Hong Kong seen draining liquidity with currency near weak end of peg vs dollar

HONG KONG’S central bank will probably take steps to tighten liquidity in the financial system as the city’s currency approaches the weak end of its peg against the greenback.

That’s according to 15 of 19 analysts surveyed by Bloomberg from March 2 to 6, who said the Hong Kong Monetary Authority (HKMA) will offer extra Exchange Fund Bills (EFB) this year, although not all agreed currency weakness would be a factor in the sales. Twelve respondents said the exchange rate will breach the weak end of its HK$7.75-7.85 band for the first time since it was imposed in 2005.

As a global financial center with open capital borders and a currency peg, Hong Kong has limited options when it comes to controlling liquidity — which is currently plentiful. Extra bill sales may help slow the local dollar’s drop, but they risk undermining a monetary system in which the HKMA is not supposed to target interest rates. Once the currency reaches the limit of the band, the HKMA will be forced to buy Hong Kong dollars, thereby shrinking the monetary base and effectively raising rates.

“HKMA will act preemptively before HKD hits the 7.85 level,” said Christy Tan, Singaporebased head of Asia markets strategy at National Australia Bank Ltd.

She added that the local currency could breach the HK$7.85 level quickly as it becomes more volatile around the Federal Open Market

Committee meeting on March 22 and if local interbank rates known as Hibor remain low. “HKMA may need to spend more to defend the peg system in this circumstance, as speculators may see this as an opportunity to test the peg,” Tan said.

The market has started to show it expects higher rates. One-year interestrate swaps jumped to the highest intraday level since 2008 on Thursday, while basis swaps — which let holders exchange floating Hibor-based payments with those based on dollar Libor — rose above zero last week for the first time since late 2016. Twelve-month forward points rose to the highest since January on Thursday.

The Hong Kong dollar has weakened 1% since end-2016 to HK$7.8344 as of