HKMA rejects two-way convertibility - so what?

One way convertibility is set to stay in Hong Kong, suggesting that confidence in the peg has returned.

The Exchange Fund Advisory Committee (EFAC) of the Hong Kong Monetary Authority (HKMA) decided on 2 August not to offer an explicit undertaking to sell Hong Kong dollars at the convertibility undertaking rate of HK$7.8 for US$1. The HKMA commits itself, through “one-way convertibility”, only to buy - but not to sell - Hong Kong dollars at HK$7.8 per US dollar to fend off speculative selling of the Hong Kong dollar. The EFAC’s decision of not guaranteeing to sell Hong Kong at the given rate effectively rules out two-way convertibility for the time being.

Why reject two-way convertibility?

The EFAC is concerned that two-way convertibility with one exchange rate at HK$7.8, or a razor-thin bid-offer band, will eliminate a large part of the Hong Kong dollar foreign exchange market. This will go against the authorities’ efforts to make Hong Kong a major financial centre in the world.

The one-way convertibility essentially puts a floor onto which the Hong Kong dollar can fall. By not guaranteeing to sell the local dollar at the convertibility rate, the HKMA is not imposing a ceiling up to which the Hong Kong dollar can appreciate. In the event of heavy capital inflow, as Hong Kong is experiencing now, some flexibility for currency appreciation may be desirable to prevent the local dollar from being undervalued. The concern is that an undervalued currency could trigger inflation and create a bubble economy again.

Two-way convertibility is a strong and rigid measure to strengthen the credibility of the currency board system. However, the regional environment has improved sharply and there is massive capital inflow into Hong Kong, suggesting that confidence in the Hong Kong dollar peg had returned. Indeed, the Hong Kong dollar forward market has bet that the HKMA would not implement two-way convertibility.

On June 12, the one-year Hong Kong dollar forward started falling from a premium to a deep discount, which is still being maintained. This discount means the market is expecting the Hong Kong dollar to trade below the HK$7.8 spot rate, and therefore appreciate, in one year’s time. With little likelihood of any speculative attacks and capital outflow, there is no imminent pressure to implement a more rigid system.

Hong Kong rates diverge from US rates

Capital inflow will continue, due to rising portfolio allocation towards the Greater China region. IPOs from local and Chinese companies will attract more foreign - including the mainland’s - capital. Hence, the longer-dated Hong Kong dollar forward could stay at a discount for a while longer. Ample liquidity in the local system will also keep Hong Kong inter-bank rates low, despite the risk of further rise in US interest rates.

This is a peculiar situation because the currency board system requires Hong Kong’s interest rates to rise in tandem with rising US rates. Indeed, Hong Kong’s prime rate and the HKMA’s Base rate have tracked US rate moves. But these rates are irrelevant for local funding purposes because corporate loans are now priced over the inter-bank rates, such as one- and three-month HIBOR, which are well below both prime and US LIBOR rates. Mortgages are also priced significantly below the prime rate. The Base rate is also a non-binding funding constraint, as banks do not need to borrow from the HKMA due to ample liquidity in the inter-bank market.

Heavy capital inflows should keep HIBOR and mortgage rates low, despite the currency board restrictions. Hence, the Hong Kong dollar peg that theoretically ties local interest rate movement to US rates should not jeopardize Hong Kong’s economic recovery. The flushed liquidity conditions should help underpin local asset prices. The capital inflow will also keep the longer-dated HK$/US$ forwards in discount in the short-term, though the discount should narrow after 12 August when the “one pip per day” program to move the Hong Kong dollar towards 7.8 will be completed.

Risk of one-way convertibility

However, speculation against the Hong Kong dollar will persist as long as there are doubts about the authorities’ commitment to the currency peg. These doubts will intensify when a negative shock hits again. Signs that China is moving towards more exchange rate flexibility will not help.

This is because throughout the Asian crisis, Beijing had pledged to back Hong Kong’s currency peg along with its pledge to keep the Renminbi fixed against the US dollar. A change in China’s foreign exchange regime would inevitably create uncertainty about Beijing’s commitment to support the Hong Kong dollar peg in case of financial turbulence.

A two-way convertibility undertaking with a single exchange rate will eliminate all speculative incentives by eliminating foreign exchange volatility - speculation is not possible without bid and ask prices. Hence, the HKMA will eventually have to implement the bullet-proof two-way convertibility when another negative shock hits Hong Kong. And it has indeed left the door opened - when it announced its rejection of two-way convertibility, it also qualified it by saying that it would review the convertibility undertaking again if needed.

Chi Lo is  regional head of research & senior economist, Standard Chartered Bank Treasury, Hong Kong

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