Hong Kong’s dollar weakened to its lowest level in more than three decades, as the gap between the city’s borrowing cost and US interest rates widened ahead of the US Federal Reserve’s March 21 meeting, drawing more dealers into the carry trade to sell the local currency for the greenback. The Hong Kong dollar weakened for the third day on Monday, slipping to 7.8322 per US dollar, approaching the lower end of a 2005 trading band that could compel the Hong Kong Monetary Authority to support the currency. “People are selling Hong Kong dollars to position for an interest-rate increase by the US Federal Reserve in March,” said Jasper Lo Cho-yan, senior vice-president at iBest Finance in Hong Kong. “As Hong Kong’s banking system is flooded with ample liquidity, banks will likely keep market rates unchanged even if benchmark and US rates go up.” Consequently, the premium of the US interbank rate, known as the Libor, over Hong Kong’s equivalent – known as the Hibor – is at the widest since 2008. That has attracted more dealers into the carry trade, encouraging them to use the low Hibor to borrow and sell Hong Kong dollars to buy US dollars, which in turn pushes local currency’s value lower. The local currency has not traded at such levels since its peg to the US dollar 35 years ago, transacting at 8.7 per dollar on September 26, 1983 just before the currency board system kicked in to peg the local currency at 7.8 per US dollar. The local currency is “heading into uncharted territory and the market development in the near term will probably test the function” of the peg, Mizuho Bank’s senior Asian foreign exchange specialist Ken Cheung Kin Tai wrote in a note on Monday. “We expect market participants to push USD/HKD spot higher to test the policy responses” by the Hong Kong Monetary Authority (HKMA). Hong Kong dollar falls most in 22 months Under the linked exchange rate system (LERS), the HKMA is obliged to prevent the currency from breaching either side of a trading band between 7.75 and 7.85 per US dollar. In the current situation, it would sell US dollars and buy Hong Kong dollars to reduce interbank liquidity and raise Hong Kong dollar rates to curb depreciation pressure. A spokesperson at the HKMA said that the de facto central bank had not conducted any market operations within the convertibility zone on Monday. The recent easing of the Hong Kong dollar against the US dollar was in line with the design of the LERS and should not cause any particular concern, the HKMA said. Local media also reported that Hong Kong’s Financial Secretary Paul Chan Mo-po said he expected some funds would flow out of Hong Kong, causing weakness in the currency. However, he said that capital outflows was good for the city which should normalise Hong Kong’s market rates at a more ideal pace. Hong Kong’s crowded currency trade enters perilous territory Pressure had been building on the Hong Kong dollar – the world’s 13th most-transacted currency – as worries over tightening Chinese regulation turned off the spigot of southbound capital flowing into the city’s real estate, stock market and assets recently. Mainland investors sold a net 350 million yuan (US$55 million) of Hong Kong shares via the Shanghai- and Shenzhen-Hong Kong stock connects in February, the first monthly net outflows since December 2016, according to Bloomberg calculations. We’re back to currency wars, and here’s why that is bad for markets However Carie Li, economist at OCBC Wing Hang, said that outflows by Chinese investors was only temporary, so the pace of any further declines in the Hong Kong dollar was expected to be very gradual. The Hong Kong dollar had been able to find support at near its 10-year low of about 7.825 last year amid strong inflows globally into the city’s property and stock markets.