Hong Kong Dollar Strength Reflects End of Yuan Rally, ING Says

By Bob Chen

Dec. 19 (Bloomberg) -- A stalled rally in the yuan may be driving the flood of capital to Hong Kong that’s lifted the city’s currency to the upper end of its dollar peg, according to Tim Condon, ING Groep NV’s head of Asia research in Singapore.

The Hong Kong dollar has strengthened 0.6 percent since China checked the yuan’s advance in mid-July to help exporters weather a global recession. China’s currency climbed 21 percent in the three years after its fixed exchange rate was scrapped in July 2005, a rally that drew Hong Kong investors keen to profit from the appreciation.

Hong Kong residents can purchase up to 20,000 yuan ($2,928) per day to put on deposit and these funds can only be converted back into the city’s currency at a similar pace, Condon said.

“We think it’s the unwinding of renminbi revaluation trades,” he wrote in a Dec. 17 note. “If we are correct, USD/HKD selling pressure will switch suddenly when the liquidation of renminbi deposit accounts ceases.”

To profit from the forecast change, Condon suggests investors sell Hong Kong dollar interest-rate swaps against their U.S. dollar counterparts. The 10-year swap differential was minus 42 basis points late yesterday in Hong Kong and Condon predicts this will turn positive, making the trade profitable, should the city’s currency weaken.

Drift Lower

“If the Hong Kong dollar is not going to strengthen, the Hong Kong interest rates should not be priced below U.S. rates,” Condon said. “Once this technical driver stops then the fundamentals will take over, which argue for the Hong Kong dollar to drift toward the weak end of the band.”

In an interest-rate swap, two parties agree to exchange fixed payments for variable-rate payments over a set period. Condon’s trade involves making fixed payments in Hong Kong dollars and receiving fixed payments in the U.S. currency. Investors betting on falling rates will look to receive fixed rates, while those betting on higher rates will choose to pay variable costs.

The Hong Kong Monetary Authority has injected about HK$130 billion ($16.8 billion) of liquidity into the financial system since the city’s currency started trading around the upper limit of its peg two months ago. Pressure on the Hong Kong dollar to appreciate may have been caused by investors cutting carry trades, purchases of overseas assets funded in the city, Joseph Yam, the head of the de facto central bank, said last month.

Hong Kong pegged its dollar to the U.S. currency in 1983 and allows it to trade 5 cents on either side of HK$7.80 per dollar. It recently traded at HK$7.7500.

To contact the reporter on this story: Bob Chen in Hong Kong at bchen45@bloomberg.net.