Photographer: Xaume Olleros/Bloomberg

Dollar Pegs Seen Bending While Reserves Keep Them From Breaking

  • Option traders see 41% chance of Hong Kong dollar testing peg
  • Saudi Arabia and Hong Kong hold $1 trillion reserves to defend

Countries with currencies pegged to the dollar are coming under increasing attacks by traders who bet it’s become too expensive for policy makers to continue defending exchange rates amid a soaring greenback and a collapse in commodities prices. It may be the speculators who end up losing.

It’s a tempting trade. Already, Kazakhstan, Azerbaijan and Argentina have been forced to devalue, and derivatives tied to the Saudi Arabia riyal and Hong Kong dollar suggest traders expect it won’t be long before the same happens to those currencies. Options prices put the odds of the Hong Kong dollar weakening beyond the weaker end of its current trading range this year at 36 percent, Bloomberg data show.

What traders may be underestimating are the hefty reserves available to policy makers and their willingness to defend the pegs, which have anchored their economies for decades and helped them survive financial crises in 1997 and 2008, according to analysts at Deutsche Bank AG and Union Bancaire Privee Ubp SA.

Together, Saudi Arabia and Hong Kong hold $1 trillion in foreign reserves, or enough to cover their imports and spending for years. Devaluations would only serve to destabilize their economies and could undermine Hong Kong’s status as Asia’s financial center, the analysts say. Hong Kong Monetary Authority Chief Executive Norman Chan on Monday reiterated his commitment to keeping the exchange rate’s existing link to the U.S. dollar.

Take the Pain

Countries are unlikely to de-peg “without exhausting their ammunition,” said Koon Chow, a currency strategist at Union Bancaire Privee in London. “They can take the pain in defense.”

QuickTake Currency Pegs

Oil exporters in the Gulf region are under unprecedented stress. A 69 percent drop in crude prices over the past two years has dwindled their U.S. currency revenues. Hong Kong’s 32-year-old dollar peg was threatened last week after a slide in the Chinese yuan sparked speculation that the authorities may revise the system to tighten its link to the mainland.

Twelve-month forwards for the Saudi Arabian riyal, which investors use to bet on or hedge the currency, tumbled to an all-time low of 3.87 per dollar this month. That was about 2 percent weaker than the country’s 3.75-per-dollar peg, suggesting traders are betting on the end of the 30-year peg, according to data compiled by Bloomberg. 

Policy Response

Hong Kong’s dollar posted its biggest two-day drop since 1992 last week to HK$7.795 versus the greenback in New York. A measure of volatility surged to the highest since 2003 amid speculation that the Chinese city will revise its linked exchange-rate system, which limits fluctuations in the currency to a range of HK$7.75-HK$7.85, compared with HK$7.799 on Monday.

Policy makers are rushing to damp such expectations. The Saudi kingdom pledged last week to stick with the peg and said “mis-perception” is driving forwards contracts higher. HKMA’s Chan said there is no intention or need to reform the exchange rate and he expects the Hong Kong dollar to drop to the weak end of its trading range.

While Saudi Arabia, the world’s largest oil exporter, has burnt through 15 percent of its foreign reserves since August to defend the riyal, the stockpile, at $636 billion, is still the third largest in the world after China and Japan. Instead of devaluing the currency, the kingdom is cutting spending and subsidies to cope with the decline of oil revenue and may tap debt markets this year to fund a deficit.

‘Stay Away’

“Stay away from the Saudi riyal peg trade,” Deutsche Bank analysts including Daniel Brehon wrote on Jan. 12. Devaluation wouldn’t restore the kingdom’s competitiveness as oil dominates exports and will make imports of labor and materials more expensive, according to their report.

Hong Kong holds a record $359 billion in foreign reserves and can tap into China’s $3.3 trillion coffer. Its currency board arrangement, which requires every Hong Kong dollar in circulation to be backed by an equivalent amount of the U.S. currency, means the money supply would shrink in case of capital outflows, pushing interest rates higher and making the local currency more attractive.

Hong Kong companies, in the past, were also able to slash costs and wages, to maintain their competitiveness without having the city resort to a devaluation.

“We expect speculation on the Hong Kong dollar peg to dissipate,” as seen in “episodes of similar speculations in the past,” analysts at Australia & New Zealand Banking Group Ltd. wrote in a report on Jan. 15.

Rewarding Bets

That hasn’t deterred speculators. With relatively low costs, a bet on the de-peg can be rewarded handsomely.

Buying put options against the Saudi riyal could double the investment if the currency weakens by about 8 percent in a year, according to data compiled by Bloomberg.

Even without de-pegging, short selling via forwards and options can be profitable, as long as the pressure remains, which will push the prices of derivatives higher.

Payout Graph on 1-Year Saudi Riyal Puts
Payout Graph on 1-Year Saudi Riyal Puts

Policy makers in Saudi Arabia and Hong Kong showed their commitment under even more distressed times. Saudi Arabia’s peg remained intact with foreign reserves less than $13 billion and oil prices below $11 a barrel in 1998. Hong Kong’s link survived a change of sovereignty in 1997, a 1998 attack by speculators during Asia’s financial crisis and almost three months of pro-democracy protests in late 2014.

“Hong Kong has been tested,” said Stephen Jen, co-founder of SLJ Macro Partners LLP in London and a former economist at the International Monetary Fund. “They’ve seen much worse before. The peg is not going to go away.”

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