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Normalisation of Monetary Conditions

Since the global financial crisis in 2008, central banks in major economies have pushed down interest rates to very low levels and implemented the well-known quantitative easing (QE), akin to printing large amounts of money, to revive their economies. As the interest rates are already close to zero, the next move can only be heading up, even though we cannot predict when that will happen and how fast they may go up. There are now indeed signs that there might not be further monetary easing in major economies such as the US, the Eurozone and the UK, with the exception of Japan, which was recently affected by the earthquake and tsunami. On the contrary, the very loose monetary conditions in most developed economies would likely return to a more normal state gradually, i.e. a "normalisation" of monetary conditions may be on the horizon.

In fact, faced with strong inflationary pressure, reflecting the rising food and energy prices, several Asian economies have already begun to raise interest rates to combat inflation. For example, the People's Bank of China has raised interest rates and required reserve ratios to curb both consumer and asset price inflation on the Mainland. Other central banks such as the Bank of Korea and the Bank of Thailand have also raised interest rates in March this year.

Even in developed economies which were most affected by the financial tsunami, the central banks are increasingly alert to the risks of inflation. The European Central Bank just raised interest rates last week, to guard against upside risks of inflation. In the UK, a few members of the Bank of England's Monetary Policy Committee repeatedly voted for interest rate hikes at the past few meetings. As regards the US, there are signs that the economic recovery is now on a firmer footing. Market expects that there will be no more QE after the completion of the second round of QE in mid-2011. If we look at the indicators which gauge market expectations for the policy interest rate in the US, market participants have advanced the expected timing of a hike since late last year.

What does it mean for Hong Kong should interest rates turn up in major economies especially the US? Many readers may already know that under the Linked Exchange Rate system, the Hong Kong dollar interest rates will rise with the US dollar interest rates. But how does this happen? This will actually be preceded by some net outflows from the Hong Kong dollar under our Currency Board arrangement. More precisely, when the US dollar interest rates rise, the local interest rates may remain relatively soft at the beginning because of the ample liquidity in the banking system. As the gap between the local interest rates and the US dollar rates widens, market participants would take advantage of the higher US dollar interest rates and start selling Hong Kong dollars against US dollars. Such carry trades would lead the Hong Kong dollar exchange rate to soften such that it may eventually ease to 7.85 per US dollar, the weak-side Convertibility Undertaking rate, at which the HKMA undertakes to buy Hong Kong dollars against US dollars from banks. As Hong Kong dollars are sold to the HKMA for US dollars, the Aggregate Balance will fall, and so will the local interbank liquidity, leading to higher interest rates. When the local interest rates rise to levels closer to the US dollar interest rates, the interest carry trades would no longer be as attractive and the exchange rate would not weaken further. This is how the auto-adjustment as envisaged under the design of the Currency Board may be kick-started after the US begins to raise interest rates.

Under the Currency Board arrangements, the Hong Kong dollar exchange rate is bound to move within the Convertibility Zone of 7.75 and 7.85, depending on the demand and supply of Hong Kong dollar in the foreign exchange market. There was a bit of interest earlier when the HKD exchange rate briefly weakened beyond the 7.80 level after the Japanese earthquake as risk aversion came in. One has to put this into the right perspective. It is perfectly normal for the market forces to carry the exchange rate to either the strong or weak side.

Readers may recall that the substantial inflows to Hong Kong between September 2008 and December 2009 have pushed the Hong Kong dollar to 7.75 per US dollar and repeatedly triggered the strong-side Convertibility Undertaking. This increased the liquidity in the banking system considerably, pushing local interest rates to exceptionally low levels. Any eventual net outflows in the future, whether by the emergence of interest carry trades or other reasons, will help bring the monetary conditions and interest rates in Hong Kong back to a more normal state, which is perhaps a welcome development against the background of rising consumer and asset prices.

We do not know when exactly net outflows will occur and their pace. Nevertheless, there is no need to worry or fear when this happens because we understand that it is necessary for the sizeable inflows to Hong Kong dollar during late 2008 and 2009 to switch out of the Hong Kong dollar (i.e. through triggering the weak-side Convertibility Undertaking) in order to restore monetary conditions to more normal state. Inflows and outflows are normal phenomena under the Currency Board arrangement in maintaining exchange rate stability. But we have to manage the risk of higher interest rates carefully, and maintain the strong fundamentals of the economy and the soundness of the banking system so that Hong Kong will be able to cope well with any eventual normalisation of monetary conditions. This is the main reason why the HKMA has introduced a series of prudential measures on residential mortgage loans and stepped up monitoring of fast growth in other types of loans as well. Such measures would help ensure that banks are lending to borrowers who are able to withstand an eventual rise of interest rates. For the same reason, the public, businesses or individuals, should also manage the interest rate risks properly and avoid overstretching themselves. This will enable us to better weather the changes in the monetary conditions in the future.

Eddie Yue
Deputy Chief Executive
14 April 2011

Last revision date: 1 August 2011
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