skip navigation
Blog

Stay up to date on timely topics and market events. Subscribe to our Blog now.

ECONOMY
06 August 2019

Hong Kong’s Currency Peg and Short-Term Rates in Times of Crisis

By Desmond Soon

Stay up to date on timely topics and market events. Subscribe to our Blog now.

The Hong Kong economy is very externally oriented and open, with foreign trade in goods and services equivalent to around three times its GDP. Therefore, it is important for Hong Kong to maintain a stable exchange rate.

Since its launch on 17 October 1983, Hong Kong’s Linked Exchange Rate System has been functioning smoothly despite three significant volatile events that include the Hong Kong stock market crash of 1987, the Gulf War in 1990 and the Asian financial crisis of 1997-1998 (see Exhibit 1).

Exhibit 1: Resilience Against External Shocks
Resilience Against External Shocks

Hong Kong’s Linked Exchange Rate System

Hong Kong’s Linked Exchange Rate System is a currency board system, which requires both the stock and flow of the monetary base to be fully backed by foreign reserves. This means that any change in the monetary base is fully matched by a corresponding change in foreign reserves at a fixed exchange rate. Currently, the Hong Kong Monetary Authority (HKMA) foreign reserves stands at US$446 billion (more than 2x the monetary base).

The HKMA’s strong-side Convertibility Undertaking (CU)—to buy USD from licensed banks at HKD7.75 to one USD—removes the uncertainty about the extent to which the HKD may strengthen. Conversely, under the HKMA’s weak-side CU at HKD7.85, the authority will sell USD from its FX reserves and buy HKD.

Under the Currency Board system, it is interest rates rather than the exchange rate adjusting to inflows or outflows of funds. The expansion or contraction of the Monetary Base causes interest rates for the domestic currency to fall or rise, respectively, creating the monetary conditions that automatically counteract the original capital movement, while the exchange rate remains stable. This process is very much an automatic mechanism (Exhibit 2).

Exhibit 2: The Hong Kong Currency Board Mechanism
The Hong Kong Currency Board Mechanism

The Situation in HKD Short-Term Interest Rates

Since the beginning of 2019, USD LIBOR has gradually declined following the Federal Reserve’s dovish pivot. However, HKD HIBOR has risen due to a number of specific events, such as expectations of mega equity IPOs (e.g., Alibaba) soaking up liquidity and competition for HKD deposits following the handing out of Digital Bank licenses. Further, a series of HKMA FX interventions (to cap the USD rise versus the HKD in the last two years due to large negative spread between HIBOR and LIBOR) have significantly reduced the Aggregate Balance to HKD 54 billion (this is the balance of the clearing accounts of banks kept by the HKMA). With a low level of Aggregate Balance, HKD short-term rates will be increasingly volatile and prone to liquidity squeezes. In the last few years, the HKMA has also increased the issuance of Exchange Fund Bills (EF) in efforts to mop up excess HKD liquidity and to satisfy investor demand.

Exhibit 3: HKD Peg Stability and HKD Short-Term Interest Rate Drivers
 HKD Peg Stability and HKD Short-Term Interest Rate Drivers
Source: Bloomberg. As of 31 Jul 19. Select the image to expand the view.

Conclusion

The robust construct and mechanism underpinning HK’s Linked Exchange Rate System makes it likely that the HKD-USD peg should withstand crisis situations including the large scale protests that we are seeing in the Special Administrative Region in China. Ultra high net worth individuals are likely to have already accumulated significant foreign assets so the convertibility pressure for HKD into USD should not be as great. As a result, we focus more on foreign funds outflows from the HK Exchange. The steadfast nature of the HKD peg means that the adjustment should be for higher HK short-term interest rates. However, the large amounts of EF Bills outstanding provide an avenue for the authorities to soften HKD short-term rates by not rolling over maturities. We believe higher HKD short-term rates will have a dampening effect on corporate and mortgage loan demand. Our base case, however, remains that HK financial institutions are well capitalized and macro prudential measures pre-emptively instituted by the HKMA should shield banks from a severe correction in the HK property market.

© Western Asset Management Company, LLC 2024. The information contained in these materials ("the materials") is intended for the exclusive use of the designated recipient ("the recipient"). This information is proprietary and confidential and may contain commercially sensitive information, and may not be copied, reproduced or republished, in whole or in part, without the prior written consent of Western Asset Management Company ("Western Asset").
Past performance does not predict future returns. These materials should not be deemed to be a prediction or projection of future performance. These materials are intended for investment professionals including professional clients, eligible counterparties, and qualified investors only.
These materials have been produced for illustrative and informational purposes only. These materials contain Western Asset's opinions and beliefs as of the date designated on the materials; these views are subject to change and may not reflect real-time market developments and investment views.
Third party data may be used throughout the materials, and this data is believed to be accurate to the best of Western Asset's knowledge at the time of publication, but cannot be guaranteed. These materials may also contain strategy or product awards or rankings from independent third parties or industry publications which are based on unbiased quantitative and/or qualitative information determined independently by each third party or publication. In some cases, Western Asset may subscribe to these third party's standard industry services or publications. These standard subscriptions and services are available to all asset managers and do not influence rankings or awards in any way.
Investment strategies or products discussed herein may involve a high degree of risk, including the loss of some or all capital. Investments in any products or strategies described in these materials may be volatile, and investors should have the financial ability and willingness to accept such risks.
Unless otherwise noted, investment performance contained in these materials is reflective of a strategy composite. All other strategy data and information included in these materials reflects a representative portfolio which is an account in the composite that Western Asset believes most closely reflects the current portfolio management style of the strategy. Performance is not a consideration in the selection of the representative portfolio. The characteristics of the representative portfolio shown may differ from other accounts in the composite. Information regarding the representative portfolio and the other accounts in the composite are available upon request. Statements in these materials should not be considered investment advice. References, either general or specific, to securities and/or issuers in the materials are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendation to purchase or sell such securities. Employees and/or clients of Western Asset may have a position in the securities or issuers mentioned.
These materials are not intended to provide, and should not be relied on for, accounting, legal, tax, investment or other advice. The recipient should consult its own counsel, accountant, investment, tax, and any other advisers for this advice, including economic risks and merits, related to making an investment with Western Asset. The recipient is responsible for observing the applicable laws and regulations of their country of residence.
Founded in 1971, Western Asset Management Company is a global fixed-income investment manager with offices in Pasadena, New York, London, Singapore, Tokyo, Melbourne, São Paulo, Hong Kong, and Zürich. Western Asset is a wholly owned subsidiary of Franklin Resources, Inc. but operates autonomously. Western Asset is comprised of six legal entities across the globe, each with distinct regional registrations: Western Asset Management Company, LLC, a registered Investment Adviser with the Securities and Exchange Commission; Western Asset Management Company Distribuidora de Títulos e Valores Mobiliários Limitada is authorized and regulated by Comissão de Valores Mobiliários and Brazilian Central Bank; Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services License 303160; Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services License for fund management and regulated by the Monetary Authority of Singapore; Western Asset Management Company Ltd, a registered Financial Instruments Business Operator and regulated by the Financial Services Agency of Japan; and Western Asset Management Company Limited is authorised and regulated by the Financial Conduct Authority ("FCA") (FRN 145930). This communication is intended for distribution to Professional Clients only if deemed to be a financial promotion in the UK as defined by the FCA. This communication may also be intended for certain EEA countries where Western Asset has been granted permission to do so. For the current list of the approved EEA countries please contact Western Asset at +44 (0)20 7422 3000.