Weak Hong Kong Dollar Riding Close to Limit

The Hong Kong dollar has continued to weaken against the U.S. dollar, pushed to fresh lows by traders seeking to profit from the widening interest rate gap between the city and the U.S.

The Hong Kong dollar settled near 7.8490 against the U.S. dollar on Tuesday. It briefly touched 7.8499 on Monday morning — its weakest level in about three decades, according to Bloomberg data.

Hong Kong linked its currency to the U.S. dollar in 1983 at a fixed rate of HK$7.8 to $1. Under a mechanism installed in 2005, the Hong Kong dollar is allowed to trade between 7.75 and 7.85 against the U.S. dollar. If it breaks the limits of the band, the city’s monetary authority must intervene.

The recent volatility is pushing the Hong Kong dollar ever closer to how far it is allowed to weaken.

Norman Chan Tak-lam, chief executive of the Hong Kong Monetary Authority (HKMA), told media on March 22 that the authority will defend the peg by buying the Hong Kong dollar and selling the U.S. dollar if the limit is touched.

Such action would cut down liquidity in the local banking system and force banks to increase their lending rates, Chan said. On the same day, the HKMA raised the city’s base lending rate by 25 basis points to 2% to match a similar increase by the U.S. Federal Reserve.

Since December 2015, the Fed has raised rates six times, from near zero to the current 1.75% set on March 21.

Wu Zhuoyin, an analyst at French investment bank Natixis, told Caixin that the steeper path of interest rate hikes in the U.S. has led to a widening gap between U.S. and Hong Kong rates, which encouraged traders to carry out arbitrage trading by selling low-yielding Hong Kong dollars to buy the high-yielding U.S. currency.

The Hong Kong interbank offered rate (Hibor), which reflects the local borrowing cost, has been rising over the past months but at a much slower pace than the U.S. borrowing cost, measured by the London interbank offered rate (Libor).

According to the Hong Kong Treasury Markets Association, the three-month Hibor was set at 1.21% on Wednesday, compared with 2.32% of the three-month U.S. dollar LIBOR.

Eddie Cheung, foreign exchange analyst at Standard Chartered, said recent stock market fluctuations caused by concerns over U.S.-China trade tensions may further weaken the Hong Kong dollar as more capital will depart the city.

Expectation of a weaker Hong Kong dollar persists. In a recent report, Bank of America Merrill Lynch predicted that the currency would break the 7.85 lower limit in the second quarter, forcing the HKMA to drain HK$80 billion ($10.2 billion) from the market to boost the currency’s value.

But Zhang said the squeeze on liquidity triggered by currency depreciation will help the city rein in the overheated property market.

Contact reporter Han Wei (weihan@caixin.com)