Quantitative easing

inSight

15 Jan 2009

Quantitative easing

Our rule-based Currency Board system makes this monetary tool easier to use in Hong Kong than elsewhere.

The inflow of funds to the Hong Kong dollar that we have been seeing is a welcome development. With a rule-based fixed-exchange-rate system that, under normal circumstances, eschews the sterilisation of the monetary effects of exchange-market intervention, capital inflow makes it easier to maintain accommodative monetary conditions. When the HKMA buys US dollars from the licensed banks for the account of the Exchange Fund within the Convertibility Zone (HK$7.75 to HK$7.85 for one US dollar) or at the strong-side Convertibility Undertaking (7.75), the Hong Kong-dollar equivalent of the transactions is "created" and credited to the clearing accounts of the licensed banks. This leads to a corresponding increase in the Aggregate Balance and the process is commonly, and correctly, referred to by the press as the HKMA injecting money into the interbank market.

With the economy in recession and inflation much less of a concern now, monetary easing is of course the appropriate monetary-policy stance, whether or not we have a choice given that we have to maintain a fixed exchange rate. In jurisdictions with discretionary monetary management, monetary easing is achieved mainly through lowering policy interest rates and monetary policy operations to maintain the desired level of interest rates in the interbank market. But when policy interest rates are near zero, the stimulus effect of interest-rate cuts on the economy diminishes. Indeed, when credit concerns are so intense, banks will just not lend and borrowers just cannot borrow.

But there is an increasing recognition among central banks that, when policy interest rates have already been cut to near zero, "quantitative easing" may provide further help to the economy. Quantitative easing involves the central bank injecting large amounts of money into the banking system in the hope that the banks, with large amounts of assets (money in their clearing accounts held with the central bank) earning very little or no interest, may feel more inclined to deploy these assets by lending them out to borrowers to earn a return (after appropriately pricing in the credit risks of the borrowers). The money can be injected either through lending to the banks or buying assets of one type or another. In the US, the Federal Reserve has been buying quite a lot of financial assets, in support of the relevant financial markets and, at the same time, engaging in quantitative easing.

In Hong Kong, the HKMA also finds itself engaging in quantitative easing, which seems to be an appropriate monetary policy stance under the circumstances. Although we do not practise discretionary monetary management, quantitative easing is made possible by the substantial inflow of money that we have been seeing since the global financial crisis turned sharply worse with the collapse of Lehman Brothers. Short-term interbank interest rates are near zero and the Aggregate Balance had increased to HK$158.0 billion by the end of 2008. This is a large amount when compared with what is needed to oil the interbank payment and settlement machine, estimated to be half a billion given the efficiency of the Real Time Gross Settlement system serving the interbank market. But it is only about 1.5% of the balance sheet of the banking system as a whole, which is over $10 trillion. However, it is not clear what proportion of non-interest-earning assets to total assets a bank would typically see as the threshold, above which it has an additional incentive to lend. I suspect that it is higher than 1.5%, although the proportion (actual or threshold) obviously varies among banks.

There is, incidentally, no limit on how big the Aggregate Balance may grow. It is now about 10% of the size of the Exchange Fund. This liability item on the balance sheet of the Exchange Fund is fully backed by US dollar assets, along with the other components of the Monetary Base as required by our well-established Currency Board system. It will stop growing when the inflow stops. And here I would like to draw attention to the possibility of a reverse since the market will not always be one-sided. The task at hand is to ensure that, when a reverse does occur, it will be an orderly process. And it will be, given that we have assets (US dollars) that we can sell back to the market, in a manner consistent with the Currency Board principles and the three refinements introduced in 2005, and make a profit. Our position contrasts favourably with that of jurisdictions that have injected money into the banking system through buying domestic financial assets. Domestic circumstances may not be conducive to selling these assets back to the market when it becomes necessary to exit from quantitative easing.

Joseph Yam
15 January 2009

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