Hong Kong Dollar: is the peg under threat?

The Hong Kong Dollar (HKD) isn’t a currency we often talk about at FOREX.com as it is pegged to the USD and usually doesn’t move too much. However, USDHKD has recently fallen to its lowest level since the end of 2012, at 7.75 – the lower bound of its trading band versus the USD- which, combined with social unrest in the region, is making us sit up and take notice.

7.75 is a critical level, and even though the Hong Kong central bank has intervened to weaken the currency to the tune of $2 billion, it remains stubbornly strong.

There are a few reasons why the Hong Kong dollar has strengthened:

1, Demand for cross-border loans: This is a long-term issue, since supply of credit is tight in China and interest rates are higher, demand for loans from Hong Kong banks to Chinese customers has surged in both RMB and local currency. In fact, loans and advances in HKD rose to their highest ever level at the end of May (see chart), with HK$3.8 trillion outstanding. This is helping to keep demand for HKD strong.

2, Cross-border M&A: Hong Kong has also seen a surge in M&A activity, which is partly due to the popularity of Chinese corporates borrowing in HKD in recent years. Hong Kong was the busiest location for cross boarder deal activity in Asia –ex Japan, with deal activity valued at $16.6bn for the first six months of the year.

Until China has a fully open financial system then Hong Kong may see demand for loans and M&A activity continue, which could keep upward pressure on the HKD.

What does this mean for the peg?

If the authorities are worried that demand for HKD will stay strong then it may be getting ready to defend its peg with the dollar. It may need to intervene in larger sums than it did last week, which could cost the central bank many billions of dollars, or it could try and loosen monetary policy. There are problems with both of these approaches:

1, If you loosen monetary policy then it risks stoking inflation, which at 3.7% is just above the average level of the last 5 years.

2, As the central bank found out last week, physical intervention to try and reduce pressure on your currency can be costly, and largely ineffective, USDHKD has barely budged.

A more effective short-term solution for the Hong Kong authorities would be some hawkish minutes from the Federal Reserve this evening, which may boost the dollar.

The peg and social concerns:

The currency peg permits USD/HKD to trade between 7.75 and 7.85, in recent years the peg has come under international criticism. Some have said that the Hong Kong authorities should allow a 30% currency re-valuation, to boost the value of HKD and limit upward pressure on inflation and boost purchasing power. This could pay political dividends, especially during the recent wave of pro-democracy protests that have taken place across the region. A depressed local currency is pressuring visitor and capital flows from mainland China, which is pushing up local prices in everything from property to rice. While the recent protests have ostensibly been about universal suffrage and greater democracy in elections for Hong Kong’s leader in 2017, the experience of the Arab Spring protests shows how important rising prices can be in sparking social discord.

While we continue to think that the HKD peg will be maintained, at least in the short term, there is a good case to be made for ditching it altogether, especially if the Fed maintains its dovish mantra keeping the USD weak, and domestic protests continue.

Some of the recent buying pressure on the HKD could be some investors testing the Hong Kong authority’s resolve to maintain the peg, in anticipation of a currency re-val. So watch HKD for greater currency flexibility. Although change may not be around the corner, it is a viable option if the Chinese authorities want to promote greater political and social reform in the coming years.