20 April 2018, 14:15 GMT
Market commentators have become excited about the capacity of the Hong Kong Monetary Authority (HKMA), the de facto central bank, to defend the Hong Kong dollar’s (HKD) currency peg to the US dollar (USD) following a series of recent interventions by the HKMA in the currency market. But is this really the most important debate for investors?
The HKD/USD link has remained resilient since its inception in 1983, including through several major economic and market shocks, and the HKMA has a lot of dry powder to sustain a more meaningful and prolonged intervention if required —foreign currency reserves are equivalent to around 125 per cent of GDP.
Instead, a more pertinent deliberation might be over the cost of continuing support for the currency if it leads to a meaningful tightening of liquidity in the local economy. Here there is more to worry about, especially the potential impact of higher borrowing costs on the city’s red hot property market.
The full extent of this risk does not appear to be priced into the equity market —discounts to net asset value on real estate stocks have meaningfully narrowed compared to a year ago, despite long-held expectations among investors for a gradual rise in interest rates.
Perhaps equity market investors believe there is a limit to how far HKD and USD money market rates can diverge from here. The difference between three month Hong Kong interbank offered rate, or HIBOR, and US LIBOR is already at its widest level in just over a decade, although during the last US rate rising cycle, from 2004-2006, the spread peaked at around 220 basis points, compared to 105 basis points today.
Another interpretation is that investors may have moved a little too early to price in concerns over higher borrowing costs, causing wider discounts to net asset value on real estate stocks, which have since narrowed as liquidity in the financial system remained higher than expected. On this basis, further intervention by the HKMA could lead to renewed focus on and a revival of the discounts. Either way, real estate stocks in Hong Kong appear at risk of underperforming the market while downward pressure remains on the HKD.
The interest rate differential between HKD and USD money markets will undoubtedly remain the key indicator to watch for future developments. But it will also be important to monitor the size of investment flows into Hong Kong-- particularly as the additional quota for the Stock Connect programs comes on stream and domestically traded Chinese stocks enter MSCI indices in the coming months, all while a number of Chinese companies are reportedly waiting to list on the Hong Kong exchange in due course.
Source: Bloomberg. 19th April 2018.
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