Hong Kong's Defense of the Local Dollar Not Working -- For Now

The Hong Kong dollar was trading near HK$7.85 for every US dollar in morning trade on Monday, April 16, despite a US$1.2-billion intervention by the Hong Kong Monetary Authority (HKMA) on Friday, April 13. 

Outflows are likely to accelerate as the US further tightens its monetary policy, China Everbright Bank deputy head of treasury in Hong Kong told Bloomberg. That will increase short-end rates in Hong Kong, he warns. 

The Hong Kong dollar is pegged to the US dollar at a band of HK$7.75 to HK$7.85. To keep the peg and avoid wild swings in the currency, the HKMA intervenes whenever the local currency becomes so strong that it breaches the upper band, or becomes so weak it breaches the lower end. 

While the de facto central bank has the firepower to continue intervention, its ammunition is not unlimited. By buying Hong Kong dollars, the HKMA in effect is curbing the abundance of liquidity in Hong Kong, which has kept local interbank rates lower than that in the US. Hong Kong interbank rates are expected to rise as the HKMA continues to defend the peg.

"If the downward pressure on the Hong Kong dollar persists, policy makers are likely to step up its intervention over the coming months," wrote Chang Liu, Capital Economics China economist, in a research note. The worry is that rising interest rates could push the highly inflated property market to the brink. A collapse, wrote Chang, could lead to "a slump in consumption and a sharp rise in non-performing loans." 

Updated April 17:

"The recent weakening of HKD does not signal a currency crisis," writes ICBC, China's largest bank, in a report, about Hong Kong's first intervention since 2005. "We believe HKD is fundamentally stable and continues to be safe and sound in the short and long term."

ICBC says the government "has to use the exchange rate as a tool to passively downsize the balance sheet given the global trend of a faster monetary policy turnaround." It describes the "temporary weakening" of the Hong Kong dollar as "necessary for the normalization of HK interest rates and HK's integration with the global general recovery."

The real risk, says ICBC, is "the depreciation fear." But with more than US$400 billion in foreign exchange reserves and "rich experience in dealing with crisis," the banks argues that the "HKMA has the capability to stabilize HKD exchange rate expectations and finish the course of interest rate normalization."

The HKMA bought another HK$5.77 billion on April 17 (with US$735 million). The Hong Kong currency traded at HK$7.8498 against the US dollar as of noon of April 17.