Hong Kong dollar to extend weakening trend, driven by excess cash, spreads

[HONG KONG] The Hong Kong dollar firmed marginally against its US counterpart on Thursday but traders expect the steady weakening trend since the beginning of the year to continue, driven by excess liquidity and widening interest rate spreads between the territory and the United States.

The local currency spot rate, which has fallen about 0.7 per cent so far this year and is on track for a seventh straight month of decline, was 0.01 per cent stronger at 0620 GMT, 86 pips on the weaker side of the peg at 7.8086.

The Hong Kong dollar is pegged at 7.8 to the US dollar, but can trade between 7.75 and 7.85.

Under the currency peg arrangement, the city's de facto central bank the Hong Kong Monetary Authority (HKMA) is obliged to intervene when the Hong Kong dollar hits 7.75 or 7.85 to keep the band intact.

Analysts said the primary reason for the weakness in the currency has been a surge in cash flows into Hong Kong because of loose global monetary policy and despite a slowing of capital flows from neighbouring China.

"Liquidity has been accumulating in the system since the global financial crisis because of the peg exchange regime. All the liquidity is from loose monetary policy in the United States," said Andy Ji, currency strategist at Commonwealth Bank of Australia.

Excess liquidity makes the Hong Kong dollar a handy funding currency for carry trades, whereby investors borrow cheaply in Hong Kong dollars and invest in higher-yielding assets elsewhere.

In a June policy meeting, the HKMA raised the base rate charged through its overnight discount window by 25 basis points to 1.50 per cent following a rate rise by the US Federal Reserve.

Still, spreads between short-term Hong Kong and US rates have been widening in anticipation of faster policy tightening and stimulus withdrawal by the Fed.

While the HKMA has been raising the base rate, the Hibor or the floating rate at which banks lend to each other has been rigid.

Hibor-Libor spreads have gradually widened since 2015, and the 3-month spread is now 0.55392 versus -0.02878 basis points at the beginning of 2017. The spread is currently at its widest since September 2008.

In the June meeting HKMA chief executive Norman Chan had warned investors that if the interest rate differential widened further, there would be more arbitrage activities involving fund flows from the Hong Kong dollar to the US dollar, which would spur capital outflows.

"The hike of HKD interest rates didn't really push HKD interbank market rate up. The real market interest rate is quite low," said a trader with a mainland bank.

While the central bank needn't wait for the currency to breach the lower limit of the trading band to intervene, traders believe it will refrain from doing so to allow the economy to strengthen further.

Hong Kong's economy expanded at a robust rate of 4.3 per cent in the March quarter from a year earlier, its fastest annual pace in six years.

"I think from the perspective of boosting economy, HKMA would like to see a weakened HKD," a trader said.

"Also, there's no effective measure to withdraw interbank liquidity by the HKMA, so I think they might want to encourage the weakness of the Hong Kong dollar."

REUTERS