(Bloomberg) — An unprecedented disconnect between Hong Kong and US interest rates is fueling the world’s top-performing carry trade — and stoking a fresh debate about the long-term appeal of the city’s pegged exchange rate.
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Hong Kong’s currency has slumped in recent weeks toward the weak end of its official trading band against the greenback, after local interest rates fell to a three-year low and widened the discount to their US peers to rarely seen levels. This has fueled demand to use the Hong Kong dollar to invest in the higher-yielding US currency, turning the bet into the world’s most rewarding carry trade over the past month by one measure.
While there are few signs of an imminent threat to the 42-year-old currency peg, its relevance is coming under fresh scrutiny at a time when Hong Kong’s economy is increasingly integrated into China’s and global trade is under siege. While a relatively steady exchange rate is considered key to the Asian financial hub’s open economy, it brings along the often undesirable side effects of local interest rates being dictated by the Federal Reserve’s policy.
The one-month Hong Kong Interbank Offered Rate, a gauge of funding costs also known as Hibor, dropped to the lowest level since 2022 this week. Within two months, the benchmark has slumped at the fastest pace since the global financial crisis.
Ironically, a key driver of the rate plunge was HKMA’s record liquidity injection early last month, when a selloff in the US dollar drove Hong Kong’s currency to hit the strong end of its HK$7.75 to HK$7.85 band. The intervention has led to a fourfold increase in the city’s interbank liquidity pool.
Meantime, the low rates are also a reflection of anemic corporate demand for loans, as the city continues to battle its way out of a post-pandemic slump. Hong Kong lenders’ loan-to-deposit ratio fell to a 16-year low in March.
As the Hong Kong dollar inches closer to the low end of its trading band, concerns are growing that any aggressive intervention by the HKMA may undermine the city’s nascent property market recovery and a world-leading rebound in stock listings. The prospect of such economic distortions has revived discussions about the benefits of the rigid currency peg.
“One of the arguments for de-peg is that Hong Kong’s rates won’t be passively affected by US policy especially when the economic situation is diverging,” said Carie Li, global market strategist at DBS Bank. “However, there are more drawbacks than benefits for an imminent adjustment, as that could erode confidence in the peg system and hence local assets, as well as spark speculation on more changes to the currency regime.”
The notional value of outstanding dollar call options betting on the Hong Kong currency to hit or fall beyond HK$7.85 reached around $51 billion on Thursday, about 25% more than the amount a month ago, according to data from the Depository Trust & Clearing Corp. Trades on a drop past the weak end of the band doubled to $2 billion over the same period, the data show.
In the forwards market, contracts longing the US dollar against Hong Kong’s currency have registered record-high annualized carry trade returns, according to a report from Goldman Sachs Group economists led by Andrew Tilton.
The peg has held firm despite being repeatedly targeted by speculative investors. Kyle Bass, founder of Hayman Capital Management, and Bill Ackman, chairman of hedge fund Pershing Square Capital Management, have both said they have wagered against the currency in recent years.
Over the years, there has never been a shortage of suggestions to reform or abandon the peg, including widening the trading band, adopting a market-driven floating exchange rate, as well as anchoring it to the yuan.
That said, the status quo remains the authorities’ preference for now. Hong Kong’s Chief Executive John Lee said in a recent local media interview that the city will maintain its currency’s peg to the US dollar, citing it as a key success factor and rejecting calls to abandon the link amid escalating geopolitical tensions.
The current mechanism still has its supporting factors. For one, the US currency is fully convertible and can be traded freely in large amounts on foreign exchange markets. The yuan doesn’t fit that bill for now. The US dollar also dominates as an international reserve currency, while its Chinese counterpart still has a ways to go to boost its reserve status.
“It is good to peg to the most important currency in the world, before the yuan becomes fully convertible,” said Ju Wang, head of Greater China foreign-exchange & rates strategy at BNP Paribas. “It offers an alternative for Chinese capital to go overseas and it is not ideal to introduce excess volatility to the market.”
To be sure, the risk of a full-blown crisis for the city’s currency peg remains remote.
With Hong Kong stocks among the world’s best performers this year, equity inflows from mainland Chinese investors will underpin the local currency, according to DBS Bank, adding that seasonal demand induced by corporate dividend payments may also be of help.
Still, the Hong Kong dollar is likely to weaken in the near term due to the carry trade, analysts say.
“Our estimates suggest that around HK$70-100 billion of liquidity would be drained” amid official intervention, Citigroup Inc. analysts led by Philip Yin wrote in a note. “This should bring short-term Hong Kong dollar rates to 2-3% and the currency to around 7.82-7.83.”
–With assistance from Masaki Kondo.
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