Why does domestic lending continue to be so sluggish in Hong Kong when the economy is making such a vigorous recovery?
While the Hong Kong economy has staged a strong V-shaped recovery since the second quarter of 1999, domestic lending has remained sluggish: it only resumed mild positive year-on-year growth in August 2000. This is an unusual phenomenon because in previous economic cycles, growth in domestic lending lagged behind the rebound in economic recovery by only one to two quarters. Empirical evidence on the basis of past data shows a strong correlation between domestic loans and GDP, with a lag of one quarter. Yet, in the present cycle, the lag lasted for around a year and the recovery in loan growth has not been anywhere near as pronounced as the economic recovery. The continued shrinkage of domestic loans for two years was unprecedented, although obviously the same can be said about the severity of the financial turmoil of 1998. In order to gain a better understanding of the reasons behind this unusual phenomenon, we have informally consulted a number of banks that are active in the domestic lending market. The results of this informal survey are interesting.
The banks consulted were unanimous in the somewhat obvious view that loan demand has been weak. There was also consensus that the weakness was associated with the downturn in the property market, which has traditionally been a main driver of both corporate and personal lending. The extent of the downturn in the property market associated with the financial turmoil of 1998 has been unusually sharp and beyond expectation, having regard to past experience. This shock has affected the outlook for the property market, in that developers have built in a degree of uncertainty in its prospects that is much higher than before. Consequently, they have been more cautious than before in committing themselves to new large-scale building projects, notwithstanding the sharp rebound in economic growth. This behaviour is reflected in a significant shrinkage in the size of the balance sheets of property companies, as cash proceeds from sales of flats were used to reduce debt, thus at the same time prudently, from their point of view, preventing debt-to-equity ratios from increasing. Where there has been funding demand from property developers, much of it has been for re-financing existing facilities at more favourable terms, taking advantage of keen competition among banks.
Very much the same story applies to demand for residential mortgages. The property price shock has been quite a severe one, resulting in many having to sit on negative assets and therefore shying away, to an unusual degree, from trading up. The same uncertainty has also affected the sentiment of potential first-time buyers, in that they have stayed on the side of caution. Whether or not property developers and home buyers have been overly cautious is a question that nobody can answer, but the fact of the matter is that, on this occasion, the time lag in the recovery of bank loans behind the economic recovery is about four times as long as usual.
On the supply side, the banks we consulted told us that they have long relaxed their lending policy, following closely, without too much time lag, the improvement seen in economic prospects, and as the pressure of bad debts and credit risks on their capital bases faded. They have also been encouraged by the excess liquidity that they faced, as deposit growth picked up since late 1998. However, lower collateral values, reflecting sharply lower property prices, have constrained their ability to lend. So, instead of a pick-up in loan growth that follows closely the economic recovery, the supply side factor, interacting with depressed demand, brought about a significant lowering of loan rates that we are all familiar with, particularly in residential mortgages.
Interestingly, there are two structural changes identified in this consultation, which may have contributed to the dampening loan growth. Although the effect was considered to have been small, they are significant developments worth monitoring closely. The first is the greater availability of renminbi funding. We were told that bank clients with manufacturing operations in the Mainland are increasingly able to seek renminbi funding directly from Mainland banks, by pledging their factory premises as collateral or presenting a stand-by letter of credit from Hong Kong banks. This has reduced the need to borrow from banks in Hong Kong to finance their operations in the Mainland, as manufacturers have not only benefited from the lower renminbi interest rates, but have also avoided currency mismatches, since their outlays are largely denominated in renminbi. To the extent that these activities were otherwise financed by general-purpose loans in Hong Kong - and many of them were - domestic loan growth in Hong Kong has been adversely affected.
The second development is the increased volume of trade conducted through so-called open accounts, under which overseas importers would pay directly to the account of exporters, rather than using letters of credit under traditional trade financing. Presumably this reflects the increased bargaining power of some importers who are able, through this mechanism, to save the costs of arranging letters of credit. Exporters may nevertheless still be able to obtain funds by discounting their receivables (i.e. factoring).
The availability of equity market and debt market financing are also relevant. The banks, however, feel quite relaxed about the former, as some recent IPOs have been for newly established technology companies that they would not in any case lend to. The banks felt that a more significant development was with the latter in view of the significant growth recorded in 1999 in new Hong Kong dollar corporate debt issues, which has extended into 2000. But since the banks are also the main investors of these corporate bonds, the shift may well be in the form rather than the substance of the financing. Whether this is the case or not, from the point of view of the need to promote diversification in financial intermediation, and therefore greater resilience in our financial system, this is something that is to be welcomed.
Joseph Yam
22 February 2001
Statistics on Authorized Institutions' loans and advances can be found here
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