The current differential between Hong Kong and US interest rates is due in part to the market's using the Hong Kong dollar as a proxy for a long position in the renminbi: this position represents a somewhat far-fetched view.
Whether or not there is another increase in the US Fed funds target rate in December, it looks likely that the rising trend of US interest rates will continue for a while. The US economy continues to perform well and higher oil prices are putting some upward pressure on consumer prices. These are good reasons for continuing to remove the accommodative stance of monetary policy and to move the Fed funds target rate back to a more normal level. What this level should be is anybody's guess. Historical data on the Fed funds target rate do give some guide to what it is, but with information technology enhancing productivity to such an extent that inflation has been held down, history may not be very indicative.
Maintenance of the Linked Exchange Rate between the Hong Kong dollar and the US dollar requires, by and large, that Hong Kong dollar interest rates track closely those of the US dollar. Short-term deviations do occur, however, when for one reason or another there is substantial flow of funds into or out of the Hong Kong dollar. Adherence to Currency Board arrangements requires us to engage in "non-sterilised foreign exchange intervention" to keep the exchange rate stable and let the Aggregate Balance and interbank interest rates fluctuate. Thus inflow of funds into the Hong Kong dollar produces an interest rate differential and therefore a disincentive to holding on to idle Hong Kong dollars, at least in the form of bank deposits.
Currently the interest rate differential at the short end (for short-term Hong Kong dollar deposits and US dollar deposits), after the November increase in the Fed funds target rate, is nearly two percentage points. Whether this is big enough to discourage the holding of Hong Kong dollars is up to the holders to decide, in the light of their specific circumstances. Perhaps the opportunity cost of two per cent per annum is small in relation to whatever they are up to in accordance with their own assessment of the potential benefits (and I hope the risks) of maintaining a long Hong Kong dollar position. In any case the Hong Kong dollar asset markets have been performing well, with the Hong Kong stock market in particular out-performing other stock markets in recent months.
So for the time being Hong Kong dollar interest rates are out of line with those of the currency to which our currency has been linked for 21 years. We have, of course, seen this before, not least last year, although one can argue that the current episode is an extension of the one that started in September last year. The main reasons seem to be the same - the continued weakening of the US dollar, the prospects of the renminbi exchange rate strengthening when eventually more flexibility is introduced in the exchange rate policy of the Mainland, and the recovery of the domestic economy. But a two-per-cent, possibly increasing, opportunity cost a year is not small if it is sustained for a considerable period. Some may, of course, have longer staying power than others, but I think none has longer staying power than the Linked Exchange Rate system itself.
In any case, the timing for a change in renminbi exchange rate policy and, of course, what form the change will take are very open questions. Exchange rate reform is admittedly on the cards on the Mainland, but it is a long-term issue and there is doubt about whether it will be undertaken at a time when "macro adjustment and control" is in progress. Some would argue that the opportunity should be taken to use the exchange rate as an additional instrument for adjustment. This is not impossible, but I have doubts about the advisability of tackling additional complex structural issues at this time. And to be taking a long position in the renminbi, using the Hong Kong dollar as a proxy, is, to put it mildly, a little far fetched.
It will, I fear, take a little time for this reality to sink in and for the consequent outflow from the Hong Kong dollar to materialise, as it did earlier this year, with the Aggregate Balance declining from HK$55 billion to HK$3 billion. But it will come, and when it does, Hong Kong dollar interest rates will rise.
Joseph Yam
25 November 2004
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