The jump in demand for yuan has pushed the Hong Kong dollar to the weak end of its narrow trading band since early March. Cash balances in Hong Kong's banking system are still high but have been gradually falling.
The Hong Kong Monetary Authority (HKMA) has been intervening to defend the currency and keep it within its 7.75-7.85 band against the U.S. dollar.
It has bought HK$11.6 billion ($1.48 billion) in five interventions so far this year. All took place this month, including three this week.
However, the currency is still trading at 7.8475 per U.S. dollar, close to the weak end of the band.
The protracted weakness is partly driven by rising appetite for Chinese A-shares in recent months, said Ronald Man, a FX strategist at Bank of America Merrill Lynch in Hong Kong.
That is because offshore investors, including Hong Kong-based funds and individuals, largely buy into domestic Chinese markets via the Hong Kong-hosted Stock Connect, which requires them to exchange other currencies for the yuan.
China's A-share market has jumped around 24 percent this year, driven by hopes that a long-running Sino-U.S. trade war will end soon and buoyed by Beijing's policies to support economic growth. Global index provider MSCI's decision to quadruple China's weighting in its benchmark index has also led to heavy foreign investment inflows.
Flows into China, known as northbound flows, under the Connect scheme hit 121 billion yuan ($18.09 billion) in January and February, 3.73 times more than the same period last year.
(Graphic
- Northbound Stock Connect net buy Jan 18-Feb 19, https://tmsnrt.rs/2Hz7fgu
Demand for yuan in Hong Kong has risen as investors chased the rally, said Bruce Yam, a forex strategist at local broker Everbright Sun Hung Kai.
"We've had some big orders from clients, retail mostly, since Chinese New Year," he said.
The yuan is up 2.8 percent this year, and the yuan deposit pool in Hong Kong, the largest offshore yuan centre, declined by 2.6 percent to 599.1 billion in January, according to HKMA. [https://www.hkma.gov.hk/eng/key-information/press-releases/2019/20190228-6.shtml].
Simon Derrick, chief currency strategist at BNY Mellon in London, says the negative correlation between the Chinese and Hong Kong currencies since early December is at odds with past trends, noting that historically a weaker yuan had put pressure on Hong Kong's equity markets and currency.
(Graphic - Hong Kong dollar vs Chinese yuan, https://tmsnrt.rs/2CwC15B
AGGREGATE IMPACT
The Hong Kong dollar could recover as the ample cash in its banking system, a hangover of the synchronised easing by global central banks, is reduced and as yields rise.
With investors borrowing Hong Kong's low-yielding currency to fund their A-share purchases, capital has been leaving the city's banks. Yet, Hong Kong's markets have been flush with cash and yields have therefore not yet reacted to the outflows.
The aggregate balance, which reflects liquidity levels in the banking system, stands at HK$68.9 billion, despite HK$7.4 billion being absorbed by the HKMA interventions.
(Graph
ic - HK aggregate balance of settlement accounts, https://tmsnrt.rs/2Oi5xAO
"Until you bring it down to at least HK$10 billion, at global financial crisis levels, it's unlikely that HK rates would rise in a significant way," said Man.
Norman Chan, chief executive of the HKMA, said in a statement on Thursday that the wide spread between U.S. and Hong Kong interest rates will continue to lure funds away from the city.
Hong Kong's one-month interbank borrowing rate lagged its U.S. counterpart by 1.58 percentage points in late February, the highest in over a decade.
The spread has narrowed to about 90 basis points this week. Pressure for it to widen again is easing after the U.S. Federal Reserve shelved projected 2019 rate hikes on Wednesday.
(Reporting by Noah Sin; Editing by Kim Coghill)
By Noah Sin
