Hong Kong mulls yuan options

As speculation about a possible revaluation of the Chinese yuan continues to roil Hong Kong's markets, financial authorities here are taking a new look at their options for calming the waters.

Market speculation on a rise in the yuan has drawn lots of money into Hong Kong, whose open markets are a favored way for traders and investors to gain exposure to China. Because of the way Hong Kong's own peg to the US dollar works, that influx of funds has pushed down interest rates to unusually low levels, and kept them there. Such a loose monetary policy, at a time when inflation is returning and property prices are looking frothy, has officials worried.

Joseph Yam, chief executive of the Hong Kong Monetary Authority, said last week he is considering whether to "do something" to "rationalize" the market, and make Hong Kong interest rates return to their historical pattern.

Local interbank rates are now more than a full percentage point below comparable US rates, though traditionally Hong Kong rates have been slightly higher than in the US

Market watchers believe the Hong Kong Monetary Authority's most likely course is to soak up liquidity by selling more bonds, thereby locking up banks' short-term funds in longer-term instruments. The technique is known as "sterilization" in central bankers' jargon, and it is also practiced by other jurisdictions that maintain fixed currencies, including China.

If this monetary-policy tool is indeed adopted by Hong Kong, it would be the first major change to how the 21-year-old currency board system operates since a series of technical adjustments were made following the Asian financial crisis of 1997-98. While current market conditions may not be extreme enough for the Hong Kong Monetary Authority to step in, analysts say the turmoil that is likely to follow an actual yuan revaluation could demand a response.

Yam's boss, Financial Secretary Henry Tang, said the government is looking at "contingency plans" in case China does in fact make a change to its currency regime.

Philip Lau, treasurer for CITIC Ka Wah Bank, said, "If there are massive inflows to Hong Kong, then probably the HKMA should do something at that time to jack up interest rates and contain inflation."

Even a small action would send a strong signal to the markets, he said. "I think it would have a psychological impact much greater than the actual amount involved," he added.

Since officials say Hong Kong won't change its own peg, a yuan revaluation could stoke inflation by pushing up the price of Chinese goods. And if, as many deem likely, a yuan move sparks massive buying of China-related assets, the resulting fund flows could further push down Hong Kong interbank interest rates.

Joe Lo, an economist at Citigroup, said that sterilization would be a good option.

"Sterilization is very commonly used by other central banks," he said. "It is almost risk free. The HKMA can issue notes to absorb the excess liquidity and invest the money it raises in US Treasurys, for example, and pocket the difference in yield."

Many traders think there could be some difficulties if the HKMA chooses the sterilization option. The biggest hurdle would be convincing reluctant banks to buy the additional paper. That's because banks may not be willing to switch those short-term funds into longer term instruments, as they could be caught short if speculative funds pull out. Traders argue banks probably would have already invested those funds elsewhere if the money was really expected to stay in Hong Kong for the long term. And the HKMA also may not want to risk exposing itself to a reversing market sentiment.

To avoid those pitfalls, the HKMA may have to keep the actual size of any sterilization operation rather limited, and rely more on the psychological impact of its actions. By sending signals to the market now, it can also influence traders' thinking before deciding whether to make a move.

"The idea that the authorities are going to have to come in ... will have an impact on speculative interest in the Hong Kong dollar," said Tim Condon, an economist at ING in Singapore. "I think traders do look at that as a signal on how to position."