen, it should be noted that the interbank rates are rising from near-zero levels and their current levels remain relatively low (the prevailing 1-month and 3-month HIBORs are at 0.4% and 0.7% respectively). We expect that even if the Hong Kong dollar interbank rates would continue to rise in response to outflows, the pace of the increase would not be as rapid as that seen in 1997-98. This is because the current Hong Kong dollar Monetary Base is over HK$1 trillion, of which the Aggregate Balance accounts for HK$390 billion, much higher than that of several billion Hong Kong dollars in 1997-98. Therefore, it will be very difficult for speculators to “squeeze” interest rates higher. In addition, the HKMA introduced the Discount Window in 1998 to provide banks access to overnight Hong Kong dollar liquidity through repurchase transactions using Exchange Fund Bills and Notes (EFBNs). At present, outstanding EFBNs amount to about HK$850 billion, and the bulk is being held by banks for liquidity management. This arrangement has helped dampen excessive volatility in interest rates. In order to ensure that the banking system will be able to deal with fund outflows, the HKMA carries out liquidity stress tests on banks regularly. Banks are also well prepared in managing liquidity risks.
- As regards the timing for and magnitude of interest rate increase, it will depend on the timing, speed and size of fund outflows. Recently, HKD HIBORs have risen slightly, but they remain at relatively low levels. The rises were largely driven by market expectations. Banks, in determining their deposit and lending rates, will take into account other factors affecting their funding cost such as changes in deposits and loan demand, in addition to interbank interest rates.
4. Are the recent slide in the Hong Kong equity market and the sharp fall in the Hong Kong dollar spot and forward rates the result of “double play” on the Hong Kong dollar by speculators?
- “Double play” refers to market manipulations during the Asian financial crisis in 1997-98, under which speculators shorted stocks and Hang Seng Index futures and then short-sold Hong Kong dollar to push up interest rates, with a view to creating panic in the market such that they could make huge profits from their short positions in stocks/index futures and the Hong Kong dollar.
- The recent decline of the Hong Kong dollar exchange rate and Hong Kong equities at the same time was because a result of some investors reducing their Hong Kong equity holdings on the back of their bearish sentiment towards the prospects of the Hong Kong and Mainland economy and converted the Hong Kong dollar proceeds into US dollar. This caused the Hong Kong dollar exchange rate and Hong Kong equity prices to decline at the same time.
- It is worth noting that it is now very difficult for “double play” to work because the Hong Kong dollar Monetary Base is now much bigger than that in 1997-98. With the Hong Kong dollar Monetary Base over HK$1 trillion and the discount window in place, it would be more difficult for speculators to short-sell the Hong Kong dollar to push up interest rates, as that will require hundreds of billions of Hong Kong dollars. Moreover, during 1997-98, the constituent stocks of the Hang Seng Index mainly comprised local property and banking stocks, which were sensitive to interest rate movements. However, the Hong Kong stock market currently comprises many Mainland stocks that are not closely connected with Hong Kong dollar interest rates. Thus, an increase in Hong Kong dollar interest rates may not immediately exert a significant downward pressure on the equity prices.
- That said, the market is full of uncertainties. The HKMA will continue to closely monitor market conditions and further developments.
5. Is there a risk of a recurrence of the Asian financial crisis in 1998?
- While the Hong Kong dollar exchange rate and Hong Kong equities fell at the same time recently, Hong Kong’s economic and financial conditions are very different from those prevailing during the Asian financial crisis in 1997-98. Firstly, the robustness of our systems has been strengthened markedly. Hong Kong now has foreign reserves of some US$360 billion, far more than the amount of US$70-90 billion in 1998. Our monetary base, at about HK$1.6 trillion, is also much bigger than that of HK$190 billion then. With the HKMA’s introduction of the Discount Window in September 1998, banks have since been able to obtain overnight Hong Kong dollar funds via repurchase transactions using EFBNs. The total amount of outstanding EFBNs is about HK$850 billion, of which the majority is being held by banks for liquidity management purpose. All these can help reduce the risk of excessive volatilities in interbank interest rates arising from fund outflows.
- Secondly, the valuation of the Hong Kong equity market is now relatively low. The price-to-book ratio of Hang Seng index constituent stocks has dropped to 1, compared with the levels of 1.4 during the 1998 Asian financial crisis, 1.27 following the outbreak of SARS in 2003, and 1.1 during the global financial crisis in 2008. The Hang Seng Index’s price-earnings ratio at 8.4 is also lower than the range of 9.6 to 13.4 during the period between 1996 and 1998.
- Since 2009, the HKMA, through the roll-out of multiple rounds of counter-cyclical and prudential measures, has significantly strengthened the banking system’s resilience to shocks. This enables the banking system to meet the challenges arising from market volatility and outflows of funds.
- The HKMA will continue to monitor market developments closely and stands ready to undertake measures to safeguard the stability of Hong Kong’s monetary and financial systems.
Executive Director (Monetary Management)
Hong Kong Monetary Authority
27 January 2016