The HKMA has introduced the composite interest rate as a tool for banks to manage their interest rate risks. But it is still for the banks to determine their own interest rates.
Despite the many HKMA articles, particularly in this column, about the role of the HKMA in determining interest rates in Hong Kong, from time to time I notice that there is still some confusion. The issues involved different desirable policy objectives sometimes appearing to be in conflict with each other. To help the public better understand what exactly our role is, it may be useful to look at two distinct policy areas.
The first is of course monetary policy. Given that the clearly stated objective of monetary policy in Hong Kong is exchange rate stability, the HKMA should not play any role in determining interest rates. But monetary management is more complicated than that in practice, particularly when Hong Kong is an international financial centre embracing the free flow of capital. Because we allow the size of the Monetary Base to be determined by the inflow and outflow of capital, through a clear and non-discretionary undertaking to buy and sell Hong Kong dollars for US dollars at a fixed exchange rate, we must be prepared for volatility in interbank interest rates and, as a consequence, volatility in deposit and lending rates for consumers. But as we saw in 1997-98, extreme interest rate volatility can be quite damaging - to borrowers, the financial markets, and the property market - and can lead to an unacceptable level of risk to the stability of the financial system, in particular the banking system. So, without undermining our resolve to maintain exchange rate stability, we have developed ways to dampen interest rate volatility. Including the large pool of Exchange Fund paper as part of the Monetary Base, allowing banks which hold the paper to acquire liquidity through the Discount Window (at a base Discount Rate that bears a fixed, penal premium of 150 basis point over the Fed funds target rate most of the time), provided a welcome cushion against upward pressure on interest rates arising from capital outflow. The introduction of the strong-side Convertibility Undertaking (in addition to the existing weak-side Convertibility Undertaking) and the 10-cent Convertibility Zone provided a further cushion against downward pressure on interest rates arising from capital inflow. But that really is as far as we go in the monetary-policy context. Setting deposit and lending rates is still entirely a matter for the individual banks, which operate in a freely competitive environment.
But we are also responsible for another policy area, which concerns the stability and effectiveness of the banking system. As I mentioned earlier, interest rate volatility can undermine the stability of the banking system. Apart from doing what we can (mainly through refining the structure of the monetary system) to dampen interest rate volatility, we always encourage the banks that we supervise to manage prudently the risks arising from interest rate volatility. One obvious way for them to do this is to price their lending, in other words to determine lending rates by making reference to the cost of funds. After the full liberalisation of interest rates, deposit rates, except perhaps those for savings deposits, are now more closely related to interbank rates, which as I mentioned earlier can be quite volatile. On the lending side, a larger proportion of loans than before is admittedly priced against the interbank rates or HIBOR, but the bulk (mortgages for example) are still prime-based and the prime rate, under normal circumstances, only changes when there is a change in the Fed funds target rate. Readers probably remember the days in 1997-98 when interbank rates frequently shot up to well above the prime rate. They might also remember the 18-month period before May 2005 when interbank rates fell to near zero and, because the prime rate was not correspondingly adjusted downwards, competition drove the mortgage rate down to as low as prime minus 2.8% (and with cash rebates thrown in as well), thus sowing the seeds for the leap-frogging that came later when interbank rates returned to normal. That phenomenon came as quite a shock to the economy, in particular the residential property market.
In the interests of the stability and integrity of the financial system I did, exceptionally, make comments in public to try to dampen the potentially adverse impact of the leap-frogging. But I emphasised that it was still for the individual banks to determine their deposit and lending rates, and that, in suggesting the use of the composite interest rate, I was simply encouraging them to manage their interest rate risks and not trying to influence the setting of deposit and lending rates. There was no intention to get into consumer issues, on which the HKMA does not have a mandate: whether the banks decide to lend at C+2% or C+3% is entirely their own decision.
Joseph Yam
16 February 2006
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