Hong Kong dollar interest rates broadly follow their US dollar counterparts over the long run. In the short run, as recent trends have shown, there is scope for some divergence.
There is considerable community interest in the likely trends in interest rates. This is understandable. There are many of us who have borrowed money to finance our investments, including of course the purchase of our home. Although the current mortgage rates in Hong Kong are at historically low levels, mortgage payments do represent a very significant part of household income.
With the Hong Kong dollar firmly linked to the US dollar, Hong Kong dollar interest rates broadly track those of the US dollar. Short-term deviations, particularly for interest rates for short-term money, are nevertheless possible as market sentiment is influenced by discussions or events perceived to have a bearing on the sustainability of the Linked Exchange Rate system. Different economic prospects between Hong Kong and the US manifested in different performances in asset markets may generate short-term flows of funds that temporarily prevent close tracking. This has been the case in the recent past, when there has been much talk about introducing greater flexibility to the renminbi exchange rate, economic recovery in Hong Kong has strengthened, public finances have improved and the current account of international payments has moved into substantial surplus. But there is no doubt that this deviation is a temporary phenomenon.
Indeed, interest rates in the Hong Kong dollar interbank market have firmed significantly in the past two months. From nearly zero, the short-term interbank rates have increased to more than two per cent, although they have not yet fully caught up with the corresponding US dollar interest rates. The amount of liquidity in the interbank market, as measured by the Aggregate Balance, has been coming down as the interest rate differential between the Hong Kong dollar and the US dollar gradually reversed the earlier inflows of funds. But the Aggregate Balance is still at an unusually high level, compared with the amount necessary for the smooth functioning of the interbank payment system.
It will be interesting to observe the extent to which the significant firming of interbank interest rates will lead banks to adjust their best lending rates and retail deposit rates upward. The relationship between the interbank interest rates on the one hand and the deposit and lending rates on the other is a rather complex one. Other than the short-term interbank interest rates being largely somewhere between the retail deposit rates (for example the savings rate) and the best lending rate, its precise position within that band, or rather how the band moves along the interbank rates, has not exhibited a defining pattern. Sometimes the interbank rates are at the lower end of the deposit and lending rates band and sometimes at the higher end. And indeed the width of the band varies over time. The banking industry in Hong Kong has not remained static, given the increasing competition and the structural changes that have taken place, in terms of interest rate liberalisation and banking consolidation.
It is not clear, therefore, whether the best lending rate, and consequently the mortgage rate that is priced against it, will experience a full "catch-up". Let us all observe the market closely to see if the interest rate structure of Hong Kong is now adequately flexible and competitive to produce an outcome that is in the best interest of depositors and borrowers. Certainly, the net interest margin has been coming down under the pressure of competition and the efficiency of the banking system in financial intermediation has been on the rise, to the benefit of the economy.
The increasing trend of Hong Kong interest rates is nevertheless clear, having regard to the economic circumstances in the US, the policy statements made by the Federal Open Market Committee of the Federal Reserve and our Linked Exchange Rate to the US dollar. In the US, after seven rounds of increase of 25 basis points in the federal funds target rate, monetary policy is considered to be still "accommodative" and there is still the intention to remove the accommodative stance "at a measured pace". Meanwhile, US economic growth is described as "solid" and inflation is now more of a concern than before. There are similarities to be observed in the Hong Kong economy. Deflation is out of our system and prices have been on the rise, albeit moderately. The economy continues on its recovery path. The current monetary policy stance of the US is entirely appropriate for Hong Kong, if our economic recovery is to be sustainable and the probability of another destabilising bubble reduced.
Joseph Yam
31 March 2005
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