Hong Kong dollar credibility still intact with future challenge being capital flow reversal

• It has been more than two years since the FED started the interest rate hiking cycle. Since then, there have been episodes of the Hong Kong Dollar (HKD) volatility with a very weak HIBOR against the LIBOR for most of this time. More recently, we have seen a new bout of depreciation of the HKD, which has led to increased worries in the market. We believe the situation is in full control so far as HIBOR continues to be stay within our own estimation of “credibility band”.
•  We explained in our previous report that the recent depreciating HKD and the low HIBOR can be explained by the market expectation of future appreciation of the currency. This indirectly shows that market participants have strong confidence in the Currency Board System. First, investors are still willing to hold the HKD as they expect their loss from a lower interest rate to be compensated by the HKD appreciation. Second, the HKMA has an arsenal of instruments to be used if the market where to deviate from the “credibility band”. The buffer is such that we remain confident on the HKD exchange rate regime as long as there is the desire to maintain it.
•  The most obvious test to the HKD currency board regime cannot but be a sudden and massive exit of capital from Hong Kong. For this to happen, one can think of two shocks which could happen together. First, there will be a rapid reduction in USD global liquidity if the FED were to reduce its balance sheet more aggressively. Second, a very confident China with an increasingly strong RMB can attract massive capital inflows, and thereby withdrawing the liquidity parked 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.

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