Markets

Christopher Langner is a markets columnist for Bloomberg Gadfly. He previously covered corporate finance for Bloomberg News, and has written for Reuters/IFR, Forbes, the Wall Street Journal and Mergermarket.

Hong Kong investors have nowhere to run. 

Their currency is pegged to the dollar and with Janet Yellen talking about accelerating the pace of interest rate increases, U.S. dollar funding costs have risen. But so have those in China, for completely different reasons. Sandwiched between the two, the Hong Kong interbank offered rate was pushed this week to the highest since 2009.

Fed Sandwich
Hong Kong benchmark interbank rates rose to the highest since March 2009 this week just as a cash crunch hit Chinese banks
Source: Bloomberg

While the peg means that Hong Kong's monetary policy is dictated by the Fed, the spike in Hibor may have more to do with what's going on north of the border than across the Pacific.

For most of this year, Hibor's 89-day correlation with its Chinese yuan equivalent has been tighter than the link with Libor, the dollar benchmark. After the Fed's rate hike on Wednesday, the correlation with Shanghai rates was 2.6 times stronger than with the U.S. dollar interbank market.

Beijing-Bound
The longstanding correlation between Hong Kong and U.S. rates has weakened as China holds more sway
Source: Bloomberg

That means Hong Kong banks should look to Beijing, not Washington, for comfort from the squeeze they're facing. They're unlikely to get it.  Yuan borrowing costs have spiked onshore because of a cash crunch in the mainland.

The solution for banks may be to increase deposit rates, thus reducing their reliance on wholesale markets for funding. Doing so will cost them profits, though that cost is certain to be passed on to borrowers in the form of higher lending rates, which has uncomfortable implications for Hong Kong's economy and financial markets.

Apart from mortgages and corporate loans, margin finance is also tied to benchmark rates. If these suddenly become more expensive, borrowing money to invest in securities may stop being profitable. That could exacerbate a selloff in stocks and bonds.

No surprise, then, that Hong Kong was among the worst-hit major stock markets on Thursday. While the Hang Seng Index's 1.8 percent decline was partly explained by the Fed's move, the gauge also had a terrible day on Monday, when Chinese shares slumped as a result of an onshore cash crunch. 

Blame It on China
The Hang Seng Index took a tumble on Monday as a cash crunch in China weighed on markets onshore
Source: Bloomberg

Critics of the peg have long pointed out the anomaly of tying Hong Kong's monetary policy to a far-away economy whose cycles may be out of sync with those of the city, a former British colony that returned to Chinese sovereignty in 1997.

It turns out that Hong Kong's money markets are starting to dance to the beat of China's drum after all, even as the fixed exchange-rate regime endures. Unfortunately, it's happening at the worst possible time.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Christopher Langner in Singapore at clangner@bloomberg.net

To contact the editor responsible for this story:
Matthew Brooker at mbrooker1@bloomberg.net