Since the meeting of the Federal Open Market Committee on 27 April which signalled that it would complete QE2 by the end of June as planned, there have been some discussions about the implications of that for monetary conditions in Hong Kong, in particular the timing of a potential adjustment of interest rates in Hong Kong relative to that in the US. These are important issues pertinent to our unique monetary regime - the Linked Exchange Rate system (LERS) - and we do see the merits in promoting better public understanding of the interest rate adjustment mechanism under the LERS, which will clearly be conducive to the maintenance of the system. This has always been a challenging task given the slightly different dynamics behind the movements of different HKD interest rates, ranging from the overnight HIBOR in the interbank market to the long-dated lending rates for residential mortgages. I would therefore like to take this opportunity to clarify some further issues by explaining the characteristics of, and relation between, different types of interest rates in Hong Kong.
First of all, it is important to realise that under the LERS, movements of interest rates in Hong Kong will have to follow those in the US in the long term. This will be assured by the interest rate arbitrage mechanism under the Currency Board system when there is any substantial interest rate differential between HKD and USD. When the USD interest rates are higher than the HKD interest rates, funds will flow out of the Hong Kong banking system. On the contrary, when HKD interest rates are higher than the USD interest rates, there will be fund flows from the USD into HKD. Such arbitrage activities will bring the HKD interest rates to move in line with the USD interest rates. The HKMA has explained this auto-adjustment mechanism under the Currency Board system on many occasions before and will not repeat it here. What I would like to emphasise here is that the above-mentioned interest rate arbitrage mechanism would apply most prominently to the short-term interest rates in the interbank market (particularly the overnight HIBOR) as these short-term rates in the Hong Kong money market are most sensitive to capital flows. While the overnight HIBOR, by design of the Currency Board system, will follow the Fed Funds Target Rate in the US very closely, other longer-term interest rates may, and, do differ to various degrees from their USD counterparts. For example, the long-term bond yields may differ because of different debt levels of the two economies, and the commercial deposit and lending rates may also differ because of different supply and demand factors.
In fact, the relation between Hong Kong banks' commercial deposit and lending rates and the Fed Funds Target Rate is not so direct compared with the short-term interbank rates. In other words, banks may adjust these commercial deposit and lending rates with or without a change in the US rates. This is because the level of USD interest rates, and thus the HKD interbank rates, is only one factor affecting banks' consideration in setting their HKD deposit and lending rates. Very often, banks will also need to take into account other factors such as changes in local liquidity situation, changes in demand for loans, and even changes in market dynamics including increasing competition in the market. In the past decade or so, we have indeed seen substantial reduction in residential mortgage interest rates in terms of bigger discount to the prime rate due to increasing competition in the market for such lending following the deregulation of interest rates in Hong Kong, at a pace much faster than the speed of decline in the Fed Funds Target Rate.
As we mentioned earlier, one crucial factor behind banks' commercial decision to change HKD deposit and lending rates is the supply and demand of HKD in the local banking system. In this respect, significant changes have been observed in the past two years. In late 2008 and in 2009, strong net inflows had induced an 11.2% growth in HKD deposits, while HKD loans only recorded a 2% growth due to weak loan demand following the outbreak of the global financial crisis. Coupled with zero bound US interest rates, such a supply and demand position had suppressed both the HKD deposit and lending rates. This situation however began to change in 2010 during which the Aggregate Balance had remained constant and growth in HKD deposits had slowed to 7.2% in the year. At the same time, however, growth in HKD loans had outpaced the deposit growth and accelerated to 17.6% in the year. This trend continues into 2011 with HKD loan-to-deposit ratio of all Authorized Institutions increasing rapidly from 71% in early 2010 to 81.7% by the end of March 2011. Against this background, many banks have raised their HKD lending rates (in particular for new mortgage loans) by charging borrowers a higher spread over HIBOR even though HIBOR has remained at low levels.
In other words, although Hong Kong's interbank rates would remain soft owing to the large Aggregate Balance until we see the commencement of the US tightening cycle, there is likely to be continued upward pressure on banks' lending and deposit rates as a result of the strong loan demand from various sectors including Mainland-related opportunities. This is why we had earlier warned the public to be alert to this upward pressure on the lending rates and manage the interest rate risks carefully.
I hope that this further article has helped clarify the operation of the Currency Board system and the behaviour and relation between different types of interest rates under the system. It is important for the public to understand how different types of interest rate might be affected in different market circumstances under this system and manage their interest rate risks accordingly.
Norman T. L. Chan
Hong Kong Monetary Authority
18 May 2011