Banks and their customers should be alert to interest-rate volatility.
As readers are aware, the three refinements introduced to the Linked Exchange Rate system in May last year established a Convertibility Zone defined by the two Convertibility Undertakings on the strong and weak sides of 7.80 per US dollar. The Convertibility Zone is 1,000 pips wide, allowing the market exchange rate some flexibility to move between 7.75 and 7.85. This flexibility is of course limited, and rightly so, because we are operating a fixed-exchange-rate system.
This well defined, limited flexibility in the exchange rate also serves to lessen interest-rate volatility. Inflows and outflows of funds will not immediately cause volatility in the interbank interest rates, unlike when the exchange rate is fixed at one number. Sharp interest-rate volatility affects the asset markets, particularly the capital markets, making them vulnerable to relatively small movements of international capital and market manipulation. We are all of course familiar with the notorious double play in our stock futures and foreign exchange markets in 1997-98, which necessitated our extensive intervention in the stock market and the measures taken then to allow banks to use Exchange Fund paper for obtaining liquidity through the Discount Window. The seven technical measures of 1998 and the three refinements of 2005 can both be seen as measures to dampen interest-rate volatility while continuing to maintain exchange-rate stability.
Of course, we are just talking about volatility of the Hong Kong dollar interest rates around the US dollar rates. With a fixed exchange rate, our interest rates should, in the medium to long term, closely follow US dollar rates, and this is indeed the case. But short-term deviations can be substantial, for one reason or another, as we saw during the 18 months before May last year, when the market expected the Hong Kong dollar exchange rate to be affected by the renminbi exchange rate if flexibility was introduced to the latter.
If the short-term deviations in interest rates are restricted to the wholesale market, chiefly the interbank market, there is not much to worry about. Depending on the interest rate risk profile of banks, such as the extent to which individual banks are net lenders or net borrowers in the interbank market, their profitability will be affected to different degrees. Some of them may change their business strategies to reduce their vulnerability to interbank interest rate movements. Managing interest rate and other risks is something they do every day. Of slightly greater concern is the possibility that interest rate deviations at the wholesale level might be transferred to the retail level, in which case many more in the community? depositors and borrowers? will be affected. They are obviously not always as well equipped as the banks to manage interest rate risks.
With very keen competition among the banks, the tendency for them, in managing interest rate risks, to pass on the risks to their customers is understandable. Alternatively, they may use different pricing strategies to better protect their profitability. While this is a reflection of the free market at work, we should not overlook the possible adverse impact on people who might not be in a good position to identify, assess and manage interest rate risks. Homebuyers of course would like to see lower mortgage interest rates, but low interest rates might not be sustainable if the underlying trend dictated by US interest rates is taken into account. Few people would consider whether they would face hardship if the short-term interest rate deviations dissipated or even turned from a discount into a premium.
I am not saying that short-term deviations of Hong Kong dollar interest rates from US dollar rates are a matter of concern now. After all, the differential is only a little over one percentage point and the banks are capable of managing short-term divergence of Hong Kong dollar interest rates from US interest rates. Even if banks pass the risks associated with the short-term deviations to customers, resulting in retail rates moving in response to fund flows, I believe the mortgagees and other borrowers should still be quite resilient, thanks to a high savings rate, a declining unemployment rate and a robust economy. Indeed, this was the case even during the difficult period between 1998 and 2003. But the dynamics in the financial system are obviously changing under the influence of intense competition in the banking sector and we should all be alert.
Joseph Yam
7 December 2006
Click here for previous articles in this column.
Document in Word format
