In the inSight article in May, I shared some views on the strengthening of HKD and the triggering of the strong-side Convertibility Undertaking (CU) under the Linked Exchange Rate System (LERS) in early May. More recently, the supply-demand dynamics in the Hong Kong dollar market have further evolved. Coupled with the sustained wide interest rate differential between Hong Kong dollar and US dollar, the weak-side CU under the LERS was triggered several times. It is a testament to the smooth functioning of the LERS as the Hong Kong dollar exchange rate glided from the strong-side bound to the weak-side bound over the past two months. In view of the renewed public and market interest on the Hong Kong dollar exchange rate and interest rates, let me offer some observations.
Picking up from my last inSight article expounding on the strong-side CU triggering in early May, the inflows of funds at the time had left the Aggregate Balance considerably larger, expanding to over HK$ 170 billion from about HK$ 45 billion. Flushed with liquidity, Hong Kong dollar markets saw a significant drop in short-term interbank interest rates and a notable widening of the Hong Kong dollar-US dollar interest rate differential. Taking the overnight tenor as an example, prior to the strong-side CU triggering in early May, overnight US rate and HIBOR were at 4.36% and 4.30% respectively, a mere 0.06 percentage point difference. Coming to the end of May, abundant liquidity dragged overnight HIBOR to 0.03% while the US rate barely budged at around 4.35%, leaving a wide gap of 4.32 percentage points. A similar story took place with term interest rates. At the one-month tenor, the Hong Kong dollar-US dollar differential widened from 0.37 percentage point in early May to 3.72 percentage point at the end of May. The extent of the interest rate differentials is not often seen in the history of the LERS.
This notwithstanding, the automatic interest rate adjustment mechanism under the LERS worked according to design. An excess supply of Hong Kong dollar coupled with lower Hong Kong dollar interbank interest rates relative to US dollar will incentivise interest carry trades to sell Hong Kong dollar for US dollar. The force of these trades would drive the Hong Kong dollar exchange rate towards the weak-side CU level. Looking back on the past two months, supply of Hong Kong dollar funding has remained abundant since the sizable inflows in early May. By contrast, the demand picture is a bit murkier. Hong Kong dollar funding demand was strong during May and June but abated stepping into late June and early July. A few factors were in the work: stock dividend payout season has peaked, non-local companies were converting part or all of the Hong Kong dollar proceeds recently raised in the capital market into other currencies for repatriation or investment, and the seasonal funding demand at half-year end has also faded.
As a result, market demand for Hong Kong dollar dwindled, weighing on the exchange rate. At the same time, carry trades taking advantage of the wide interest rate differential gathered pace, and came in large volume on some days. When Hong Kong dollar eased towards 7.85 against US dollar and triggered the weak-side CU, the HKMA bought Hong Kong dollar and sold US dollars in accordance with the LERS. Since late June, the weak-side CU was triggered a few times. Including the latest triggering before dawn in Hong Kong on July 11th, the Aggregate Balance would drop to about HK$ 101.2 billion. As liquidity became less abundant, Hong Kong dollar interbank rates started to respond with moderate increases. For instance, one-month HIBOR moved up to 1.08% as of today (July 11th) and overnight HIBOR lifted from almost zero to 0.09% today.
That being said, the Hong Kong dollar-US dollar interest rate differential remains wide and carry trades continue to be seen as profitable. Hong Kong dollar hovers near the 7.85 level. It is possible that the weak-side CU would be triggered again. Whether and when this will happen, and the size of the operation, would very much depend on the market conditions and Hong Kong dollar supply-demand dynamics. A host of other uncertain factors are also at play, such as the US monetary policies and interest rates trajectory, the stock market sentiment, and global financial markets and fund flows. When the Aggregate Balance shrinks to an equilibrium level where the supply and demand are largely in balance, HIBORs could respond more sensitively to changes in liquidity condition and advance in a more noticeable way towards the US rates. In short, we should be prepared for the possibility of increases in Hong Kong interbank rates.
A lot of ink has been spilt but it is important to grasp that the interaction between liquidity and interbank rates of the Hong Kong dollar is all part of the design of the LERS. The recent widening of Hong Kong dollar-US dollar interest rate differential is no exception. We must remain clear-eyed to the fact that the objective of the LERS is to maintain the stability of the Hong Kong dollar exchange rate. The LERS does not target interest rate in itself, even though interest rate has its place in the mechanics of the system. After all, Hong Kong dollar interest rates are affected not only by the US rates but also the local funding condition. The recent movements and interactions in the Hong Kong dollar exchange rate and interbank rates are the illustration of how the LERS is supposed to work.
Amid the uncertainties in the global economy and financial markets, as well as highly volatile fund flows, members of the public are reminded to adequately assess their own financial situation and risk tolerance when making financial decisions such as property purchase, investment or borrowing, and be mindful of potential rebound of the Hong Kong dollar interbank rates. The HKMA will continue to closely monitor financial market developments and maintain monetary and financial stability through the effective functioning of the LERS.
Eddie Yue
Chief Executive
Hong Kong Monetary Authority
11 July 2025
