On April 12, the Hong Kong dollar fell to HK$7.85 against the US dollar for the first time since the Hong Kong Monetary Authority (HKMA) set the currency's current trading band in 2005.
In response, the HKMA was forced to buy HK$816 million ($104 million) to ensure the Hong Kong currency exchange rate did not weaken beyond 7.85. The Hong Kong dollar is pegged at 7.8 against the greenback but is allowed to trade between the limits of 7.75 and 7.85.
Continuing capital outflows since then has resulted in the HKMA making a further 12 interventions, for a total outlay of $6.5 billion, as of April 24.
The reduction in money supply has nudged up the overnight Hong Kong dollar interbank interest rates from 0.06% on April 12 to 0.65% on April 25 and lifted the one month interbank rates from 0.79% to 1.30% over the same time period.
If local interest rates continue to rise, the Hong Kong stock market could see outflows into fixed income, and the property market in particular may feel the effect of higher borrowing costs.
We asked a wealth manager, a family office CIO, and a fund manager whether they view the weakening of the Hong Kong dollar as part of a longer-term trend, and whether it is impacting their strategic or tactical asset allocations.
Adrian Zuercher, head of asset allocation for Asia Pacific
UBS Global Wealth Management
What's changed is that the Hong Kong Monetary Authority started draining interbank funds whenever the dollar to Hong Kong dollar spot exchange rate hit the weaker edge of the band of HK$7.85. So far, official foreign exchange reserves have burnt $6 to $7 billion, with the monetary base likewise reduced from HK$1.73 trillion to HK$1.69 trillion. This is the mechanism that drives up interest rates.
At this stage, the process is gradual but has further to run. The fixed exchange rate system means equities and property price expectations must adjust lower as interest rates find a higher level. We expect the three month Hibor-Libor spread to narrow to around 60 basis points in 12 months (it’s currently at 105 basis points) – a more typical gap at this stage of US Fed tightening -- with Hibor reaching 2.3%. Hong Kong dollar bank lending has grown vigorously at 15% and looks set to slow as Hibor catches up with Libor and asset price expectations adjust. However, Hibor at 2-2.5% in 12 months would still be low relative to equivalent rates in China, US and the rest of the region, so the Hong Kong dollar should remain a relatively cheap funding currency.
Leverage is high but debt servicing is fairly low, so any negative impact on consumption and GDP should be moderate. We currently hold a neutral [bias] on the Hong Kong equity market driven by robust earnings growth and a rising return on equity. Strong fundamentals should support the current valuation multiples and the expected increase in Hibor should not lead to a meaningful de-rating. Having said that, rising Hibor could lead to higher volatility in the domestic equity market due to a less favourable macro environment – property is an important sector. Thus, we have a preference for Chinese H-shares as they benefit from China's solid fundamentals, where the People’s Bank of China has recently cut the reserve requirement ratio, instead of Hong Kong shares, which are potentially more affected by the HKMA policy.
Stephen Pau, chief investment officer
Hefeng Family Office
Recently, the Hong Kong Monetary Authority has had to prop up the Hong Kong currency. We view this as a short-term phenomenon and we do not intend to make a large allocation shift as a result of this. Firstly, HKMA is watching this situation closely and has commented that they do not see a big capital outflow from institutional investors. Secondly, the financial system in Hong Kong is still sound, and the reserve is still more than HK$100 billion, sufficient to counter any aggressive move from speculators on the weak-side convertibility undertaking of HK$7.85 against the dollar. Thirdly, we expect to see some of the capital flow coming to this part of Asia as there will be a couple of large initial public offerings coming up in the next few months, as well as the Hong Kong Exchange's newly approved dual-class shares listing scheme. All things considered, this will give some support to the Hong Kong dollar. We doubt this will be another repeat of the 1997 situation where Hong Kong had to defend its currency against speculators.
On a valuation basis, China and Hong Kong are still relatively cheap compared to the developed markets. We are presently seeing capital discipline, like capital expenditure cuts, in Asian companies. Earnings before interest and taxes, margins and free cash flows are expected to improve over the next few years. We believe the Asian markets are still attractive from a growth and valuation perspective and money should remain here. Any upward revisions in economic forecasts and higher earnings estimates may justify a re-rating of emerging market countries, which will also support the markets and valuations.
Kelly Chung, senior fund manager
The weakness in the Hong Kong dollar is mainly attributable to 1) the continuing widening gap between Hibor and Libor, 2) deleveraging from China, and 3) inflows into A-shares from foreign investors via northbound [Stock Connect] flows and, domestically, from institutional flows in preparation for China's MSCI index inclusion and Chinese depositary receipts listings. We think the Hong Kong dollar will remain on the weak side due to the above reasons until the aggregate banking balance falls to near HK$100 billion.
However, we are also seeing the capital outflow starting to slow down as Hibor has already gone up. Starting from April 12 the one month Hibor went up from 0.8% to 0.95% in five days, so the gap between Hibor and Libor has narrowed to less than 1%. Also, the reserve requirement ratio cut in China has helped to balance liquidity from the ongoing deleveraging. We believe the Hong Kong dollar will start to gradually, slightly strengthen away from the HK$7.85 upper limit when the Hibor-Libor gap narrows a bit further.
Interest rates in Hong Kong are already starting to normalise. We have been overweight financials, which benefit from the higher net interest margin, and underweight interest rate-sensitive and highly leveraged sectors. Also, we stick to our value approach as we believe value will outperform growth as interest rates start to normalise, which will penalise high-valuation sectors that have been enjoying the low interest rate environment. Stock selection will become much more important this year as southbound [Stock Connect] flows will be slower than last year and momentum will become less of a factor in driving the market.