HKD intervention: it could get ugly

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The Hong Kong Monetary Authority (HKMA) has intervened for the first time in three years to keep the HKD in its trading band against the dollar, a move that should lend further support to the euro but could be the start of the unravelling of the city’s currency regime.

On Saturday, the HKMA sold $603 million-worth of HKD, as it moved to shore up the bottom end of its currency’s HK$7.75-HK$7.85 trading band. The central bank said the recent pick-up in demand for the HKD was the result of a “less strained European market”, as well as weakness in the US dollar and US interest rates, which have boosted capital inflows into currency and equity markets in the region. The interest in HKD follows a similar move in the CNY, which in recent weeks has hit its highest level for 19 years against the dollar as capital outflows from China reversed. On the surface, this looks like a positive story for risk, which could boost the euro and help support EURUSD above $1.30. As Hans Redeker, head of global FX strategy at Morgan Stanley, points out, continued inflows into the region suggest risk appetite has strengthened. “So far, EUR has maintained its correlation with risky assets, suggesting a higher EUR when assets prices rise,” he says. Furthermore, increasing inflows into China suggest local currency reserves might soon start rising again, says Redeker. He says although global rebalancing should lead to shifts to consumption from investment, thereby curbing global currency reserve growth in the long term, there might be periodic upticks. Those upticks are a function of US domestic demand. Recent strong US retail sales and housing figures suggest a slower pace of global rebalancing that should let global currency reserves rise in the short term. “When global currency reserves increase, the reallocation of incoming reserves will likely become a topic,” says Redeker. “Expectations that reserve managers might diversify USD holdings into EUR should lend additional support to EURUSD.”

China: temporarily rising currency reserves could boost
bullish EURUSD expectations

 Source: Morgan Stanley, Reuters EcoWin
Peg under pressure However, while the fact the HKMA has been back in the market for the first time since December 2009 might seem to be a straightforward risk-appetite story, it is more complicated than that. Indeed, given the proposal floated earlier this year by former HKMA chief Joseph Yam that the city should consider abandoning its peg to the dollar, the stability of Hong Kong’s currency regime is likely to be tested. Easier monetary conditions as a result from inflows are unlikely to be welcomed in Hong Kong, where growth is flagging, and an increasing social divide has weighed on the administration’s popularity and prompted measures to alleviate poverty and curb the city’s property price bubble. Intervention from the HKMA to defend the peg is unsterilized under the rules of its currency board. That means the buying of USD by the HKMA is a direct injection of liquidity into the banking sector – effectively QE on top of that, which they are importing directly or indirectly from the Federal Reserve. It is a toxic combination for a small, open economy such as Hong Kong, where inflation is outstripping forecasts and unemployment is rising. It also underlines the undervaluation of the HKD, which on a real-effective basis suffers from a valuation gap of about 40%, not just against China but also against peers such as Singapore.

Real effective exchange rates, January 1999=100

 Source: Deutsche Bank
One-year USDHKD forwards, which have been trapped in a +60 to -120 pip range for most of the year, are likely to press substantially lower, says one London-based analyst. He notes in 2009, when USDHKD was almost continually at the bottom of the band, they averaged -200 pips, or a revaluation of 0.25%. The low since the band was put in place in 2005 is -990. “Things could easily get uglier this time around, as market participants will be much less persuaded of the government's reiteration of unwavering support for the peg,” he says.