Opportunities in the Hong Kong Dollar?

09/14/2012 8:00 am EST

Focus: FOREX

Stephen D. Simpson explores the world's eighth-most traded currency, which is more notable for its differences from its global brethren than its similarities.

The Hong Kong dollar is an unusual currency in the world today. In some respects, it is almost like a "tracking stock" for Hong Kong—a city-state that is officially part of China, but allowed to run independently in many respects.

It is also one of the only currencies whose future seems to point to inevitable obsolescence—assuming that China eventually allows free trading of the renminbi (or yuan), there would be little point in the ongoing use of the HK dollar.

For now, though, the HKD is still a significant currency, as it is eighth-most traded currency in the forex markets. While the third-most active currency in Asia, it is not a significant reserve currency.

The Hong Kong dollar is administered by the Hong Kong Monetary Authority and not allowed to trade freely. The present exchange-rate regime is called a "linked exchange system," and it effectively means that the HKD trades within an extremely narrow band against the US dollar. Accordingly, the Hong Kong Monetary Authority does not actively pursue aggressive monetary policy, and interest rates are based on an automatic mechanism that maintains the stability of the exchange rate.

Hong Kong dollars are issued only if there are equivalent US dollars on deposit with the issuing banks, so the entire outstanding issuance of Hong Kong dollars is effectively backed by the US dollar.

The Economy Behind the Hong Kong Dollar
While part of China, Hong Kong is operated as a largely autonomous region. It is a small economy (39th in GDP), but by the standards of the Index of Economic Freedom, Hong Kong is an especially free economy.

GDP growth has been volatile over the past two decades, but has generally been above 5% and sometimes as high as 10%. Inflation has been erratic, as high as 10% as recently as 1995 and actually negative for more than four years around the turn of the century.

Interest rates have been quite low in recent years, and public debt is an insignificant consideration to the economy, though the debt underwritten by banks for real-estate developers is a significant and often volatile influence on the local economy.

With low taxes and few barriers to business, Hong Kong has long been a vital trading and financial hub in Asia. The Hong Kong Stock Exchange is the world's sixth-largest by market capitalization, and virtually every global bank and securities house of significance has an office in Hong Kong.

Not surprisingly, the economy of Hong Kong revolves around services. There is still some manufacturing within Hong Kong, but upwards of 85% of the workforce is involved in some sort of service, with retailing, financial services, hospitality, and trade being major employers.

With the rise of mainland China and Shanghai's growing significance as a financial center, there is a widely held view that Hong Kong will ultimately begin to decline in significance. That said, China's government does not appear ready for that to happen soon, and seems to favor the opportunity Hong Kong affords to keep foreign firms somewhat at arm's length.

Next: Drivers of the Hong Kong Dollar

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Drivers of the Hong Kong Dollar
Economic models designed to calculate the "right" foreign currency exchange rates are notoriously inaccurate when compared to real market rates, due in part to the fact that economic models are typically based on a very small number of economic variables (sometimes just a single variable like interest rates).

Traders, however, incorporate a much larger range of economic data into their trading decisions, and their speculative outlooks can themselves move rates just as investor optimism or pessimism can move a stock above or below the value its fundamentals suggest.

Economic drivers for the Hong Kong dollar are a bit different than for many currencies. True, economic data on GDP, trade balances, current accounts, inflation and the like still matter, but only to a point. After all, the HKD is confined to a narrow trading band, so these economic details have only limited impact.

What's more, the relationship between China and Hong Kong is such that a Black Wednesday-type raid of the Hong Kong dollar would almost certainly fail.

Unique Factors for the Hong Kong Dollar
The Hong Kong dollar stands out in that it really not an especially tradable currency. Major banks with super-fast computers can make some money from trading the fraction-of-a-penny moves in the currency, but that narrow range keeps most small speculators away. Most transactions in the Hong Kong dollar, then, are for the purposes of actual business transactions or the carry trade.

With low current interest rates, the Hong Kong dollar is attractive in the global carry trade. Speculators can borrow cheaply in Hong Kong dollars and use those funds to buy higher-yielding debt in countries like Australia or New Zealand.

Unlike freely floating currencies, the eventual unwind of the carry trade will likely not change the range in which the Hong Kong dollar trades, but will instead impact local interest rates and perhaps stimulate capital flight. All the while, the Hong Kong Monetary Authority will use its huge reserves to maintain that desired range of exchange rates.

Over the long term, there is a good chance that the Hong Kong dollar will become irrelevant and perhaps even extinct. While China will likely not bend to Western pressure to let the yuan float freely, there will likely come a point in China's economic development where those currency controls will be lifted (or significantly loosened). When (or perhaps "if") that happens, the Hong Kong dollar will cease to have an obvious role, and will likely be eliminated.

The Bottom Line
Even by the admittedly strange standards of foreign exchange, the Hong Kong dollar is an anomaly. It is an actively traded currency, but the tight trading range imposed by the Hong Kong Monetary Authority means that there is often little to be gained by small traders in speculating in its movements.

Still, it is an important part of the carry trade and certainly important in the billions of dollars of trade and financial services that flow through the area. While the prospects of the Hong Kong dollar do not look especially bright over the very long term, it is likely to remain a key Asian currency in the short term.

Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both sell-side and buy-side investment companies in both equities and fixed income. Stephen's consulting work has focused primarily upon the healthcare sector, while he has also written extensively for publication on topics pertaining to investments, security analysis, and healthcare. Simpson operates the Kratisto Investing blog.

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