Hong Kong Dollar Fund Flows

Q:

The US Federal Reserve (Fed) will hold its next policy meeting in mid-June, and the market generally expects that the possibility of a rate hike is very high.  Does this mean that the HKD will remain weak in the near future and there will be continued outflow of funds from the HKD?

A:

This is highly likely.  In theory, when the US Fed raises interest rates, the negative spreads between short-term HKD interest rates and their US dollar (USD) counterparts, in particular the overnight rates, will widen, attracting more carry trades that sell HKD for USD.  According to the design of the Linked Exchange Rate System (LERS), the HKD will be pushed towards the weak-side as a result of these carry trade activities, triggering the weak-side CU and fund outflows.  This process will lead to normalisation of interbank liquidity and HKD interest rates.  Simply put, the zero interest rates and zero spreads in the past few years had attracted large-scale fund inflows and resulted in excess liquidity.    Now that USD interest rates have been raised several times, the widening HKD-USD interest rate spreads have created incentive for carry trades which will help drain the excess liquidity.

We may expect to see news reports about the HKMA buying HKD from the market quite often in the near future.  In fact, this is in line with what Mr Norman Chan, Chief Executive of the HKMA, has indicated before – “the HKMA is looking forward to the triggering of the weak-side CU, thereby creating an environment conducive to the normalisation of HKD interest rates”.  It is important to understand that the triggering of the weak-side CU is part and parcel of the design of the LERS.  While some news headlines used by the media, such as “supporting”, “rescuing” or “defending” the HKD, are rather eye-catching, there may be a bit  of dramatisation.

 Q:

The Aggregate Balance may soon fall below HK$100 billion.  Will deposit and lending rates start going up once this barrier is broken through?  If not, how much further does the Aggregate Balance need to fall before local interest rates move up?

 A:

Round numbers like HK$100 billion or HK$50 billion may be viewed by some people as “barriers”.  However, the Aggregate Balance of the banking sector is unlike the stock market.  It does not have any psychological barriers, not to mention the question of defending or breaking through them.  Nor are interest rates directly correlated with the Aggregate Balance.  While there are a few theories out there suggesting local interest rates will go up when the Aggregate Balance falls to a specific level, the fact is that there is no such “magic” number.   Banks do not simply look at the size of the Aggregate Balance when deciding whether to adjust their deposit or lending rates.  Rather they put more weight on a host of factors including their own funding conditions, funding cost, demand and supply dynamics in the loan market, outlook for fund flows and changes in the external financial environment.  It is never a simple linear relationship with the Aggregate Balance.

To put it more simply, fund outflows are driven by carry trades in the presence of excess HKD liquidity.  When liquidity levels return to normal, i.e. being commensurate with the prevailing economic and financial circumstances, they will stabilise naturally.  We are not concerned about the size of the Aggregate Balance, as the market itself will always find an equilibrium.  The design of the LERS, including that of the discount window, allows the market to operate smoothly under different circumstances.

I would also like to point out that as HKD liquidity in the market continues to reduce, it is inevitable that HIBORs will be trending up.  The 1-month HIBOR, for example, has increased from a low of 0.2% to more than 1.3% at one point.  The outlook for the deposit and lending rates will depend on fund flows and changes in the external financial environment.  However, the pace of interest rate increases should not be too rapid.  This is because the banking sector is holding a vast amount of Exchange Fund papers, which can effectively cushion against any excessive volatility in interest rates.

 Q:

 Has the HKMA come under a lot of pressure as the HKD has weakened recently?

 A:

First of all, it is normal for the HKD to trade within the range of 7.75-7.85.  The design of the Currency Board ensures that the HKD will stay within the range of 7.75-7.85, and that the HKMA stands ready to buy HKD and sell USD at the weak-side CU and to sell HKD for USD at the strong-side CU upon requests from banks.  These operations are all in accordance with the design of the Currency Board arrangements.  Having said that, we will stay vigilant as always and closely monitor market developments to ensure the orderly operation of the LERS as designed.