Hong Kong: Liquidity Trap Supports Low Rates
Andy Xie / Denise Yam (Hong Kong)
Interest Rate Can Fall by a Further 50 bps
The Hong Kong Association of Banks (HKAB), the local banking cartel, followed the 50-bps cut by the European Central Bank (ECB) with a 25 bps reduction in its benchmark savings rate on April 9. However, Hong Kong's currency link to the dollar limits how far Hong Kong's interest rate can deviate from the Fed funds rate. Can Hong Kong's rate be cut further given that the US has a strong economy and will not likely cut its rate soon?
The differential between the Fed funds rate and Hong Kong's savings rate becomes significant when the negative spread is worth savers' trouble to shift into foreign currency deposits. This critical level is about 150 bps, in our view. This is based on experience during 1992-96, when the loan-deposit ratio (LDR) was falling and the negative spread between Hong Kong's savings rate and Fed funds rate was stable. A falling LDR implies loose liquidity conditions and allows the interest rate to drop until further declines are constrained through arbitrage.
The LDR in Hong Kong has fallen 13.6 percentage points since the beginning of 1998. Total Hong Kong dollar loans have fallen by 6.3% from the peak in September 1997, while Hong Kong dollar deposits have risen by 4.3%. The ample liquidity conditions support further rate cuts, down to the level at which arbitrage constraint kicks in. Based on this analysis, Hong Kong's interest rate can decline by a further 50 bps. We therefore maintain our call that Hong Kong's best lending rate will fall to 8% by year-end from 8.5% currently.
The risk premium on the Hong Kong dollar remains significant at 100-200 bps. This premium is priced in at the longer end (6-12 months) of the yield curve. Hong Kong banks' financing is largely done at the short end of the yield curve. This allows Hong Kong to benefit from low rates despite the high currency risk premium.
Liquidity Trap Supports Loose Liquidity Environment
We believe the loose liquidity condition is a result of a deflation-induced liquidity trap. Deflation has increased credit risks, exacerbating the adverse selection problem in the credit market. Banks, therefore, need to reduce their lending rates to attract good credits into the market but to lend less at the same time.
For example, Hong Kong banks are competing fiercely in the mortgage market for borrowers with secure income (e.g., civil servants, teachers) but are much less willing to lend to employees of small and medium-sized enterprises. Total residential property loans are at an all-time high, having increased by 10.4% since September 1997, while loans to non-finance/property industries have declined by 11% during the same period. The credit allocation in Hong Kong has become even more concentrated in the finance/property sector. This is in sharp contrast to Hong Kong's need to diversify away from the property sector, which is crucial for sustaining Hong Kong's long-term growth.
Lower Rates Won't Jump-start the Economy
The linked exchange rate limits the room for interest rate flexibility in Hong Kong. Despite the 100-bps cut since November 1998, the real interest rate is at a two-decade high as a result of deflation, being 7 percentage points higher than the average in 1997.
The real interest rate matters in Hong Kong because the economy's loan/GDP ratio is relatively high at 160%. The rise in the real interest rate last year transferred 5-6% of GDP equivalent in income from debtors to creditors. Hong Kong avoided massive bankruptcies because GDP contraction was borne entirely by the decline in the government revenue. In contrast, the 100-bps reduction in interest rate reduces the debtors' burden by around 1.3% of GDP.
We maintain our view that Hong Kong's economy is stabilizing but will not rebound quickly any time soon. Fiscal policy is a far more important stabilizing force than interest rate reductions. Hong Kong is a small, open economy. Its economy cannot recover without an increase in external income. This increase is likely to materialize only when China recovers from its reform-induced economic downturn.
