Excess Liquidity in Hong Kong Testing Hibor-Libor Limits

After almost a decade of comparatively narrow spreads and low volatility, this year Hibor-Libor spreads have hit multi-year wides (Fig 1), with the 3-month spread currently at an eight-year high of 55bps.  Spreads have widened across the curve, although the divergence is most notable at the short end.  While the HKD/USD peg implies that Hibor and Libor should be very closely correlated, two events have conspired to create the current divergence: Federal Reserve (Fed) rate hikes and excess liquidity in the local Hong Kong (HK) market.

Hong Kong runs a currency board system with the HKD pegged to the USD at 7.75 (Fig 2).  In May 2005, the Hong Kong Monetary Authority (HKMA) moved from a lower limit of HK$7.8 to US$1 and no upper band to a range that extended from HK$7.85 (lower band) to HK$7.75 (upper band). HKMA aimed to reduce the likelihood that HKD would be used for RMB speculation.  While Hibor is calculated based on local market rates for HKD interbank deposits, it typically mirrors U.S. Libor movements due to the peg.  However, the Hibor-Libor spread can widen during Fed rate movements due to inefficiencies in the transmission mechanism combined with HKD’s 1.3% trading range around the peg.  Recently Hibor has diverged from the FX forward implied yield, although this divergence does not fully explain the current Hibor-Libor spread.

Instead, the main cause of the current spread widening appears to be excess liquidity in the local HKD market.  Hong Kong has been the primary nexus for the U.S. $1 trillion of capital outflows from China over the past two years (Fig 3), which have contributed to a sharp increase in the HKMA’s aggregate balance and the reduction of local interest rates.  A combination of slower Chinese economic growth and concerns about further RMB depreciation encouraged these capital outflows. Hong Kong’s financial and property markets have been the key beneficiaries as Chinese property developers have dominated land auctions and Chinese private investors, undeterred by the sharp increases in property transaction taxes, have pushed local residential prices to new record highs.

Artificially depressed HKD interest rates combined with Fed rate hikes has created a dilemma for local fixed income investors who suffer from low yields on short duration positions, but risk capital losses on a long duration position should the Hibor-Libor spread suddenly narrow.   The HKMA has recently investigated the rationale for the widening of the Hibor-Libor spread, but offered no insight into why or when spreads will actually tighten.

Two factors could trigger spread normalization:

• If Chinese capital flight slows, this will reduce local liquidity conditions and push Hibor yields higher.
• If the HKD hits the weak side (7.85) of its trading band, the HKMA would intervene, buying HKD to support the peg, which would tighten liquidity and push interest rates higher.  On the 9th of August, the HKMA unexpectedly announced that it would increase net issuance of 3-month Exchange Fund Bills by a total of HK$40 billion.  Since the HKD had not hit the weak side of convertibility, the HKMA claimed the additional issuance was designed “to meet increased demand for paper by banks given the abundance of liquidity in the banking system”; nevertheless a secondary benefit should be draining excess liquidity and pushing Hibor rates higher.

Unfortunately, while CNY and Chinese Forex reserves have stabilized, even small outflows could continue to overwhelm the local market.  Meanwhile, although HKD has moved to the weak side of its trading band, it has not yet hit the lower bound – triggering a HKMA intervention, despite the HKMA bill issuance, liquidity remains ample and Hibor rates have not moved substantially higher.  So while Hibor-Libor spreads should eventually narrow, we believe they will likely stay wide for the foreseeable future.