Hong Kong dollar drops most since '11 as bets mount on peg's end

[HONG KONG] The Hong Kong dollar sank by the most in four years and speculation mounted in the options market that the city's 32-year-old currency peg will break as investors lose confidence in Chinese assets.

The local currency dropped as much as 0.18 per cent - its biggest intra-day loss since July 2011 - to HK$7.7738 versus the US dollar as a gauge of expected price swings was set for its highest close since 2003. The Hang Seng Index of shares fell 0.3 per cent as of 2:38 p.m. local time and the offshore yuan weakened 0.4 per cent, having slipped to a five-year low last week.

Hong Kong's fortunes are increasingly entwined with those of China, an economy that's forecast to expand this year at the slowest pace since 1990, and the local currency's linkto the US dollar can come under pressure when sentiment toward the mainland deteriorates. The yuan has fallen 5.8 per cent in Shanghai since a surprise devaluation on Aug. 11, even as the central bank burnt through US$321 billion of its foreign-exchange reserves supporting the currency over the last five months.

While the yuan's depreciation does drive haven demand for the Hong Kong dollar, "another dynamic has entered the equation and that dynamic is a potentially large devaluation of the renminbi," said Mirza Baig, head of foreign-exchange and interest-rate strategy for Asia Pacific at BNP Paribas SA in Singapore. "That dynamic has perhaps become a bit more acute in recent days. If the renminbi weakens a lot, I don't see how Hong Kong would escape speculation of de-pegging as well."

One-year implied volatility on the Hong Kong dollar, a measure of price swings cited by traders when pricing options, has doubled this month to a 12-year high of 3.43 per cent. Prices for the derivatives indicate there's a 24 per cent chance the Hong Kong dollar will have weakened beyond its permitted trading range of HK$7.75-HK$7.85 versus the greenback by the end of this year, up from 9.5 per cent on Dec. 31, Bloomberg data show. The currency traded at the strong end as recently as Jan. 4 and has since weakened 0.3 per cent to HK$7.77.

Hong Kong Monetary Authority Chief Executive Norman Chan said last month the local dollar's peg was the cornerstone of financial and monetary stability in the city and there were no plans to amend it. The authority didn't immediately respond to questions regarding the currency link on Thursday.

It's not just Hong Kong's currency that's out of favor. The Hang Seng Index has already retreated 31 per cent from last year's high, recorded in April, and CLSA Ltd. predicts property prices will drop 8 per cent this quarter after a 7.5 per cent decline over the last three months.

"The declines in offshore yuan and the risk-off sentiment have led to a selloff in Hong Kong's equities market, which causes capital outflows from the city and pressures the local currency," said Ken Cheung, a strategist at Mizuho Bank Ltd. "With the Hong Kong stock market declining and heightened worries over China's economy and markets, I see further weakening of the Hong Kong dollar."

BLOOMBERG