HKD Gains Despite Growing Unrest

Despite rising social unrest, the Hong Kong dollar traded today at its strongest level since December 18. While we see no threat to the peg, ongoing weakness in EM is likely to prevent HKD from strengthening too much more.

POLITICAL OUTLOOK

Protests over a planned extradition law have intensified. Tear gas and rubber bullets were used on protestors today in what police called a “riot situation.” Chief Executive Carrie Lam called for a return to order even as strikes have been called by protestors. As a result, the Legislative Council delayed its debate.

The law is contentious because it would allow Hong Kong to provide one-time transfers of criminal suspects to countries where it does not have formal extradition agreements. This includes mainland China. While originally meant as a response to a 2018 murder in Taiwan that was committed by a Hong Kong resident, the extradition law has triggered concerns that it would open the door to greater mainland influence on Hong Kong’s legal system.

The Hong Kong Monetary Authority (HKMA) said that local markets are operating in an orderly manner. Yet interbank lending rates continue to move higher. Some local analysts believe this is due mostly to seasonal demand for cash. Others believe the pressure is coming from falling investor confidence and growing concerns about capital outflows.

 

A BRIEF HISTORY LESSON

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 were 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 sustained pressure again.

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 obliged to buy and sell USD to prevent the HKD from breaching either side of the band. It did not have to do so until April 2018, when USD/HKD first started to bump up against the top of the trading band. Yet the mechanics of the peg remain intact. That is, intervention will shrink the money supply, which will then boost local interest rates and support HKD.

The HKMA has several lines of defense even before intervening at the band limits. 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. This can be done before HKD trades at the weak limit of the band. 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.

 

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 appropriate exchange rate arrangement for Hong Kong SAR. Since its introduction, the LERS has served as an anchor of stability, helping to ensure sustained growth, competitiveness, and the smooth functioning of the extensive financial services industry. The functioning of LERS is aided by Hong Kong SAR’s flexible economy, ample fiscal buffers, and strong financial regulation and supervision. The credibility of the arrangement is further underscored by ample FX reserves.” We concur.

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 and when 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 Hong Kong economy is likely to slow, dragged down by the mainland. GDP growth is forecast by the IMF to decelerate to 2.7% in 2019 from 3.0% in 2018 before accelerating to 3.0% in 2020. GDP rose only 0.6% y/y in Q1, the slowest since Q3 2009 and the fourth straight quarterly deceleration. With trade tensions persisting and local liquidity conditions tightening, we see clear downside risks to the growth forecasts.

Price pressures may be rising. CPI rose 2.9% y/y in April, the highest reading since February 2018. 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. The HKMA has raised the base rate nine times since December 2015 to 2.75% currently, in lockstep with the Fed.

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 pretty much at the 5% trough by the two largest commercial banks despite the 225 bp of Fed tightening seen since December 2015. This has been because Hong Kong liquidity remained ample, keeping most local markets rates low. This may be changing.

The external accounts remain in good shape. Hong Kong has run a current account surplus since 1998. The IMF expects that surplus to be around 3.2% of GDP in 2019 and 3.4% in 2020. Hong Kong runs a large positive Net International Investment Position (NIIP) that’s nearly four times GDP. HKMA foreign reserves stood at a $437.8 bln in May, just below the record high $443.4 bln in February 2018. Clearly, Hong Kong has very low external vulnerability across virtually all metrics. This supports our view that any selling pressures on HKD are likely to remain under control.

 

INVESTMENT OUTLOOK

USD/HKD traded today at its lowest level since December 18. Recent HKD gains are noteworthy since it was trading at the weak end of its trading band as recently as the end of May. Still, with much of EM likely to come under greater pressure, we suspect USD/HKD will continue to trade largely within the upper half of the trading band above 7.80.

Hong Kong equities are underperforming after outperforming slightly in 2018. In 2018, MSCI Hong Kong was -10.8% and compares to -11.6% for MSCI DM. So far this year, MSCI Hong Kong is up 10.7% and compares to 14.5% YTD for MSCI DM. This underperformance should ebb, as our DM Equity model has Hong Kong at a NEUTRAL position.

Hong Kong bonds have underperformed. The yield on 10-year local currency government bonds is -31 bp YTD. This is ahead of only the worst performers Singapore (-3 bp), Japan (-11 bp), Switzerland, (-18 bp), Norway (-27 bp), and tied with Italy (-31 bp). Inflation is likely to remain under control, but with the HKMA likely to continue tightening local liquidity, we think Hong Kong bonds will continue to underperform.

Our latest DM sovereign ratings model update had Hong Kong’s implied rating steady at AAA/Aaa/AAA. This compares to actual ratings of AA+/Aa2/AA+ and so upgrades are warranted.