xfdws HKMA-INTERVENTION sked Emerging Markets Datafile
October 06, 2003
HONG KONG IMAIL
HONG KONG
ENGLISH
HKMA intervention `freezing arbitrage’, HONG KONG IMAIL
Cathy Holcombe
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The Hong Kong Monetary Authority’s (HKMA’s) ongoing pursuit of peg speculators was paralysing the market mechanism on which the link to the United States dollar depended, bankers said.
The currency board is designed to be maintained through interest rate arbitrage, in which flows of money out of the SAR trigger a rise in interest rates, attracting back liquidity, while inflows push down rates.
Most of the arbitrage is performed on a daily basis by local and international banks operating in the territory. By constantly switching treasury funds between US and Hong Kong dollars as they chase interest rate differentials, the banks effectively act as custodians of the peg.
However, these desks are now frozen, according to local dealers and treasurers, who say they are unable to act on gaping arbitrage opportunities for fear the currency’s unusual premium over the official rate of HK$7.8 will steepen. As a result, the HKMA is the only force left in the market to counter-balance a wave of inflows seen in the past fortnight.
While the HKMA has intervened several times to curb appreciation, its chief, Joseph Yam, has not set any clear limit and has publicly delighted in the losses suffered by Hong Kong dollar bears. “There is no harm to have a little bit of constructive ambiguity, if only for the purpose of making those shorting the Hong Kong dollar realise that this is not so much of a one-way bet,” he said last week. This ambiguity has been fostered not just by Yam’s words, but by the limited actions of the HKMA to return the currency to parity after an unusual market event knocked the spot rate well off the 7.8 link for the first time in three years. As of Friday night, it was 7.7112, or 1.13 per cent stronger than its official link.
Arbitrage is only feasible if there is strict discipline surrounding the parity rate. Despite higher interest rates now available in the US dollar interbank lending market, banks cannot sell Hong Kong dollars for the greenback if they are uncertain about how much they will have to pay for the local currency when they try to get back in.
“There is no way you can do arbitrage because no one knows where the floor is,” JPMorgan economist James Malcolm said. “Enough is enough. The constructive ambiguity has worked. But we’re in a new environment where constructive ambiguity is becoming destabilising.”
Yam has long had a combative relationship with financial institutions on the issue of speculation. Bankers have said HKMA inspectors regularly visited banks, under the rubric of “routine inspection”, to intimidate lenders to speculators during the attack on the peg in 1998, which was quashed in a bold intervention directed by Yam. The HKMA was not involved in the events that chased speculators from the market overnight on September 22. That was set in place by the Bank of Japan’s decision to stop intervening in its own currency market for several hours earlier that day, in what may have been a sassy response to a Group of Seven communique requesting Asian nations show more “flexibility in exchange rates”.
Japan has spent more than US$80 billion (HK$624 billion) this year to curb the rise of its currency. When it pulled all bids, the US dollar plunged 2 per cent in several hours, knocking global stocks and bonds and forcing a sharp shift in exchange rates around the world.
Short sellers of the Hong Kong dollar were cornered in the fallout and scrambled for the currency to cover positions, sending the spot rate as high as HK$7.7050 on September 23.
The forward contracts saw a reversal of the premium, which indicates how much weaker the market predicted the currency would be in the future. They are now in a discount and will remain that way as long as local interest rates are weaker.
With the risk premium for holding the Hong Kong dollar removed, the SAR has seen strong inflows from investors. Nevertheless, dealers think arbitrage would have moved the rate back to parity by now if not for the uncertainty fostered by the HKMA.
Yam has other motives for disarming these bankers. The speculators that were chased out of the Hong Kong market this time around were quite a different breed than in 1998. Most were not gunning so much for the peg itself as seeking a series of small gains in the forward contracts when intermittent scares-Sars was a big one-caused the premiums to flare up. And because the HKMA has offered a guarantee to exchange Hong Kong dollars in clearing accounts at 7.8 to the US dollar, this bet’s downside was considered limited.
That guarantee, called the convertibility undertaking, was introduced in 1998 as a mechanism to promote confidence in the peg. It is no surprise Yam was steamed to see it used as a cushion for speculation-and more often by local banks than the despised international hedge funds.
“All the treasury desks had this trade going,” CLSA chief dealer Frederic Laine said recently.
However, the guarantee is in place only on the downside of the currency and Yam has indicated he has no plans to alter that. “No doubt there will be critical comments again on the asymmetry in the manner in which we operate the currency board system, in that there is no formal convertibility undertaking on the strong side of the link,” Yam said in his weekly market newsletter last week.
His answer to such criticism: “We are in the business of ensuring exchange rate stability, not bailing out currency speculators.”
Yet Yam’s tough talk may soon die down. He is now in a position where he is going to either have to lure banks back into the market by setting a clear upside limit on the appreciation, or spend a lot more money to support the link. The authority has thus far bought US$260 million, or sold more than HK$2 billion, in the past two weeks.
Other members of the HKMA governing board have in the past proposed making the convertibility undertaking viable on both sides of the peg. The current breakdown of the arbitrage mechanism is likely to bring that debate to the fore.
However, if the HKMA extended the guarantee to the other side of the link, Yam would also be in a bit of bind, according to Hong Kong University of Science and Technology economist Francis Lui. Because then bankers would have motivation to buy the currency at the current appreciated rate of 7.7112 and sell to it the HKMA at 7.8, a 1.15 per cent gain at the expense of Hong Kong.
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