THE Hong Kong dollar is rapidly heading towards the weak end of its trading band against the greenback as traders sell the currency to buy higher-yielding US assets.

The local exchange rate is one of the worst performers worldwide in the past two months with a 0.74 per cent drop against the US dollar, and last traded at HK$7.8464. Depreciating past HK$7.85 will prompt intervention by the city’s de-facto central bank.

The currency weakness is being fuelled by a plunge in the local cost of borrowing, which decreases the appeal of owning the Hong Kong dollar versus its US peer. One-month interbank funding costs for the currency, known as Hibor, have dropped to 2.4 per cent from a peak of 5.08 per cent in early December. Comparable rates on the greenback, or Libor, are 4.57 per cent, resulting in the widest spread since 2007. The gap makes shorting the Hong Kong dollar profitable in a revival of the carry trade.

The slump in the currency may reopen the debate over its future. Bill Ackman said in late November he’s betting big on a collapse of the Hong Kong dollar, a trade supported by hedge fund manager Boaz Weinstein, founder of Saba Capital Management.

Liquidity is plentiful right now amid capital inflows and still weak demand for loans. Money has been pouring back in as investors bet on a recovery in China after the nation’s pivot away from Covid Zero, with the benchmark Hang Seng Index surging almost 50 per cent since the end of October.

Yet economic activity remains depressed. The city’s gross domestic product shrank 3.5 per cent last year, its third contraction in four years, while home prices plunged about 16 per cent. The Hong Kong dollar loan-to-deposit ratio dropped to 88.4 per cent at the end of December from 89.6 per cent at the end of November, as deposits in the currency increased and loans fell, according to the Hong Kong Monetary Authority (HKMA).

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As a small and open economy, Hong Kong is especially vulnerable to money flowing in and out. The city uses the linked exchange rate system to manage monetary policy and prevent local borrowing costs from diverging too much from US rates. Intervention by the HKMA when the weak end of the trading band is reached will tighten liquidity, thereby putting pressure on local borrowing costs to rise.

The frequent divergence of the city’s economic conditions and those of the US has prompted wagers that the peg will break. Ackman, the founder of hedge fund Pershing Square Capital Management, said on Twitter in late November his firm owns a “large notional position” in Hong Kong dollar put options, betting the peg with the greenback will eventually break, without clarifying the size of the wager.

Part of Ackman’s premise, which referenced a Bloomberg Opinion column by Richard Cookson, is that it no longer makes sense for Hong Kong, a Chinese city deeply entwined with the mainland’s slowing economy, to be beholden to US monetary policy.

Such bets haven’t worked out in the past. Kyle Bass, the founder of Hayman Capital Management, and George Soros have both tried and failed to bet on the currency’s collapse. Ackman himself made a wager that the peg would break on the strong side in 2011.

The HKMA has repeatedly said that the linked exchange rate system — a currency peg that has endured mostly unscathed for almost 40 years — will remain unchanged. The city is well equipped to deal with external shocks, holding foreign exchange reserves of more than US$400 billion. BLOOMBERG