Some Thoughts on the HKD Peg

new hong kongDespite solid fundamentals, the Hong Kong dollar is trading at its weakest level since 2007.  HKMA is likely to start mopping up local liquidity in response.  However, we see no threat to the peg, which will be maintained for the foreseeable future. 

HKD PEG BASICS

The HKD peg to the USD was put in place in October 1983.  During that time, the negotiations for the 1997 handover from the UK was unsettling local markets.  With HKD freely floating then, it weakened from less than 5 per USD in 1980 to almost 9 per USD in September 1983 before the peg was introduced.

Under the original peg arrangement, HKD could not trade on the weak side (above) of the 7.8 peg rate, but could appreciate without limit to the strong side (below 7.8).  It has only been truly tested once, during the Asian Crisis that started in 1997.  When the crisis deepened in 1998, interbank rates soared as foreign reserves fell and the domestic money supply shrank.  The HKMA also took some unorthodox steps then, such as buying Hong Kong stocks as the Hang Seng plunged.  Ultimately, the HKMA prevailed and we would expect similar success if the HKD were to come under greater pressure now.

The HKMA runs a strict currency board.  In essence, this means that every HKD in circulation is backed by an equivalent amount (at the official exchange rate) of USD.  When run correctly, such a peg cannot be broken.  Argentina’s peg was broken because it violated several of the basic tenets of a currency board, including central bank financing of the budget deficit.

A minor adjustment was made in May 2005, when a trading band of 7.75-7.85 was introduced around the peg rate.  The Hong Kong Monetary Authority (HKMA) is now obliged to buy and sell USD to prevent the HKD from breaching either side of the band.  Note that the weak side of the band has never been tested, and that the weakest that HKD has traded is the August 2007 high for USD/HKD near 7.8305.

The HKMA has several lines of defense before HKD even reaches the limits of the trading band.  The HKMA has a mandate to conduct FX and money market as needed to promote the “smooth functioning” of local markets.  As a first line of defense, the HKMA typically sells extra debt to mop up liquidity when HKD faces selling pressure.  The last time it announced extra bill issuance was back in September, and we believe HKMA will announce another round soon in response to HKD weakness.

As a second line of defense, the HKMA can intervene in the FX market ahead of the trading band limits.  Reports suggest it has not done so since 2008.  However, we would not rule out such smoothing operations if the liquidity drain from selling extra bills does not have the desired impact. 

HKD PEG OUTLOOK

In its annual Article IV consultation in January, the IMF did not see any reason to change the peg now.  It noted that “The Linked Exchange Rate System (LERS) remains the best arrangement for Hong Kong SAR.  The US dollar is still the most commonly used international currency in trade and financial transactions and Hong Kong SAR’s economic cycles and financial conditions are, to a large extent, influenced by the U.S. and the global economic/financial environment.  The currency board arrangement has been supported by the flexible economy, ample fiscal and reserve buffers, and strong financial regulation and supervision.”

Yet we continue to believe that it is realistic scenario to expect a re-pegging of the HKD to the Chinese yuan at some time in the future (perhaps in 10-15 years?).  It seems that if conditions merit (full yuan convertibility, continued integration of Hong Kong into mainland China, etc.), then the Chinese authorities could eventually link or perhaps even unify the Hong Kong dollar with the yuan.  This is a long-term proposition, and there will likely be ample warnings and leaks during the process so that investors are not caught unaware.  For now, we see no change to the HKD peg.

ECONOMIC OUTLOOK

The economy is likely to slow, dragged down by an uncertain mainland outlook.  GDP growth is forecast by the IMF to decelerate to 2.8% in 2018 and 2.6% in 2019 from 3.8% in 2017.  GDP rose 3.4% y/y in Q4, the slowest of 2017 and the third straight quarterly deceleration.  With the HKMA likely to tighten liquidity soon in response to the weaker HKD, we see some modest downside risks to the growth forecasts.

Price pressures have stabilized, with CPI rising 1.7% y/y in both December and January.  This is down from the 4.3% y/y peak back in August 2016.  The Hong Kong Monetary Authority (HKMA) does not have an explicit inflation target nor does it run an independent monetary policy due to the HKD peg to USD.  Indeed, the HKMA has raised the base rate five times since December 2015, in lockstep with the Fed.

However, Hong Kong commercial banks do not always adjust their Prime Lending rates in response to changes in the Bank Rate.  Indeed, the Prime rate has still been kept at the 5% trough by the two largest commercial banks despite the 125 bp of Fed tightening seen since December 2015.  That’s because Hong Kong liquidity remains ample and has kept most local markets rates low even as the Fed tightens.  The gap between 3-month HIBOR and 3-month LIBOR has risen to almost one percentage point.  This gap is typically between 0-25 bp.

The external accounts remain in good shape.  Hong Kong has run a current account surplus since 1998.  The IMF expects that surplus to remain around 3% of GDP in both 2018 and 2019.  Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP.  HKMA foreign reserves stood at a record high $441.5 bln at the end of January.  Clearly, Hong Kong has very low external vulnerability across virtually all metrics.  This supports our view that selling pressures on HKD are likely to remain under control.

INVESTMENT OUTLOOK

USD/HKD traded yesterday at its highest level since August 2007, breaking marginally above the high from January 2016.  It fell back today but still appears to be on track to test the August 2007 high near 7.8305, which for all intents and purposes is also the high from January 2016.  When local interest rates spiked then, the pair quickly moved back below the 7.8 area.  This should happen again if HKMA tightens liquidity as pressures on HKD intensify.

Hong Kong equities have done OK after a solid 2017.  In 2017, MSCI Hong Kong was up 34%, about the same as MSCI EM.  So far this year, MSCI Hong Kong is up 2.5% and compares to 3.5% YTD for MSCI EM.  This modest underperformance should end, as our EM Equity model has Hong Kong at a VERY OVERWEIGHT position.

Hong Kong bonds have performed OK.  The yield on 10-year local currency government bonds is up 19 bp YTD.  This is in the middle of the EM pack and compares to the best performers Egypt (-105 bp), Brazil (-65 bp), and South Africa (-47 bp) as well as the worst performers Philippines (+110 bp), Hungary (+60 bp), and India (+42 bp).  Inflation is likely to remain under control, but with the HKMA likely to start tightening local liquidity, we think Hong Kong bonds could start underperforming more.

Our latest sovereign ratings model update had Hong Kong’s implied rating steady at AA/Aa2/AA.  S&P’s downgrade to AA+ in September matches Fitch and brings it closer to our model, while Moody’s downgrade to Aa2 in May lines up exactly with us.