EXPECTATIONS for Hong Kong dollar moves against the US currency more than tripled in the past year as investors bet faster inflation and a more convertible yuan will hasten an end to the city's fixed exchange rate.

One-year implied volatility, a measure of exchange rate swings used to price options, climbed to 2.23 percent from 0.55 percent a year ago.

The jump is the biggest in Asia even as fluctuations anticipated for the Hong Kong dollar are smaller than for the yuan, whose volatility rose to 4.8 percent from 3.97 percent, and for the South Korean won, which climbed to 18.5 percent from 13.5 percent.

While the Hong Kong Monetary Authority reiterated last Thursday that it has "no plan or intention" to end the 28-year peg to the greenback, the yuan is up 30 percent against the US dollar since the start of 1999, the fourth-best performance of 25 emerging-market currencies tracked by Bloomberg News. Chinese mainland's one-year government bond yields 3.8 percentage points more than similar-maturity Hong Kong debt, the most in at least four years.

William Ackman, founder of hedge fund Pershing Square Capital Management LLP, said last week he's using options to bet that Hong Kong will switch its currency link to the yuan.

"We believe the Hong Kong dollar peg will eventually go because of the ongoing appreciation of the Chinese yuan against the US dollar," said Rupert Watson, the Southampton-based head of asset allocation at Skandia Investment Group, which oversees US$15 billion. "I would have thought it will come around the same time the Chinese currency moves toward full convertibility, somewhere around 2015."

Review urged

The spot rate for yuan in Hong Kong rose 1.1 percent this quarter to 6.3920 versus the greenback, and the Shanghai rate gained 1.2 percent to 6.3868. Hong Kong's dollar weakened 0.14 percent to HK$7.7950. The yield on China's benchmark 10-year bonds rose 19 basis points to 4.08 percent, according to Chinabond prices.

In January, Hong Kong lawmakers Chim Pui Chung and Lam Tai Fai urged a review of the peg. They argue that the currency link has helped fuel the fastest inflation in 16 years by tying the city's monetary policy to that of the US Federal Reserve, which pledged last month to maintain a near-zero benchmark interest rate through mid-2013.

Ackman is buying Hong Kong dollar call options, which give investors the right to buy the currency at a set price by a specific date, because they are inexpensive, he said on September 14.

The easiest way for the authorities to allow the currency to appreciate would be to change the peg to HK$6 per US dollar, a 30 percent gain, and then link to the yuan over three to six years, he told an investor conference in New York.

Growing pressure

"There is some growing pressure on Hong Kong authorities to move the peg," said Robert Reilly, the co-head of flow fixed income and currencies in Hong Kong at Societe Generale CIB. "The relative cheapness of the Hong Kong dollar and the record low interest rates are fueling inflation. The low level of volatility means that this bet is a relatively cheap one."

The yuan's lack of convertibility and restrictions on holding China's government debt mean the currency still can't take the place of the US dollar in central bank reserves or linked exchange-rate systems, said Raymond Yeung, an economist at Australia & New Zealand Banking Group Ltd in Hong Kong. He said the yuan is another decade away from taking this role.

"The dollar peg is the best option for the Hong Kong economy," Yeung said. "The system has helped weather so many storms for the city in the past 28 years. The government can cope with inflation by administrative measures such as one-off relief or selling inflation-linked bonds. A one-off revaluation would damage Hong Kong's credibility."

Hong Kong is also unlikely to make major policy changes before the selection of a new chief executive for the city and elections for the Legislative Council next year, said Daniel Lin, a Hong Kong-based managing partner at Grant Thornton Jingu Tianhua, an accounting and consulting company. China also faces a reshuffle of its senior leadership early next year.

"Taking a risk with something that has served Hong Kong so well over the last 30 years is a risk too far," Skandia's Watson said. "There are still significant risks in the global economy, not least in Europe."

Five-year credit-default swaps, the cost of insuring Chinese government debt against default, rose 4.7 basis points to 131 yesterday, according to data provider CMA, which is owned by CME Group Inc and compiles prices quoted by dealers in the privately negotiated market. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should an issuer fail to adhere to its debt agreements.

Yuan forwards

Twelve-month non-deliverable forwards lost 0.09 percent yesterday to 6.3501 per dollar, a 0.6 percent premium to the onshore spot rate.

The Hong Kong dollar peg was adopted in 1983, when negotiations between China and the UK over returning the city to Chinese control triggered capital outflows. China, which took sovereignty of Hong Kong in July 1997, maintained the dollar link as it used the city as a hub for overseas trade and a testing ground for the opening of its financial markets.

Current Chief Executive Donald Tsang fended off a speculative attack to weaken the Hong Kong dollar and break the peg when he was finance secretary during the Asian financial crisis in 1998, a policy that involved US$15 billion in stock purchases and proved profitable for the city.

In 2005, the HKMA committed to limiting the currency's decline to HK$7.85 per dollar and capping gains at HK$7.75.

HSBC Holdings Plc Chief Executive Officer Stuart Gulliver and his counterpart at the Bank of East Asia Ltd, David Li, said last month that any shift by Hong Kong could be to a link with a basket of currencies. HSBC is Hong Kong's biggest lender in terms of number of customers, while Bank of East Asia is the third-largest Hong Kong-based lender by market capitalization.

Cheaper way

Chinese officials told European Union business executives that the yuan will achieve "full convertibility" by 2015, EU Chamber of Commerce in China President Davide Cucino said on September 7.

Hong Kong dollar options are "a cheaper way, although not necessarily the best way, to play yuan convertibility prospects," said Dirk Gradehand, a Singapore-based trader at DZ Bank AG, Germany's fifth-largest lender.

China's economy expanded 9.5 percent from a year earlier in the second quarter, while the US had growth of 1.5 percent, official figures show. Hong Kong's gross domestic product gained 5.1 percent and its jobless rate of 3.5 percent compares with 9.2 percent in the US.

Real-estate values in Hong Kong climbed in each of the last 10 quarters, jumping 75 percent in that time.

Yuan deposits in the city rose more than five-fold to 572 billion yuan (US$90 billion) in the year through July, HKMA data show. The value of trade settled using yuan was 953 billion yuan in the first seven months of 2011, almost triple the 2010 total of 369 billion yuan, Tsang said last Thursday.

"The surge in RMB deposits and the rapid uptake of the renminbi is indicative of its imminent rise as one of Hong Kong's trusted currencies," Grant Thornton's Lin said, using an alternative name for the yuan. "We are starting to quote for our clients in renminbi instead of the Hong Kong dollar."

A weak Hong Kong dollar relative to the yuan is exacerbating the city's inflation, as Hong Kong imports about 45 percent of its food and goods from Chinese mainland in 2011, according to the city's statistics department. Consumer prices in Hong Kong rose 7.9 percent in July from a year earlier, the most since 1995, according to official data.

"Reducing inflation and the risk of asset bubbles" would be good enough to justify a revaluation of Hong Kong's currency, according to Ackman.