Hong Kong dollar a natural hedge

Hong Kong Monetary Authority has a problem. It’s facing excessive inflows that is overwhelming its capacity to manage the Hong Kong dollar peg.

Investors switching out of the yuan since its devaluation last month have pushed up the Hong Kong dollar, which hit the high end of its peg to the US dollar at HK$7.75, triggering the Hong Kong Monetary Authority (HKMA) to spend some of its HK$3.27 trillion Exchange Fund to defend the currency peg for the first time in four months.

Capital inflow is driven in part by conversions of offshore yuan into the Hong Kong dollar. In two separate interventions, the HKMA bought US$1.2bil and US$800mil of US dollars by selling HK$9.3bil and HK$6.2bil of Hong Kong Dollars to weaken the local currency.

At a glance, strengthening of the Hong Kong dollar curbs tourist arrivals and makes Hong Kong rather expensive.

An expensive currency is hurting the island’s retail sales.

In July, even before the yuan devaluation, retail sales fell 2.8% from a year ago, a sharp decline compared with June’s 0.4% decline. But the bigger picture tells us that the psychological impact on the strengthening of the Hong Kong dollar plays a more vital role, particularly when financial markets start questioning the sustainability of the Hong Kong dollar peg.

A key mechanism of the Hong Kong dollar peg that is seldom mentioned is the “Backing Ratio”. It refers to the extent to which the Monetary Base in the economy is backed by foreign currency assets held in the currency board account of the Exchange Fund.

When the account was first set up, sufficient US dollar assets were transferred to the account to provide a 105% backing of the Monetary Base (also known as the Backing Portfolio).

When the backing ratio reaches 112.5% (the upper trigger point), assets will be transferred out of the Backing Portfolio to the Investment Portfolio of the Exchange Fund to reduce the ratio to 110%. (see chart)

Conversely should the ratio drop to 105% (the lower trigger point), assets will be injected from the Investment Portfolio to restore it to 107.5%. The exercise ensures there is sufficient liquid assets in the Backing Portfolio to manage the currency peg.

When the backing ratio declines, it reflects three situation:

> The first is when the Hong Kong dollar interest rates fall below US dollar rates, there may be an increase in the Monetary Base relative to the Backing Portfolio.

> Second is when the Hong Kong dollar strengthens, however slightly, against the US dollar, the US dollar assets in the Backing Portfolio are worth less in Hong Kong dollars.

> Third is when there is a sudden increase in the Monetary Base, for example in the Aggregate Balance.

In the current position facing the Hong Kong dollar, the Backing Ratio has fallen to 107% as of June 2015, closer towards the lower trigger level of the backing ratio at 105%, last seen in September 2009, corresponding with the global crisis of 2008/2009.

The big question being, for how long the HKMA can resist this unwarranted attention on the Hong Kong dollar.

The excess liquidity that is flowing into Hong Kong from mainland China, though keeps the monetary base in Hong Kong large and pushes interest rate lower, it however tends to keep the currency on an appreciation trend instead.

The risk from this would occur if the US Federal Reserve Bank starts raising interest rates.

Hong Kong’s monetary policy follows the US, as the Federal Reserve Bank is on track to raise interest rates, cost of capital in Hong Kong will rise up, exerting pressure on the local economy.

The silver lining for Hong Kong is that HKMA has US$340bil foreign exchange reserve, almost twice Hong Kong’s entire monetary base of US$183bil. For those betting on the peg collapsing, it could be a folly and a very expensive trade.