Spratt and Hunter (2019) made a piece of shocking news on the market bet of the weakening of the Hong Kong Dollar, and their reported figures are very alarming. It reported that “the value of put options that pay off if the currency weakens to HK$7.90 has been surging versus bets against that scenario. The market-implied probability this happens within the next six months has crept above 50 percent, compared with just 14% at the end of July.” Figure 1 even shows that the implied probability of the bet within the next 12 months is 75%!
It is hard to believe of such a high implied probability reflected in the option trading market, as the currency has been very stable in the past 36 years since 1983, when Hong Kong Dollar (HKD) has been pegged to USD at USD1=HKD7.8 exchange rate, which is guaranteed by a currency board system (i.e. a Linked Exchange Rate System).
The economic theory of international trade considers a currency as a commodity tradable in a market, and its exchange rate against another currency is determined by the Laws of Supply and Demand of the two currencies. In other words, if the two currencies are traded in free markets, then their exchange rates would go up and down, unless someone is “manipulating” the currency or a built-in system is counterbalancing the trading market forces.
The currency board arrangement is such a built-in counterbalancing mechanism. The de-facto Central Bank of HK, Hong Kong Monetary Authority (HKMA), fixes the exchange rate between HKD and USD by means of a Convertibility Undertakings (HKMA, 2018). By means of the undertakings, arbitrageurs shall be attracted to counterbalance the trading market forces.
For example, in case there is a sudden increase in demand of USD in Hong Kong, then the exchange rate of HKD should be weakened, to say USD1 = HKD8, but since the HKMA guarantees an exchange rate of 7.8, there will be a seem-to-be riskless profit-making opportunity for arbitrageurs to buy HKD in the open market at 1-to-8 and convert back to USD via HKMA at 1-to-7.8. Such an arbitrage mechanism is believed to be able to automatically bring back the exchange rate to the pegging level.
Since 2005, HKMA has moved in the tight HK$7.75-to-HK$7.85 per USD range. In other words, USD-HKD exchange rate would theoretically be allowed to be fluctuating within this narrow range. In reality, the exchange rate has been kept within the boundary for decades, as shown in Figure 2. In fact, most of the time HKD was on the strong side, i.e close to 7.75.
More recently, however, there have been some occasions that HKD is on the weak side, i.e. 7.85, as shown in Figure 3, which is quite rare in the past 36 years.
Figure 3 clearly shows that HKD has been weakened since 2018, and has touched several times the threshold of 7.85, but the defense has been very strong and so far successful. Why the investors would bet for a collapse of the undertakings or a shift of the threshold?
One of the major reported causes is the outflow of capital from the city for various reasons, which is reflected in the shrinkage of the Aggregate Balance. (Figure 4) A decade-long capital inflow into Hong Kong since the Global Financial Crisis in 2008 has resulted in a peak of about HK$400b aggregate balance. But when the US Fed started the normalization of interest rate, capital outflow from Hong Kong has been observed.
However, Ren and Brooker (2019) have already rejected Kyle Bass’s hypothesis of the “impending crisis” of HKD by the shrinkage of aggregate balance. Why the investors in the options market are still betting on the peg? Why the implied probability suddenly sharply increased after July 2019? Would it be related to the US-China Trade War?
In fact, when the two biggest economies cannot reach agreements on their trade conflicts, it does not only affect their trades but it also “weaponizes” the currencies. For example, the sudden depreciation of RMB and then the US announced to list China as a currency manipulator in early August 2019 can be considered an upgrade from the trade war to a currency war. (Yiu, 2019a) Then the next question is whether the two countries would tolerate Hong Kong, a SAR of China, to peg to the US currency if the wars persist?
In world history, there are basically three main types of currency exchange rate system, namely (1) fixed to a given weight of gold or silver, (2) fixed to a given currency, or (3) floating according to market forces. The gold standard (or the quasi gold standard since the Bretton Woods Agreement after the WWII) has been abandoned since 1971. There is no more country adopting the gold standard now, but it is interesting to observe that the recent upsurge of the gold price, which is said to be the consequence of the large-scale purchases by many governments including the Chinese Government. There is even a storyline of de-USdollarisation. (Turden, 2019)
Fixed exchange rate system is nowadays also very rare in the world because it is a very fragile system. Many countries adopted it after WWII but finally had to abandon it and converted into the floating system, because the convertibility undertakings requirement is very demanding for central banks.
The fixed-rate system is fragile because any rumors can cause a self-fulfilling prophecy. When people believe that the currency is allowed to be weakened beyond the weak side threshold, then people would sell the currency to protect their wealth. Because of this mass action, then the currency would confront a strong selling pressure in the market. Would the counterbalancing mechanism work in this extreme situation can be a big challenge to the currency board authority? I think the HKMA may have to make clear and firm statements to the markets on their determinations as soon as possible, to stop the worries on the recent Bloomberg’s report.
[A Chinese Version available at Yiu, 2019b]
HKMA (2018) Linked Exchange Rate System, Hong Kong Monetary Authority, April 4. https://www.hkma.gov.hk/eng/key-functions/monetary-stability/linked-exchange-rate-system.shtml
Ren, S. and Brooker, M. (2019) Kyle Bass Is Wrong on Hong Kong’s Peg too, May 23. https://www.washingtonpost.com/business/kyle-bass-is-wrong-on-hong-kongs-peg-too/2019/05/22/3e600a36-7ce6-11e9-b1f3-b233fe5811ef_story.html
Spratt, S. and Hunter, G.S. (2019) Options Traders Line Up Bets That Hong Kong’s Dollar Peg Will Snap, Bloomberg, Aug. 15. https://www.bloomberg.com/amp/news/articles/2019-08-15/options-traders-line-up-bets-hong-kong-s-dollar-peg-will-snap?fbclid=IwAR1V9DJVFE5WkSXPDntwJTUiVp8vgWFdMykE07L5wpABJuWPa-87yOfCKtU
Turden, T. (2019) De-Dollarization Spreads: Why These 5 Nations Are Backing Away From The Buck, ZeroHedge, Jan, 3. https://www.zerohedge.com/news/2019-01-02/de-dollarization-spreads-why-these-5-nations-are-backing-away-buck
Yiu, C.Y. (2019a) The impact of the US-China currency war on Hong Kong’s economy, Medium, Aug. 6. https://medium.com/@edwardyiu/the-impact-of-the-us-china-currency-war-on-hong-kongs-economy-7fbd322b06cf
Yiu, C.Y. 姚松炎 (2019b) 投資者賭注港元匯率弱方保證變化？方格子，8月16日。https://vocus.cc/eyanalysispoliecon/5d5665b7fd897800016949c5