It is well known that Hong Kong Government adopts the Currency Board Arrangement to link the exchange rate between US dollar and HK dollar at 1:7.8. It fixes the exchange rate, but why it would also link the market interest rates between the US and HK?
The answer is ARBITRAGE!
According to Investopedia, “Arbitrage is the simultaneous purchase and sale of an asset to profit from an imbalance in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms”
Imagine when the US Fed has increased the interest rate by 1%, but the Association of Bankers does not, then there is a riskfree profit opportunity by selling HKD together with buying USD at the fixed exchange rate, and get the 1% interest payment without bearing any risk of exchange.
By means of this arbitrage process, then the demand for USD goes up, and the demand for HKD goes down, which would close the interest rate gap, until there is no further riskfree profit opportunity.
The official answer to the question by HKMA is as follows:
“Interbank interest rates in Hong Kong normally follow closely the movements of their US counterparts under the Linked Exchange Rate system. The size of the interest rate spread between the Hong Kong dollar and US dollar mainly reflects the premium (be it positive or negative) that investors demand on the Hong Kong dollar. Should the interest rate differential get out of line with market expectation, funds will flow to the currency with relatively higher interest rates to reap the arbitrage profits.” (HKMA, ?)
But then why in the past 2 years, even though the US Fed has increased interest rate 9 times, but The Association of Bankers has just increased the prime lending rate once?
Figures 1 and 2 show the Fed Rate changes of the US and the Prime Lending Rate of HK in the past few years. They clearly show that the two are not tracking each other closely.
If we compare the two time series back to the year 1984 when the Linked Exchange Rate System was implemented, as shown in Figures 3 and 4, then it is clear that the two tracked each other closely from 1984 to 2007.
In the 1980s, when both the US Fed Rate and the HK PLR were very high (with the peak at about 20%). Then both of them dropped to about 6% in the end of the 1980s. And then the 3 local peaks in the early 1990s, 2000s and 2007 are the same in the two series. However, after the GFC in 2008, the two deviated. The US Fed Rate started to reduce down to almost 0, but the HK PLR was just down to 5%.
The reason is probably due to the huge inflow of hot money into Hong Kong after 2008. Figure 5 shows the sudden inflows of more than HKD1000 billion dollar capital into Hong Kong after 2008. The huge amount of hot money inflowed into HK causing the great demand of HKD, which allows bankers in Hong Kong not to follow fully the ultra-low interest rate from the US Fed.
However, when the arbitrage exists especially after 2016 when the US Fed started increasing the Fed Rate, some funds started to get out of Hong Kong as shown in the reducing blue zone since 2018. In fact, HKMA has to inject so far more than HKD100 billion into the Currency Board System to stop the exchange rate rise above the guaranteed cap.
HKMA (?) 1. How are local interest rates set in Hong Kong and what is their relationship with their US counterparts? Frequently asked questions. https://www.hkma.gov.hk/media/eng/publication-and-research/background-briefs/hkmalin/10.pdf