The Hong Kong dollar's strengthening over recent weeks has changed more than one preconception. Not only has the bet that the unit must weaken been shown to be wrong, but traders have discovered that the de facto central bank has no obligation to make a two-way market in the currency. A belated realisation that the convertibility mechanism is one-sided has sparked an unexpected risk element at a time when the question of Asian currency appreciation has jumped on to the agenda. Given that until only a few weeks ago, most concerns were all about a depreciation of the HK dollar, many investors seemed unaware that upside risk even existed. Hence the frantic unwinding of positions that brought the currency to a six-year high against the US dollar on September 22. That rapid movement, coupled with the Hong Kong Monetary Authority's apparent reluctance to stem the appreciation and stabilise the market, paralysed normal arbitrage activity that ordinarily corrects imbalances once short-term Hong Kong interest rates fall below their US equivalents. A fear that billions of US dollars worth of speculative positions against the HK dollar were about to be reversed - and the possibility that massive amounts of foreign currency assets held by local banks, companies and individuals could follow suit - was a very persuasive deterrent. 'This time around we have seen clearly that the arbitrage mechanism has not worked very well, because we don't know where the floor in the market is,' said James Malcolm, regional currency strategist at JP Morgan. 'The moves seen in the past couple of weeks could well have regulatory ramifications in the sense that they could rethink this asymmetric convertibility.' The HKMA has an undertaking to buy HK dollars against US dollars at a fixed exchange rate of HK$7.80, thus effectively preventing the spot rate from weakening too much. And while the HKMA has no such undertaking to sell HK dollars or buy US dollars, it may do so at whatever level it sees fit to maintain stability in the market. After the HKMA painstakingly moved its formal convertibility undertaking rate to HK$7.80 from HK$7.75 over a 500-day period ending in August 2000, many players had assumed a line would be drawn close to HK$7.80. But as the HK dollar rallied to HK$7.7050 overnight just over two weeks ago, this was proven wrong. The HKMA has re-entered the market and sold HK dollars four more times since then, at a total value of US$360 million. But each time it has done so at a different level. Consequently the market has been left with no firm idea of how much further the HKMA will allow the HK dollar to strengthen. 'If there is no formal undertaking how can people do arbitrage?' asked Eddie Wong, chief Asian strategist at ABN Amro. He noted that since US dollar rates are at such low levels (1.15 per cent for three-month US-Libor) the interest rate differential is not enough. 'Arbitrage will only work if there is a belief that the HK dollar will eventually go back to 7.80 or that it will not deviate too much from there. 'But how do you define not too much? [The HKMA] has sold HK dollars at 7.74, 7.73, 7.72 and even at 7.71. Who knows? Perhaps next time they will do it at 7.65.' The HKMA compounded the uncertainty last week when chief executive Joseph Yam Chi-kwong said there was 'no harm' in having 'a bit of constructive ambiguity'. His suggestion that he was happy to see speculators holding short HK dollar positions only added to a sense of market unease. That may not represent a shift in doctrinal thinking but combined with huge fund flows into Hong Kong, the effect has been a substantial currency mismatch problem. Banks alone have net foreign currency assets of around HK$142 billion, while corporations have been holding large amounts of foreign assets as a guarantee should the peg be scrapped, money which could be rapidly exchanged into HK dollars if the market senses that the US dollar slide is continuing. To be sure, there are people who argue that warnings about things possibly getting out of hand are exaggerated as it is still quite a small appreciation. 'There is absolutely no inconvenience about having the currency appreciate 1 per cent against the US dollar,' said Patrick Guillot, head of global markets, Northeast Asia, at Standard Chartered Bank. Once the unwinding of long US dollar positions was finished, the market would stabilise and bring in buyers that have a natural demand for US dollars, he noted. Indeed, the HK dollar slipped back a little yesterday to HK$7.7370 from HK$7.7078 on Tuesday, while the one-year forward discount narrowed. But even if the HK dollar did come back to HK$7.75, it was still trading away from the parity rate, noted JP Morgan's Mr Malcolm. 'If that persists for more than a couple of weeks, then it could become destabilising in the sense that you are encouraging people to believe that there has been a policy change, an introduction of a band and not just the fixed rate,' Mr Malcolm said.