Hong Kong dollar's resilience is pegged to positive investor sentiment

Only a massive and sudden capital outflow can break the currency board’s strength.

Even with a bout of depreciation dragging the value of the Hong Kong dollar, analysts remain bullish about the currency’s resilience to weather the market downturn provided that the Hong Kong Interbank Offer Rate (HIBOR) stays within a desirable range, according to a Natixis Asia Research report. 

The HIBOR is an interest rate on the lending and borrowing between banks. 

The value of HKD is pegged to the confidence of market participants in the Currency Board System. Investors are still willing to hold the HKD amidst losses due to depreciation and lower interest rate because they expect to be compensated later by its appreciation. 

“The buffer is such that we remain confident on the HKD exchange rate regime as long as there is the desire to maintain it,” noted the report. 

Moreover, de-facto central bank Hong Kong Monetary Authority’s strong capital controls can be used if the market deviates too far from its credibility brand. 

“On the one hand, it has withdrawn USD liquidity from the money market when the HKD was close to the bottom of the band. The HKMA stands ready to sell HKD to banks for USD when the USD-HKD strengthens to 7.75. On the other hand, the HKMA has issued exchange fund bills to manage interbank liquidity and has recently stepped up the extra issuance to soften the HKD depreciation, and reportedly also to help banks to comply with Basel III related liquidity criteria,” the report added. 

In worst case scenario, HKMA can also take an extreme measure in the form of forex intervention. 

Abundant liquidity thanks to quantitative easing from the dollar-peg and steady capital outflows from China is also buffering the currency against overall market volatility. 

“The amount of liquidity flowing into Hong Kong is massive comparing to the economic size. We estimate that the capital inflows amounted to 167% of GDP based on the expansion in monetary base and the average size of Hong Kong economy between 2008 and 2016,” Natixis reports. 

Only a sudden and massive capital outflow is expected to bring the resilient currency board regime to its knees. The first can occur in the case of a rapid reduction in USD global liquidity as the Fed moves to reduce its balance sheet and a second case if China withdraws the liquidity it housed in Hong Kong. 

“Both shocks would obviously push up HIBOR aggressively and squeeze liquidity in Hong Kong. This means a weak HKD with a low HIBOR should not worry us, but rather a weak HKD with a high HIBOR versus LIBOR. In other words, liquidity squeeze could be much more of a problem than the situation we see today for HKD,” Natixis adds.