Managing interbank liquidity

inSight

13 Nov 2003

Managing interbank liquidity

Banks need to exercise great skill and care in managing their Hong Kong dollar interbank liquidity when Hong Kong dollar interest rates fall below their US dollar counterparts.

Whatever the reason behind the recent strength of the Hong Kong dollar, under our Currency Board system, such strength has manifested itself in Hong Kong dollar interest rates being significantly lower than those for the US dollar. This is quite obvious in the interbank market, where the interest rate for overnight money has gone down to nearly zero. The interest rate differential between the Hong Kong dollar and the US dollar, for overnight usage, is thus around one full percentage point. Although this does not look very large, it represents the current opportunity cost for banks holding on to Hong Kong dollar inter-bank liquidity instead of switching the money into US dollars. It is, of course, up to the banks to decide whether or not to incur such an opportunity cost, or to switch out and assume the exchange rate risk, in case the Hong Kong dollar strengthens further from its current level, notwithstanding our commitment to exchange rate stability.

In arriving at a decision, a bank would obviously look at the amount of surplus Hong Kong dollar interbank liquidity it has at its disposal - the balance in its Hong Kong dollar account maintained at the Hong Kong Monetary Authority. One per cent of, say, HK$10 million overnight is only HK$274, but one per cent interest on HK$1 billion is about HK$27,400 a day. With the Aggregate Balance in the clearing accounts of banks now at HK$5.9 billion, the banking system as a whole is incurring an opportunity cost of HK$161,640 a day, or HK$1.1 million a week, or HK$4.8 million a month. Perhaps that is still a small amount, but it would not be if the Aggregate Balance were, for the sake of argument, ten times bigger at HK$59 billion. In other words, there must be a threshold beyond which the opportunity cost starts to affect the bottom line and attracts the serious attention of the banks.

In managing its Hong Kong dollar liquidity, a bank would also assess the exchange rate risk of temporarily parking its Hong Kong dollar liquidity in the form of US dollars. The interest rate differential of one per cent per annum would obviously pale into insignificance if there were an adverse exchange rate movement of, for the sake of argument, also one per cent in a week. It is therefore necessary for the bank to exercise great care before assuming this exchange rate risk. But in its assessment the bank should obviously take into account the probability of such an adverse movement in the exchange rate occurring, having regard to the exchange rate policy objective determined clearly by the Financial Secretary and the transparent operations undertaken by us to achieve that objective.

It is possible that the uncertainty surrounding when and by how much we would increase the Aggregate Balance, with a view to nudging the exchange rate back to 7.80, is making it difficult for the probability of that adverse exchange rate movement to be accurately gauged. This is understandable. But this is the only challenge posed by our monetary system to those responsible for managing interbank liquidity in banks - not much of a challenge compared with that faced by those working in other monetary systems in which exchange rate volatility is a day-to-day feature. It should be noted, in this connection, that the Aggregate Balance would not be reduced back to its normal level until the exchange rate is back to 7.80 and we are asked to sell US dollars through the Convertibility Undertaking at that exchange rate.

With continuing deflation, and looking at the matter from a macroeconomic point of view, we do not mind seeing Hong Kong dollar interest rates being kept low, and lower than US dollar interest rates, as the banks ponder on what to do with their surplus Hong Kong dollar liquidity. Low interest rates will hopefully encourage consumption and credit expansion, and help stabilise and perhaps inflate asset prices and the economy, although the situation may seem a little harsh on those living on interest income from their savings.

 

Joseph Yam

13 November 2003

 

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