In accordance with the Linked Exchange Rate System, the Hong Kong Monetary Authority (HKMA), Hong Kong’s de facto central bank, has set a trading band of 7.75 and 7.85 for the Hong Kong dollar (HKD) vs. US dollar exchange rate since 2005. Since the beginning of April this year, the HKD/USD exchange rate has been lingering at the weaker end (HKD/USD=7.85) of this range. On April 12, the exchange rate hit 7.85, automatically triggering FX intervention by the HKMA and arousing widespread concern over a possible significant capital outflow from Hong Kong and even the soundness of the currency system. However, we expect the HKD to end its downtrend against US dollar soon.

We believe that the recent HKD depreciation against USD is mainly the result of a widening Hong Kong and US interest rate differential, rather than being reflective of economic fundamentals. As shown in the chart below, the HKD/USD exchange rate is largely (negatively) correlated with the interest rate differential between LIBOR and HIBOR (Hong Kong Interbank Offered Rate). This year, US interest rates have risen following expectations of Fed rate hikes, while Hong Kong interest rates have risen only relatively modestly during the period, resulting in the widest USD-HKD interest rate differential since 2007 and an uptick in HKD-USD speculation.

However, we expect the first best lending rate hike in a decade is approaching. After ten FX interventions by HKMA with a cumulative amount of HK$33.7bn in the past few days, HIBOR has risen significantly, narrowing the US-HK interest differential. At the current rate of depletion of the aggregate balance, we may fast approach the first rate hike window for the best lending rate in more than a decade. And we still expect for a 75~100bp hike in the HK best lending rate in 2018. This should restrain HKD-USD speculation. Furthermore, we think that the Hong Kong economy is likely to prove more resilient to interest rate rises this year, as a potential rate hikes at this stage is considerably “behind the curve” and won’t derail the ongoing reflation and we remain optimistic on the HK economy on stronger consumer expenditure growth in 2018.

In addition, we still see fast fund flows into Hong Kong and A-share markets despite the weakening southbound funds (Chinese investors buying HK-listed shares), dissipating the risk of massive fund outflow. And HKMA is financially capable of defending the currency system in view of its foreign exchange reverse as high as US$440bn.

For more information, refer to our macroeconomic report 'Weak HKD: a prelude to rate hikes, not a sign of softer fundamentals', our strategy report 'Weak HKD nears turning point; remain positive on HK market' and our sector report 'NIM to benefit from HKMA defense in LERS; BoCHK still top pick' published in April 2018.