The Hong Kong dollar technically touches the weak side guarantee, no need to worry

Core Views

How to understand the linked exchange rate system and the significant fluctuations of the Hong Kong dollar this time?

The linked exchange rate system "ensures" that the exchange rate of the US dollar to the Hong Kong dollar remains in the range of 7.75 to 7.85. This mechanism is simple and transparent, but there are two points to note: 1) The Hong Kong Monetary Authority's foreign exchange operations are not QE. The Monetary Authority does not actively decide the scale of operations but passively accepts buy or sell orders, with the specific scale determined by bank demand. 2) Foreign exchange buying and selling alone cannot fully adjust the exchange rate; more importantly, it affects the balance of payments and interest rates, leading to spontaneous fluctuations in the exchange rate. Although HIBOR has weakened rapidly this time, and the exchange rate has switched between strong and weak guarantees at the fastest pace in history, there is essentially nothing special about it.

What impact does the change in local funding costs have on the financial market?

Changes in local financial conditions affect the Hong Kong economy and capital markets, but this factor is marginal. The core influencing factors for the Hong Kong economy and market are still the economic fundamentals of mainland China. The correlation between Hong Kong's GDP growth rate and mainland China exceeds 60%, and since 2020, the proportion of mainland income for Hong Kong-listed companies has exceeded 70%. The year-on-year growth rate of the Hang Seng Index has a high correlation of 56% with the year-on-year change in China's manufacturing PMI, but only -14% and 12% correlation with the changes in 3-month HIBOR and US Treasury yields, respectively.

The effects of changes in local interest rates in Hong Kong are more reflected in the following points: 1) The main driving force of the Hong Kong economy comes from financial services, and the vast majority of bank loans are linked to HIBOR (H-linked). Lower financing costs help stimulate the credit cycle and invigorate economic vitality. 2) Margin trading (leverage) borrowing costs are generally also linked to HIBOR. When there are not significant changes in the mainland economy, the impact of interest rate changes on the stock market is more pronounced, controlling the range of PMI changes to -1%~1%, the correlation between HIBOR and the Hang Seng Index increases to -34%. 3) By sector, changes in Hong Kong interest rates have a relatively greater impact on local stocks.

What does it mean when the Hong Kong dollar touches the weak side guarantee?

We believe that the Hong Kong dollar touching the weak side guarantee is merely a technical adjustment. After the Monetary Authority released liquidity in May, the interest rate differential between the US and Hong Kong widened, causing the Hong Kong dollar to weaken due to carry trades. Recently, the escalation of the geopolitical conflict between Israel and Palestine has led to a significant rise in oil prices, a rebound in the US dollar, and a general weakening of Asian currencies. However, we are skeptical about the sustainability of the current situation; for example, in the medium to long term, the supply and demand for crude oil do not support a long-term rise in oil prices (《Risks of Escalation in the Israel-Palestine Conflict and Its Macroeconomic Impact》，Huatai Macro published on June 15, 2025).

There is no basis for a sustained shock to the weak side guarantee of the exchange rate, so it is unlikely to cause a large-scale tightening of liquidity, and there is no need for excessive concern. The undervaluation of Asian currencies such as the Renminbi is a given (《The Renminbi May Have Appreciation Potential》，Huatai Macro published on May 22, 2025). The Renminbi has returned from a weak position of 2% above the central parity to the central parity level, with long and short forces being relatively balanced. The current situation is completely different from the previous weak position of the Hong Kong dollar when there was depreciation pressure on the Renminbi Therefore, the HIBOR rate may adjust upwards from a very low level, with the final point in the mid-low range. After locking in exchange rate risks through forward contracts, carry trades yield no returns. Naked carry trades bear exchange rate risks, and the profit margin after deductions is also limited. If the future 1/3M USD to HKD midpoint reaches 7.83/7.80, the corresponding 1M and 3M HIBOR rates are expected to reach 1.25% and 1.73%, respectively, which is not a significant increase from the current levels.

In the short term, the Hong Kong Monetary Authority may withdraw HKD liquidity, but the negative impact on the market may be relatively controllable in terms of time and degree. In the medium term, under the demands for expansion and allocation, the liquidity environment is not bad, and profit growth remains resilient, so the risk of a significant market downturn is low. Therefore, if volatility arises due to adjustments in the Hong Kong Monetary Authority's policies, it may provide participation opportunities.

Main Text

How to understand the linked exchange rate system and the significant fluctuations of the Hong Kong dollar this time?

Hong Kong implements a linked exchange rate system, limiting the USD/HKD exchange rate to a range of 7.75-7.85. Under the linked exchange rate system, the HKD monetary base is supported by 100% USD assets. When the HKD exchange rate strengthens and reaches 7.75 HKD/USD, it hits the so-called strong-side convertibility guarantee level. At this point, the Hong Kong Monetary Authority commits to selling HKD to banks at 7.75 HKD/USD. Conversely, when the exchange rate reaches 7.85 HKD/USD, it hits the weak-side convertibility guarantee level, and the Monetary Authority commits to buying HKD at the corresponding price.

The Hong Kong linked exchange rate system is very simple and transparent, but there are still two key points to note in understanding it. 1) The Monetary Authority does not actively decide the quantity of HKD to buy or sell. The Monetary Authority's exchange rate mechanism is not like the Federal Reserve's QE, which is often misunderstood. The Monetary Authority only commits to supplying/recovering HKD in unlimited quantities at the corresponding exchange rate, but the specific buying and selling scale is determined by the banks' demand. 2) Simple foreign exchange buying and selling cannot fully adjust the exchange rate; more importantly, it is about the spontaneous changes in bank reserves and interest rates. Suppose the HKD exchange rate remains at the strong-side guarantee, but the HKD-USD interest rate differential remains unchanged; this would create unlimited carry trade opportunities: traders can continuously exchange USD for HKD at banks and invest in interest rate differential trades, forcing the Monetary Authority to supply banks with unlimited HKD as needed. The significance of foreign exchange buying and selling lies in adjusting the banks' reserve levels (money supply) and adjusting HKD interest rates, thereby affecting the spontaneous changes in the exchange rate.

Although the HIBOR rate has quickly weakened this time, and the HKD-USD exchange rate has experienced the fastest switch between strong and weak guarantees in history, there is essentially nothing special about it. HIBOR is the interest rate quoted by Hong Kong banks, with terms ranging from overnight to 12 months. Since the beginning of this year, due to strong demand for HKD driven by financing in the Hong Kong market, corporate dividends and buybacks, and high interest in Hong Kong stocks [1], the demand for HKD has been very strong, while the USD has remained weak in comparison. The HKD exchange rate continued to strengthen in April and reached the strong-side guarantee on May 2, with the Monetary Authority acting as a counterparty to banks, providing HKD at 7.75 HKD/USD, selling a total of HKD 129.5 billion within four days, leading to a 2.9-fold increase in bank reserves in Hong Kong. Such a large-scale liquidity easing has caused HIBOR rates to drop significantly, especially short-term rates The 1-month and 3-month HIBOR rates have fallen to 0.6% and 1.7%, respectively. The decline in Hong Kong dollar interest rates has created an arbitrage opportunity, leading to a rapid weakening of the Hong Kong dollar exchange rate. By Monday evening, foreign exchange trading data had repeatedly touched the weak side guarantee.

What is the role of HIBOR in the Hong Kong financial market?

For the Hong Kong financial market, the most important interest rate is not the benchmark rate, but HIBOR, as the former follows changes in the Federal Reserve, while the latter is the core anchor for pricing.

1) Under the linked exchange rate system, Hong Kong does not have an independent monetary policy, and its benchmark interest rate completely follows changes in the Federal Funds Rate of the Federal Reserve. The benchmark interest rate in Hong Kong, which is the basic rate for the discount window, is set at 50 basis points above the lower limit of the target range for the U.S. Federal Funds Rate or the 5-day moving average of the overnight and 1-month Hong Kong HIBOR rates, whichever is higher.

2) The vast majority of financial transactions are linked to HIBOR rates. Loans in Hong Kong are generally divided into two forms: P-loans and H-loans. The P-loan interest rate is generally the best lending rate offered by banks minus a margin, while the H-loan interest rate is generally the HIBOR rate plus a margin, with the best lending rate serving as a floating cap. Currently, the vast majority of loans are in the form of H-loans. In leveraged trading in the capital markets, the borrowing costs provided by intermediaries are generally also linked to HIBOR rates. For example, the borrowing fee for margin accounts provided by HSBC Hong Kong is the Hong Kong dollar borrowing interest rate of the interbank offered rate on the first working day of each week plus 5%. The HIBOR rate is determined by banks themselves and reflects the level of liquidity in the interbank market.

**3) Hong Kong also has long-term interest rates, such as those for long-term bank deposits and government bonds, but these assets are not very liquid, so U.S. Treasury rates often serve as the anchor for long-term interest rates **

What impact do changes in local financial conditions in Hong Kong have?

Local financial conditions being loose (tight) will stimulate (suppress) the Hong Kong economy and capital markets, but these factors are marginal and more concentrated in sectors sensitive to local funding interest rates. From a macro perspective, the core influencing factors of the economy and market in the Hong Kong region are still the economic fundamentals of mainland China.

**The growth rate of Hong Kong's macro economy is highly correlated with that of mainland China, and the revenue share of listed companies also comes more from mainland China. As a small open economy, Hong Kong's largest trading partner is mainland China, closely related to the mainland economy. The GDP growth rate of Hong Kong maintains a correlation of over 60% with that of mainland China. In the Hong Kong stock market, taking the Hang Seng Index as an example, the market capitalization of Chinese-funded enterprises accounts for over 80%; since 2020, the revenue share from mainland China in the overall Hong Kong stock index has exceeded 70%.Therefore, the fundamentals of Hong Kong's economy and stock market rely more on the development of the mainland economy. The year-on-year growth rate of the Hang Seng Index has a high correlation of 56% with the year-on-year change in China's manufacturing PMI, but only -14% and 12% correlation with the changes in the 3-month HIBOR and U.S. Treasury yields, respectively.

The effects of changes in Hong Kong's interest rates are more reflected in marginal impacts and interest rate-sensitive sectors. Taking the example of declining interest rates (the opposite is true for rising interest rates), low interest rates will have three levels of impact on Hong Kong.

1. The economic prosperity of Hong Kong rises. The economic drivers of Hong Kong come from financial services, tourism, trade and logistics, professional and other industrial and commercial support services. Lower financing costs help stimulate the credit cycle, thereby invigorating the Hong Kong economy. Data shows that changes in HIBOR rates have a good correlation with Hong Kong's M2 year-on-year, and the growth rate of Hong Kong's M2 is highly correlated with the actual GDP growth of Hong Kong
2. For the stock market, low interest rates can expand liquidity. On one hand, margin trading is linked to HIBOR rates; lower interest rates reduce leverage costs, stimulating an increase in market trading activity and improving trading liquidity. On the other hand, according to data from the Hong Kong Stock Exchange in 2020 (which has not been updated since), 30% of trading in the Hong Kong stock market comes from local investors, and a decline in Hong Kong dollar interest rates helps enhance financing liquidity in Hong Kong. When controlling the range of changes in China's manufacturing PMI to -1% to 1% (indicating little change in economic growth), the year-on-year change in the 3-month HIBOR rate has a correlation of -34% with the Hang Seng Index, making the stimulus effect of lower interest rates on the stock market more evident.

During this round of declining interest rates, we found that the stocks with a significant increase in holdings by local intermediaries in Hong Kong are more concentrated in small-cap stocks, with fewer companies eligible for the Stock Connect program. Moreover, there has been a noticeable rebound in small-cap stocks across the entire Hong Kong market. Since mainland funds primarily purchase Hong Kong stocks through the Stock Connect (which favors large-cap stocks), and foreign capital also prefers large-cap companies, the aforementioned changes may reflect a boost in local funds' risk appetite following improved liquidity.

3) By sector, changes in interest rates have a relatively greater impact on local Hong Kong stocks. We used MSCI Hong Kong and MSCI China (of which nearly 80% are Chinese-funded Hong Kong stocks) as representative indices for local Hong Kong stocks and Chinese-funded Hong Kong stocks, respectively, to calculate the weekly changes in the indices and their relationship with the 3-month HIBOR rate. The correlation between interest rates and the performance of these two indices is not high, consistent with our previous conclusion that growth is more important than changes in local Hong Kong interest rates. However, in comparison, the correlation for the Hong Kong index (-6.1% vs. -3.3%) and the beta elasticity of interest rate changes (the regression coefficient for percentage changes in the index corresponding to each percentage point change in interest rates is -0.013 vs. -0.009) is slightly larger than that of the MSCI China index.

What does it mean for the Hong Kong dollar to hit the weak-side guarantee?

Recent fluctuations in the Hong Kong dollar exchange rate have drawn widespread attention from investors. The market's concern about the Hong Kong dollar hitting the weak-side guarantee is that if the Hong Kong dollar continues to be at the weak-side guarantee, the Monetary Authority will have to take on a large amount of selling pressure, thereby tightening Hong Kong dollar liquidity, leading to higher interest rates in Hong Kong, which will put pressure on both the economy and the financial market.

We believe that the Hong Kong dollar hitting the weak-side guarantee is merely a technical adjustment. 1) After the Monetary Authority released liquidity in May, the interest rate differential between the U.S. and Hong Kong widened, leading to capital selling Hong Kong dollars to buy U.S. dollars under the influence of carry trades, resulting in a weakening of the Hong Kong dollar exchange rate. 2) Recently, the escalation of the geopolitical conflict between Israel and Palestine has led to a significant rise in oil prices, a rebound in the U.S. dollar, and a weakening of Asian currencies. However, we doubt the sustainability of the current situation; for example, in the medium to long term, the supply and demand for crude oil do not support a long-term rise in oil prices (《Risks of Escalation in the Israel-Palestine Conflict and Its Macroeconomic Impact》，Huatai Macro published on June 15, 2025).

The exchange rate does not have sustained fundamental pressure to hit the weak-side guarantee, so it is unlikely to cause a large-scale tightening of liquidity. The undervaluation of Asian currencies such as the Renminbi is a given; the current situation is completely different from the previous weakness of the Hong Kong dollar when there was depreciation pressure on the Renminbi. Year-to-date, compared to other Asian currencies, the Renminbi's appreciation has not been fully compensated. From both a fundamental perspective and the extent of currency mismatch (rebalancing pressure), we believe that the Renminbi should not undergo deep adjustments relative to major trading partners and may even have appreciation momentum (《The Renminbi May Have Appreciation Momentum》，Huatai Macro published on May 22, 2025). Currently, the Renminbi exchange rate has returned from a weak position within a 2% range around the central parity to the central parity level, with bullish and bearish forces being relatively balanced, no longer under unilateral depreciation pressure. This fundamental environment does not support continued shorting of the Hong Kong dollar.

In the future, HIBOR rates are more likely to adjust upwards from extremely low levels, with the final level possibly remaining in the mid-to-low range. In the medium to long term, Hong Kong and U.S. interest rates are highly correlated and should change in tandem. However, the speed and extent of the Hong Kong dollar interest rate recovery are uncertain. If we only consider the force of carry trades: 1) Assuming forward contracts hedge exchange rate risks, HIBOR rates have almost no carry trade space; 2) Assuming naked carry trades bear exchange rate risks while keeping U.S. interest rates unchanged, we reverse-engineer the HIBOR rate points under different forward exchange rate conditions where carry trade returns are 0 based on interest rate parity theory, resulting in the following simulated hypothesis table (Chart 22). If, due to the operations of the Monetary Authority, the Hong Kong dollar central parity comes to 7.83/7.80 in the next 1/3 months (which is the current forward contract point), the corresponding 1M and 3M HIBOR should be 1.25% and 1.73%, which is not significantly higher than the current level. The greater the pressure for exchange rate appreciation, the greater the losses from carry trades. Moreover, there is currently another important force in Hong Kong's capital flows, namely the demand for Hong Kong dollars created by funds participating in the primary and secondary capital markets, which partially hedges the selling pressure from Hong Kong dollar carry trades Therefore, overall, Hong Kong's liquidity remains ample in the medium term.

In the short term, the Hong Kong Monetary Authority may withdraw Hong Kong dollars due to foreign exchange touching the weak side, but the negative impact on the market is relatively controllable. The ample liquidity of the Hong Kong dollar is not solely due to the decline in HIBOR; on the contrary, the continuous inflow of funds into the Hong Kong market is the common reason for the decline in HIBOR and the ample market liquidity. In the medium term, the liquidity environment is not bad under the demands for expansion and allocation, and the profit growth rate still shows resilience, making the market's downside risk relatively controllable. Therefore, if fluctuations arise due to adjustments in the Monetary Authority's policies, it may instead provide participation opportunities.

1. Hong Kong stock financing has instead brought about an increase in funds this year. We pointed out in our report "Hong Kong Stocks Revaluation Ready to Take Off" on May 23, 2025, that Hong Kong itself is not a stock market. The quality of the financing targets is more important than the size of the financing scale. Historically, there is no clear relationship between the scale of financing and the market's rise and fall. Financing in Hong Kong does not necessarily bring supply pressure (the market does not necessarily need to sell old stocks to buy new ones), and financing by "star companies," whether through IPOs or refinancing, may further attract funds, thereby improving the overall market liquidity and forming a positive cycle. Moreover, the current low financing costs and ample Hong Kong dollar liquidity can provide good funding conditions.

2. Hedging against the impact of rising U.S. Treasury rates creates relative return space. Referring to Huatai Macro's report "Not an Easy Economic 'Soft Landing'" on June 3, 2025, it is predicted that U.S. Treasury rates may rise to 4.7% by the end of the year, which still has a marginal impact on Hong Kong stocks. Especially considering that in the third quarter, U.S. Treasuries also face uneven issuance pressure, a temporary peak may form in the short term, which the U.S. stock market has not fully accounted for. Rising U.S. Treasury rates generally exert pressure on overseas assets, and Hong Kong stocks are no exception. Referring to our report "Index Relatively Stable, Sector Rotation Strengthens" on June 15, 2025, market volatility may be relatively high in the third quarter.

However, we found that as long as the external market does not decline significantly, Hong Kong stocks are expected to achieve relative performance. Since 1990, when the S&P 500 declines in a month, the correlation with the Hang Seng Index's performance in that month is about 44%. However, when the U.S. stock market declines slightly (with a monthly decline of less than 3%), the correlation with Hong Kong stocks drops to 13%, and the average decline of Hong Kong stocks is less than that of U.S. stocks (Hang Seng Index -1.3% vs S&P 500 -1.5%).

In addition, the rise in U.S. Treasury yields may have a smaller constraint on Hong Kong stocks compared to U.S. stocks. The increase in U.S. Treasury yields in the second half of the year may also suppress the valuation recovery space for Hong Kong stocks. We estimate the correlation between U.S. Treasury yields and the Hang Seng Index to be about -52%, but compared to U.S. stocks, Hong Kong stocks can still benefit from domestic and Hong Kong liquidity easing, especially considering the revaluation of RMB assets and the potential for incremental funds to further flow into the Hong Kong stock market. Since the beginning of the year, even though U.S. Treasury yields have remained high, Hong Kong stocks have still risen over 30% since October 2023, leading the global market.

3) The momentum of external capital inflow into Hong Kong remains strong. Referring to our estimates in the report "Overseas Market Outlook for 2H25: Rebalancing in Progress" dated June 3, 2025, in terms of foreign capital, the top 20 global investment institutions increased their positions in Chinese stocks in Q1 2025, but due to underperformance relative to market gains, the degree of under-allocation has passively increased. If the ultra-low allocation ratio returns to the level of Q4 2024, it would mean an increase of 0.22 percentage points in holdings of Chinese stocks, corresponding to a potential increase of $30 billion in holdings of Hong Kong stocks by the top 20 global investment institutions. On the southbound side, the reasonable investment ratio is estimated to be around 26%, and the current 40% allocation to Hong Kong stocks by public funds could bring about HKD 200 billion in incremental funds. If the current actively managed equity public funds allocate proportionally, it could lead to an increase of around HKD 500 billion in incremental funds.

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