The Hong Kong Monetary Authority (HKMA) has bought 14.8 billion HKD to keep the currency stable. Right now, the HKD is trading close to the lower limit of its range against the U.S. dollar. Since 1983, Hong Kong has kept the HKD tied to the U.S. dollar through the Linked Exchange Rate System. This system helps stabilize the exchange rate, fixing the HKD at around 7.80 per U.S. dollar. It allows the currency to trade between 7.75 and 7.85.

The Currency Board System

The HKMA uses an automatic adjustment system to uphold this currency band. The Currency Board System requires that each HKD in circulation is backed by U.S. dollar reserves. Changes in the money supply adjust according to foreign exchange movements. Through its Intervention Mechanism, the HKMA helps maintain the currency within this band. If the HKD gets close to the strong end at 7.75, the HKMA sells HKD and buys U.S. dollars, increasing liquidity. If the HKD approaches 7.85, the HKMA buys HKD and sells U.S. dollars, which reduces liquidity to keep the exchange rate stable. The recent purchase of nearly 15 billion HKD is not a sign of panic; it’s just the beginning. The strategy for the upcoming weeks is set, and it has nothing to do with challenging the peg itself. Trying to go against a central bank with over US$410 billion in reserves—something it’s proven willing to use repeatedly since the 90s—is unwise. The USD/HKD exchange rate will remain at 7.85. The real focus is on the secondary effects of this defense. The authority’s intervention mechanism is a well-designed yet strong system. When it buys HKD, it directly reduces liquidity in the city’s banking system. This is a fact, not speculation. We’ve seen the aggregate balance—a key measure of interbank liquidity—drop from over HK$330 billion in early 2022 to below HK$45 billion today. Each intervention, like the recent one, pushes that number down. With less money available, borrowing costs will rise.

Interest Rate Arbitrage

This brings us to the key trade. The pressure on the peg comes from interest rate arbitrage. This week, the 3-month U.S. SOFR is around 5.3%, while the 3-month Hong Kong Interbank Offered Rate (HIBOR) is about 4.7%. As a result, money is flowing out to chase the higher and safer yield in U.S. dollars. To stop this outflow, the authority’s liquidity drain must push HIBOR higher to close that gap. Thus, we are positioning ourselves through interest rate swaps and forward rate agreements to benefit from the expected rise in HIBOR. The more the authority defends the peg, the higher local rates will go. The second investment opportunity is in equities. History teaches us a hard lesson. During the 1998 Asian Financial Crisis, those who bet against the peg lost. However, the authority’s defense caused overnight HIBOR to spike to extreme levels. The peg held, but the Hang Seng Index dropped over 60% from its peak. Today’s situation is a similar slow-motion replay. As HIBOR rises to match U.S. rates, borrowing costs for companies increase, making safer assets more appealing than stocks. Given the Hang Seng’s already weak performance, we see strong value in buying put options on the index. Each intervention to support the currency creates additional challenges for the equity market, a trade-off the authorities have always been willing to accept. Create your live VT Markets account and start trading now.

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