Hong Kong: Convergence Trade

Hong Kong’s economy is in its deepest recession since 2008. Real GDP contracted by 2.9% YoY in Q4. Q1 is on track for a sub -5% YoY print.  

And yet, spot USDHKD has fallen close to the strong side of its 7.85/7.75 trading band. And 3m HIBOR continues to fix stubbornly 50bps above 3m LIBOR – a symptom of tight liquidity.

The unusual strength of the HKD and tight liquidity are out of whack with the state of the economy. In my view, it is time for HKMA to make a course correction, and utilize what policy space it has within the Linked Exchange Rate System (LERS) to ease financial conditions in the Hong Kong economy.

But why is the HKD so strong and liquidity tight in the first place? There are three reasons, in my view.

First, when the protest movement turned violent, the HKMA’s first priority was to safeguard financial stability. The peg was under attack from offshore speculation and domestic capital flight. HKMA was very proactive behind the scenes to shore up the peg. For instance, the Authority quietly transferred ~USD16bn of foreign currency deposits to local banks to offset any depletion caused by capital flight.   

Second, it appears the protests perversely improved Hong Kong’s current account surplus. While services exports (e.g. tourism) have been hurt, demand for luxury imports also dried up (nobody is shopping!). The latter outweighed the former, and together with the income surplus, Hong Kong has ended up with a near-record current account surplus.

Third, a rise of system-wide risk aversion may be affecting the willingness to make uncollateralized inter-bank loans. Since the Aggregate Balance – a measure of excess inter-bank liquidity – is at a very low level, there is limited cushion in the system against liquidity shocks.

Looking forward, I think the Authority could shift its focus from fighting speculative outflows to supporting the economy. I am not suggesting they will devalue the HKD. But I think there is room within the existing Linked Exchange Rate System (LERS) framework to ease liquidity. There are several policy tools available, including term liquidity injection, rolling off EFN bills or conducting buy/sell FX swap intervention, or simply using window guidance to encourage large banks to lend HKD via FX swaps.

When would HKMA make this pivot? They could either be passive, allowing spot USDHKD to reach the bottom of the corridor and then pumping in liquidity via FX operations. Or they could be a bit more proactive in deploying the tools mentioned above. Both paths lead to HIBOR-LIBOR convergence, though the speed and timing would be different. The 5Y HKD vs. USD IRS spread has been fluctuating around 30bps. I would be happy to build a received position in this spread, and target a compression to par.

Chart 1: USDHKD 1Y FX Forward Points vs. 5Y HKD-USD IRS Spread

Source: Bloomberg

Chart 2: USDHKD Spot, Policy Bands and Reported FX Operations

Source: Bloomberg, HKMA

Mirza is a macro strategist, specialising in Asian FX and fixed income markets. Mirza is currently working as a desk analyst at Morgan Stanley, prior to which he worked in macro strategy roles at BNP Paribas and Deutsche Bank

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