Hong Kong Interbank Rates Soars To 2008 Highs To Preserve Bank Stability, Crush FX Shorts

With the world's attention now focused on whether the US will launch World War 3 over another Gulf of Tonkin false flag event in the Persian Gulf, it seems like it was an eternity ago that Hong Kong was doused in tear gas and rubber bullets were being fired at thousands of protesters in a "riot" that has been dubbed the city's most violent protest since 2014 and meant to prevent the passage of a bill allowing Hong Kong to extradite its citizens to mainland China

For the local financial system it was far more difficult to forget the clashes, and to avoid the biggest threat facing not just Hong Kong but also the mainland - namely accelerating capital flight and a sharp drop in the currency - overnight Hong Kong's interbank interest rates soared to the highest since the financial crisis, in an attempt to soak up liquidity and squeeze any growing short base in the Hong Kong dollar. As a result, the currency soared and stocks plunged as the mauling of FX shorts slammed local financial assets.

The Hang Seng stock index fell 1.7% at the close, with local property developers among the biggest losers, while the Hong Kong dollar strengthened as much as much as 0.26%, the largest gain in seven months.

Why? Because the one-month Hibor, or the interbank borrowing rate, surged 20 bps to 2.42%, the highest since 2008.

The more volatile overnight Hibor advanced by nearly half to 2.33%.

There were some analysts, like DBS Group economist Samuel Tse, who pretended that the violent events of the past week had nothing to do with the sudden concern about capital outflows. Tse said banks needed to hold more cash at the quarter’s end to meet regulatory requirements, while corporations also needed cash to settle bills due at the same time and to pay dividends to shareholders. Tse said one-month rates also topped 2% in December and in June 2018; what he didn't say is that there is over two weeks until quarter end.

Other analysts, such as Linus Yip, a strategist at First Shanghai Securities, were eager to flip cause and effect, and said the fact the Hong Kong dollar had rallied against the U.S. dollar suggested there was little risk of capital leaving the city. "It is a good sign that shows a limited risk of massive fund outflow, as the demand for the local currency remains strong despite tight interbank liquidity toward the quarter-end,” he said, forgetting to add that the limited risk of massive fund outflows was only because of the surge in interbank rates, which of course is unsustainable - just ask Turkey which in late March sent its overnight rate to over 1000% for a few days.

The truth is that the only reason for the sudden surge in funding rates is that the protests sparked fears about potential capital outflows. The resulting squeeze drove up the cost of shorting the Hong Kong dollar, which also contributed to the one-day jump.

“Recent political events in Hong Kong are affecting investors’ confidence on the future of the city,” Springwaters Financial Securities' strategist Sam Chi Yung told Bloomberg by phone. "A stronger local dollar may hurt exporters while surging Hibors mean higher funding costs for companies with more debt."

Meanwhile, the local banking system - and society - remains in limbo. The controversial extradition debate scheduled to take place on Wednesday in the legislature was postponed to an unspecified time after thousands converged on the legislature, blocking roads in tactics similar to 2014 Occupy demonstrations. Police fired tear gas in the afternoon, leading to some apparent injuries among protesters and officers. U.S. House Speaker Nancy Pelosi threatened legislative action in Congress to "reassess" whether Hong Kong is sufficiently autonomous.

Of course, manipulating funding costs is a two-edged sword and while it delays or reverses sharp capital outflows, and a selloff in the currency, it also slams all local assets. In addition to the plunge in the developers, which are the most sensitive to changes in rates, among other stocks sliding in Hong Kong were Sunny Optical Technology Group which dropped 6.1% and AAC Technologies Holdings which lost 3.4%.

Hong Kong’s two benchmarks were Asia’s worst performers in an otherwise quiet session in the region. The Hang Seng Index was only just recovering from a rout that had made it one of the world’s worst performing major benchmarks in May.

"Uncertainty on local policies will confuse investors and affect the flows in and out of Hong Kong stocks," said Ronald Wan, chief executive of Partners Capital International Ltd. "Investors now need to ponder whether or not to pull out of the market given the local events and global factors including the trade war."

The good news: the US Dollar tumbled to its weakest level against the Hong Kong dollar in six months, as the shorts scrambled to cover. On Thursday afternoon in Asian trading, $1 bought about 7.8248 Hong Kong dollars.

The problem is that such artificial squeezes can only takes place so many times before the broader economy is adversely affected. For now, DBS' Tse said he didn’t see a significant risk of money outflow. "The key question remains whether the currency peg with the U.S. dollar is intact," he said, something which Kyle Bass is betting heavily against. Tse said the city’s monetary authority could defend the peg with its large foreign-exchange reserves and by injecting capital into the interbank market if needed.

He is right, of course, only as long as the demand for USD doesn't become overpowering. Because as 2015 showed, it took China just about a year to lose a quarter of its reserves in the country's most spirited defense of its currency to date. For Hong Kong, it would probably take a few weeks, if not days, of consistent rioting before the attempts to spook FX shorts stop working and Hong Kong is forced to face the reality of billions in capital outflows, something Turkey's Erdogan is fighting tooth and nail to offset even through it may now be too late for the outspoken NATO member.