Across The Border
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Yuan’s growing influence seen as factor keeping Hong Kong dollar weak

PUBLISHED : Tuesday, 29 August, 2017, 6:04pm
UPDATED : Tuesday, 29 August, 2017, 10:16pm

The yuan’s growing influence in Hong Kong’s economy is bringing a sea change to the city’s interbank market, with one outcome being the recent accelerated weakening of the Hong Kong dollar that is likely to complicate efforts to defend the currency peg.

A recovery in yuan this year saw heavy investments in stocks that make up the Hang Seng Index and Hang Seng China Enterprises Index, which increased liquidity in the economy and anchored the city’s interbank rates at discounted levels to rates of countries like the US and China.

In the past, speculators would take advantage of this “carry trade” by borrowing cheap Hong Kong dollars to invest in higher-yielding US assets. Such market forceswould lead to a reduction in the city’s money supply and push up Hong Kong rates and narrow the Hong Kong-US rate differential.

Why the yuan’s rise against the dollar is far from over

Speculators are still conducting carry trades but are choosing to borrow Hong Kong dollars to invest in CNH (offshore yuan in Hong Kong) assets, not just US assets. Analysts said this has apparently kept money supply at elevated levels, resulting in the sustained gap between Hibor and Libor rates this year. Hong Kong interbank rates, or Hibor, have not kept up with increases in the official base rate, which is also a reflection of ample liquidity.

One of the main reason for such a phenomenon lies in the increasing fungibility between Hong Kong dollars and the Chinese yuan in the economy amid heavy inflows, analysts said.

“Hong Kong’s market is not self-correcting as it would have done in the past despite people doing carry trades. One reason the rates do not converge is the growing influence of the renminbi in the economy,” said Julian Wee, senior markets strategist for Asia at National Australia Bank.

Offshore yuan is no longer just used for savings and investment, which is the main role of the US dollar in Hong Kong, but is increasingly being used for business transactions, meaning banks are gradually accepting yuan as an alternative to the Hong Kong dollar.

Hong Kong’s market is not self-correcting as it would have done in the past despite people doing carry trades
Julian Wee, National Australia Bank

So when funds are moved from Hong Kong dollars into offshore yuan it doesn’t reduce Hong Kong’s money supply because renminbi is still being circulated in the economy by banks and merchants, as well as via ATM machines, despite the fact it is not the city’s legal tender, according to Wee.

Hong Kong’s yuan deposits stabilised at around 520 billion yuan (US$66.24 billion) in the first half of this year after dropping 36 per cent last year.

As Hibor and Libor rates have maintained their differential this year, the continuous selling pressure on Hong Kong dollars in search of higher yielding assets has caused the local currency to slide 0.87 per cent this year.

“What makes this trade even more alluring is that [China’s] State Council has spelt out clear, unambiguous restrictions on overseas investments,” said Stephen Innes, Asia Pacific head of trading at Oanda. This includes a crackdown on outbound investment in assets such as property, hotels, entertainment and sports clubs, as well as setting up overseas investment platforms without verifiable documentation.

“The notion is that this will curb USD demand onshore,” Innes said.

The monetary policy objective of the Hong Kong Monetary Authority – the city’s de facto central bank – is to manage interbank liquidity to ensure exchange rate stability under the linked exchange rate system. It is obliged to prevent the local currency from breaching either side of a trading band between 7.75 and 7.85.

But HKMA’s efforts to defend the US dollar peg are being complicated because it doesn’t have control over the money supply of yuan.

This month’s decision to issue HK$40 billion (US$5.11 billion) in additional Exchange Fund Bills between August 22 and September 19 appears to have had little effect on decreasing interbank liquidity or raising interbank interest rates to support the exchange rate.

Hong Kong’s dollar was at 7.8236 per US dollar on Tuesday, making it the second worse performer this year among 11 most traded Asian currencies.

The one-week Hibor-Libor rate differential remains at a relatively wide 98 basis points, near the 8-year high of 103 basis points that was seen on August 22.

The HKMA may need to issue more exchange rate bills in addition to the HK$40 billion if rate differentials between Hibor and Libor fail to narrow and continue to exert pressure on the Hong Kong dollar, said Jasper Lo, chief strategist at King International.

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