Will Volatility Break The Hong Kong-U.S. Dollar Link?

by: Invesco US

Summary

On Jan. 20, the Hong Kong dollar fell to eight-year lows against the US dollar, prompting questions about the viability of the currency’s long-standing peg against the USD.

Fundamentally it was the recent shift in the US Federal Reserve’s interest rate policy that caused the change in market behavior in Hong Kong.

It is immensely helpful to Hong Kong as an international financial center to maintain a stable relationship between the HKD and USD.

Invesco's chief economist answers frequently asked questions about the recent HKD depreciation

By John Greenwood, Chief Economist. Posted on Expert Investment View: Invesco US Blog.

On Jan. 20, the Hong Kong dollar (HKD) fell to eight-year lows against the US dollar (USD), at HK$7.8295.1 Although it later gained back ground, the volatility prompted questions about the viability of the currency's long-standing peg against the USD. Below, I answer some frequently asked questions about the recent depreciation and its implications.

How are the HKD and USD related?

In 1983, Hong Kong's Currency Board system pegged the HKD to the USD at a rate of HK$7.8 to US$1. In later years, the peg was adjusted to a band of 7.75 to 7.85.1

What has triggered the shift in the exchange rate?

Fundamentally, it was the recent shift in the US Federal Reserve's interest rate policy that caused the change in market behavior in Hong Kong.

Ever since the outbreak of the US subprime crisis in September 2008, HKD short-term interest rates have been virtually at zero - in line with the US federal funds rate. At the same time, the HKD currency moved to the strong side of its convertibility band against the USD (7.75) as funds flowed into Hong Kong from investors who viewed the HKD - like the USD - as a safe haven. Those flows continued until the US Federal Reserve started raising interest rates on Dec. 16, 2015.

Now that the trend of near-zero US interest rates has been reversed, investors should expect the excess liquidity in Hong Kong to be reduced when the HKD spot rate reaches the weak side of the band at 7.85. At that point the HKMA will, under Currency Board rules, buy back HKD offered in the market and sell USD to the market in exchange. This should gradually tighten liquidity in Hong Kong and enable HKD interest rates to rise in line with the federal funds rate in the US. All this represents the normal functioning of Hong Kong's Currency Board system.

Why did the change in Fed policy matter?

In practical terms, it has been cheaper since Dec. 16 to borrow HKD than to borrow USD. Therefore, it has made sense for traders to sell borrowed HKD and transfer the proceeds into the higher-yielding USD or Chinese renminbi (RMB) markets. The sales of these borrowed HKD will have contributed to the weakening of the HKD currency.

Are speculators betting against the 32-year old HKD currency peg to the USD?

It is possible that speculators have taken a view against the HKD peg, but this is a pointless and futile exercise, in my view. The Hong Kong government and HKMA have repeatedly said that they will not change the pegged or linked rate system, and currently the Hong Kong authorities are under no pressure to change the system or the central 7.80 rate against the USD.

Will a speculative attack - like those that occurred during the 1997 Asian crisis - happen again?

In 1997 and 1998, currency speculators sold massive amounts of HKD in an attack on the currency, resulting in a huge spike in interest rates. Today, I see no basis for renewed speculative attacks along the lines of the 1997-1998 episodes.

  • First, the Hong Kong economy is stable, and while it may slow down or even go into recession as China slows further and US interest rates rise, I see no reason to fear a downturn on the scale of 1997-1998 or 2008-2009.
  • Second, since 1997, the HKMA has taken strong measures to make Hong Kong's currency mechanism more robust, which together should prevent any repetition of the steep increases in interest rates that were so damaging in 1997 and 1998.

Is there a risk that the HKD-USD link will break?

I believe Hong Kong's Currency Board system is the strongest form of fixed exchange rate mechanism in the world. If foreign currency flows into Hong Kong, the HKMA, acting as an agent for the HK government, will be happy to create literally unlimited amounts of HKD to meet demand at the 7.75 rate. Conversely, if money flows out of Hong Kong, the HKMA will always have sufficient US dollars to meet any conceivable demand for foreign currency. However, long before the HKMA could run out of US dollars, interest rates would rise in Hong Kong to attract funds back into the territory. In short, Hong Kong's currency mechanism is now so robust that it would be extremely difficult for currency speculators to break the system, in my view.

Will the HKD-USD link be removed and a HKD-RMB link be established instead?

There are three main reasons why it would be very impractical to link the HKD to the RMB as long as the Chinese mainland maintains either foreign exchange controls or other capital controls:

  • First, the smooth workings of Hong Kong's currency mechanism depends on all participants in the financial markets (banks, non-financial companies, investors, individuals, etc.) being able to move funds freely into and out of HKD without hindrance or bureaucratic interference.
  • Second, the fixed rate with the USD enables Hong Kong to transmit US financial conditions to Asia. This helps with a whole range of financial sector activities such as pricing IPOs, setting the price for international bond issues launched in Asia, and setting the yields on syndicated loans in Asia.
  • Third, as long as the US is more dominant in determining the global business cycle than China, then it will make sense for Hong Kong to peg its currency to the currency of the US. Since most trade and capital transactions in Asia are still denominated in USD, it is immensely helpful to Hong Kong as an international financial center to maintain a stable relationship between the HKD and USD.

I have always maintained the view that unless and until the RMB is fully and irreversibly convertible and all capital and exchange controls are abolished, it would make sense for Hong Kong to maintain the linked rate with the USD, not with the RMB.

What is the short-term outlook for the Yuan2 and HKD?

In the near term, I expect the Chinese Yuan will depreciate further against the USD - from about 6.58 today1 to perhaps 6.80 and maybe even further. How far it weakens will depend on:

  • How much capital outflow there is and whether the People's Bank of China (PBOC) is willing to allow the outflow to drive down the currency.
  • Whether the PBOC is prepared to maintain the stability of the Yuan against the USD by paying out large quantities of its foreign exchange reserves to counter-balance all outflows.

By contrast, the Hong Kong dollar will depreciate toward 7.85 as the US Fed raises interest rates, but no further. As explained above, this is the absolute lower limit permitted under current Currency Board rules, and there is no basis to expect the HKD to fall any further.

Sources

  1. Bloomberg, LP
  2. China's currency is officially called the renminbi. Yuan is a denomination of the renminbi.

Read more market and economic views by Invesco's Chief Economist John Greenwood.

Important information

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting its price.

The dollar value of foreign investments will be affected by changes in the exchange rates between the dollar and the currencies in which those investments are traded.

The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.

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