Hong Kong’s dollar aka HKD has been cause for concern in recent weeks. The currency, pegged to the U.S. dollar since 1983, is managed by an Exchange Fund. But unlike the U.S. Fed, the Exchange Fund has stayed on the sidelines and Hong Kong banks have maintained rates in a hot property market, causing an interest rate differential.

The currency has hit a 15-month low and, according to Bloomberg, and declined at its fastest pace in over a year. A serious worry now is its potential consequences for stocks, with some believing the floor rate of HK$7.80 per U.S. dollar could cause investors to flee.

Not so soon, says UBS. The Swiss bank believes the embattled currency is still within historical range, and mandates no intervention yet.

HKD  Hong Kong Banks HKD  Hong Kong Banks Hibor
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“Yes, the HKD has weakened toward roughly 7.8, but that’s well within normal historical experience and doesn’t even warrant intervention to defend the currency,” UBS said in its Macro Keys note May 18. “Recall that the prescribed trading band for the HKD is 7.75 on the strong side and 7.85 on the weak side.”

Why has the HKD currency depreciated?

According to UBS, reasons for its decline are “interesting.” Hibor typically has a positive spread over Libor. However, this time around, while Libor has increased alongside U.S. rate hikes, Hibor has fallen. This has caused a negative spread of 20-30 basis points, weakening the Hong Kong dollar.

So the underlying question is: why has Hibor fallen?

UBS contends Hibor has fallen because of excessive liquidity at the banks, more than any other reason. It makes a comparison with Singapore to bolster its argument.

“Both Singapore and Hong Kong are financial centers with completely open capital accounts, which allow interest rate arbitrage to normally force short-term interest rates to follow U.S. rates,” the bank said. “However, short-term rates in Singapore have risen recently, whereas HK rates have fallen as Libor has increased. We think the main difference is bank liquidity.”

Hong Kong banks are flush with excess funds with a loan-to-deposit ratio that is only 73% and falling, whereas in Singapore the ratio for domestic banks is slightly above 100% and no longer falling, the bank said.

“In practice this should mean that Hong Kong banks are less dependent on the interbank market for funding than Singaporean banks. In other words, if deposits flow overseas HK banks have a much larger cushion before they may need to raise rates to retain funds,” the note said.

What now?

UBS believes support for the peg policy “remains strong and is unlikely to change anytime soon.” If Hibor doesn’t rise anytime soon, the local currency will likely push toward 7.85, triggering currency intervention and tightening in liquidity conditions.

“The interventions and the pace of contraction in domestic liquidity would need to be large enough to raise Hibor until interest rate differentials would alleviate the pressure for the HKD to depreciate,” the bank said.