Why is the Hong Kong dollar probing the weak end of its band?

By Vidya Ranganathan

SINGAPORE (Reuters) - The Hong Kong dollar has been losing ground steadily to the U.S. dollar since the start of 2017 and is near its weakest in 33 years, a milestone it has now touched for six consecutive sessions.

But, even as it approached the low end of its 7.75-7.85 trading band against the U.S. dollar this week, the city's de facto central bank said it had no plans to intervene until the currency peg touches the floor of its trading band.

The Hong Kong Monetary Authority (HKMA) is obligated to intervene to defend both ends of the peg.

The currency hit 7.8440 per U.S. dollar on Friday and has dropped 66 basis points since November.

WHY IS THE HONG KONG DOLLAR FALLING?

Hong Kong's markets have been flooded with cash over the past decade as heavy money printing by global central banks, led by the U.S. Federal Reserve, directed large flows of new cash to the territory, whose financial centre serves as the main gateway to the outperforming Asian economies.

The Hong Kong market has also been a heavy recipient of investment flows from Chinese investors seeking exposure to the offshore yuan, China's H-shares and bonds.

Trading volumes on the southbound Shanghai and Shenzhen Connect scheme that links stock markets in China and Hong Kong were HK$2,259 billion (208 billion pounds) in 2017, up 170 percent versus the previous year.

While cash levels in Hong Kong's interbank markets have come off peaks of more than HK$400 billion in 2015 as the U.S. Federal Reserve started raising borrowing costs, current levels of around HK$180 billion are still not low enough to put upward pressure on HIBOR interbank lending rates.

The spread between three-month HIBOR and its LIBOR equivalent in the United States is now around percentage point, its widest since 2008.

Thus, even though the U.S. dollar has been weakening against major currencies, the Hong Kong dollar peg has been weakening within its band against the U.S. dollar.

IS THE PEG UNDER ATTACK?

No.

Unlike in 2015, when a stock market crisis in China forced investors to rush into Hong Kong at a time when the Exchange Fund, which backs the Hong Kong dollar peg, also suffered losses on investments, this time there is no threat to the peg.

Rather, the weakness in the currency is merely a corollary of the huge amounts of cheap cash in the Hong Kong economy. And analysts say that shows the peg is operating as it is meant to.

WHAT IS THE CONVERTIBILITY UNDERTAKING?

The Hong Kong dollar was pegged at a fixed rate of 7.8 to the U.S. dollar in October 1983. Since May 2005, it has been allowed to move between 7.75 and 7.85.

The peg is managed by a currency board wherein Hong Kong's monetary base is fully backed by equivalent dollar reserves, namely the Exchange Fund.

The HKMA website states that "under the strong-side Convertibility Undertaking, the HKMA undertakes to buy U.S. dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell U.S. dollars at 7.85."

WHEN DID THE HKMA LAST INTERVENE?

It last intervened in the currency markets in 2015, when the stronger side of the band at 7.75 was under threat as the Hong Kong dollar appreciated rapidly. It last bought the Hong Kong dollar to stop it from weakening past 7.85 in 2005.

However, the HKMA has been intervening intermittently in the money markets by selling exchange fund (EF) bills to soak up excess cash and put a floor under HIBOR rates. It last did this in October 2017.

WHAT IS THE HKMA'S APPROACH THIS TIME?

The HKMA has this year not stepped in with any announcements of bill sales. Analysts say it possibly does not want markets to take its intervention for granted, or it possibly wants to let the weakness run its course given its bill sale operations in 2017 had a limited impact on the Hong Kong dollar.

HKMA on Thursday ruled out interventions until the currency hits the lower end of the trading band, but warned that it had sufficient firepower to defend the currency.

(Editing by Himani Sarkar)