Answer to HK's interest rate mystery may lie at home
Analysts are scratching their heads over the curious behaviour of Hong Kong's interest rates. The explanation may lie closer to home than they think.
With the Hong Kong dollar pegged to its US counterpart and all cash in circulation backed by holdings of the US currency, local interest rates should march in lockstep with those set by the Federal Reserve.
In reality, however, Hong Kong dollar interest rates sometimes go their own way. The most famous episode came in 1998 during the Asian currency crisis. Then, speculators anticipating a devaluation borrowed Hong Kong dollars heavily in order to sell the currency short, betting they could buy them back more cheaply after the currency fell.
That demand drove local short-term rates as high as 16 per cent, more than 10 percentage points above the rate prevailing in the US at the time.
Then in 2004, the opposite effect happened. On expectations that the yuan would soon be revalued upward, international investors poured money into the Hong Kong dollar as a proxy for the Chinese currency. The resulting surge in liquidity pushed the benchmark three-month Hong Kong interbank offered rate (Hibor) down to within a whisker of zero even as US rates were climbing above 2.5 per cent.
Since then speculation in the Hong Kong dollar has abated and forward rates for the currency have reverted to more reasonable levels. Yet this year Hong dollar interest rates have remained at a stubborn discount to US rates.
While US dollar interest rates have risen steadily (see chart), local interbank rates have tracked sideways. Yesterday, for example, Hibor was quoted at just 4.28 per cent, more than one full percentage point below the equivalent US dollar Libor rate in London.
This discrepancy has UBS economists Jonathan Anderson and Vivian Chiu puzzled. On Monday they published a research paper examining possible reasons for the discount. None of them fit the facts.
The explanation cannot be renewed speculation on the Hong Kong dollar as a substitute for the yuan. Market expectations of yuan appreciation indicated by forward rates have actually declined over the course of this year.
Nor can it be a surge in inflows of portfolio funds from abroad.
The Hong Kong Monetary Authority's aggregate balance - a key indicator of how much money is flowing into or out of the territory - has remained broadly flat since the middle of last year.
Mr Anderson and Ms Chiu also dismissed either a sharp increase in the domestic money supply or a collapse in credit demand as the reason. Broad money growth is modest and stable. Loan growth has also been steady this year, averaging about 7 per cent.
The two economists were mystified. 'All we can say is that the numbers don't allow us to draw easy conclusions,' they wrote.
Clearly, however, there must be an excess in the supply of funds relative to demand that is depressing local interest rates. The likely explanation lies in Hong Kong's declining loan to deposit ratio.
Although loan growth is ticking along, rising 6.43 per cent in July compared to last year, deposit growth is increasing at a far faster rate. In July, Hong Kong dollar deposits rose 13.27 per cent, more than twice the rate of local currency lending. As a result, Hong Kong's loan to deposit ratio has fallen to 0.81 in July, from 0.86 at the start of the year.
Loan growth for trade finance and to wholesalers and retailers has slowed this year, but the main reason is the decline in demand for residential mortgage lending after flat price rises tailed off in the middle of last year. Only developers continue to boost their borrowing.
The excess of new deposits over loans has left Hong Kong's banks sitting on billions of dollars of spare cash, hence the decline in local rates relative to US dollar rates.
In theory the discount should not exist. Opportunist traders should arbitrage it away. At the moment, however, it seems that the rewards are just not enticing enough.
If the discount widens further, maybe we will see money flowing out of Hong Kong. In the meantime, however, we should continue to enjoy cheap interest rates.
