Hong Kong’s Low Aggregate Balance Sparks Rate Volatility Concern

(Bloomberg) -- As the Hong Kong dollar nears the weak end of its trading band, strategists see currency defenses raising the risk of volatility in borrowing costs, with interbank cash reserves sitting near historical lows.

The Hong Kong dollar has moved within striking distance of the weak end of its 7.75–7.85 per US dollar trading range as higher Treasury yields prompt traders to favor the greenback over the local currency. To prevent the currency from breaching its weak-side limit, the Hong Kong Monetary Authority buys local dollars, an operation that drains an interbank cash buffer known as the aggregate balance.

That liquidity withdrawal drives up interbank borrowing costs and makes it less attractive for traders to short the Hong Kong dollar. But the aggregate balance has already fallen to HK$54 billion ($6.9 billion), a threshold crossed only once in 2023 during active stretches of currency defense, according to a Bloomberg analysis of HKMA data.

Strategists see a thin cash buffer raising the risk of even modest HKMA interventions causing sharp spikes in local borrowing costs.

“For Hong Kong Interbank Offered Rates, the overall trend is set to be upward,” said Carie Li, a strategist at DBS Bank in Hong Kong. “It could be volatile if aggregate balance falls to the previous lows.”

The HKMA has already cautioned the public to manage interest-rate risks across property purchases, investments, and borrowing as the Hong Kong dollar approaches its weak-side trading limit. The local currency traded around 17 pips shy of that 7.85 boundary on Wednesday.

Should currency defenses drain remaining cash too rapidly, Oversea-Chinese Banking Corp. expects the HKMA to shift liquidity to the interbank market, either by choosing not to roll over maturing bills or via active buybacks if the time is tight.

“This shift of liquidity, if it happens, will be counterproductive to the impact of FX intervention, potentially lengthening the process with two-way fluctuations in Hong Kong dollar rates,” Frances Cheung, head of foreign exchange and rates strategy at the bank, wrote in a note last week.

That’s because injecting cash into the banking system would counteract the HKMA’s currency purchases that drain liquidity and cause two-way rate swings. Outside periods of liquidity fluctuations, Cheung expects only a mild upside in interbank rates.

The one-month Hibor has fallen to around 2.7% from a nine-month high of 3.02% touched in late September, widening the spread with the US overnight indexed swaps of the same tenor to the widest since May.

Morgan Stanley analysts noted that while a low aggregate balance revives memories of 2022–2023, when aggressive Fed rate hikes and HKMA interventions drove up Hibor and mortgage costs, Hong Kong’s broader buffers should limit the impact this time.

“A low aggregate balance raises Hibor’s sensitivity to further HKMA liquidity withdrawal, yet it captures settlement liquidity rather than the banking system’s overall funding position, which is much healthier today,” analysts led by Jenny Zheng wrote in a Sept. 28 note. The aggregate balance accounts for just 2.6% of the monetary base and fails to capture broader banking system liquidity, which remains supported as deposit growth outpaces lending, according to the bank.

While the shrinking aggregate balance is not seen as a threat to the Hong Kong dollar’s peg to the greenback, a thin liquidity buffer leaves carry traders, who look to profit from interest-rate gaps, highly vulnerable. That’s because even a small HKMA intervention could rapidly drain remaining cash and trigger a sharp spike in borrowing costs that wipes out their profits.

Because of that risk, traders remain cautious about pushing the Hong Kong dollar lower while the aggregate balance is thin, keeping any potential intervention moderate, according to DBS Bank’s Li.

“Whether there could be bigger swings depends on whether financial market activities are thriving,” Li said. “Currently, such activities are not particularly strong.”

--With assistance from Wenjin Lv.

More stories like this are available on bloomberg.com

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