Less than zero: how deposit rates could turn negative
When the policy-setting committee of the United States Federal Reserve concludes its December meeting today, many market watchers believe the Fed will lower its benchmark short-term interest rate to zero in an attempt to bolster the flagging US economy.
Because of our currency peg to the US dollar, that could create some unusual side-effects in Hong Kong.
In theory at least, Hong Kong's interest rates could even drop below zero. In practical terms, that means the city's banks would begin charging us for depositing our money.
Happily, the probability of negative interest rates is remote, but it's still worth examining how we could end up in this bizarre situation.
Over the last couple of months since the collapse of Lehman Brothers, demand for Hong Kong dollars in the foreign exchange market has gone through the roof.
That's partly because risk-averse Hong Kong investors are repatriating money from overseas markets for safe-keeping at home. But mostly it's because investors are unwinding carry trades funded with Hong Kong dollars.
Back in the first half of the year, leveraged investors like hedge funds took advantage of Hong Kong's low interest rates to borrow Hong Kong dollars and sell them in the foreign exchange market for higher-yielding currencies like the Australian dollar.
Now that investors are reducing their leverage, they need to buy Hong Kong dollars back again to close out their positions. The demand has pushed the Hong Kong dollar right up against the strong side of its permitted trading band, forcing the Hong Kong Monetary Authority to sell the local currency in massive quantities to prevent it strengthening any further.
As a result, Hong Kong's aggregate balance - the key measure of local currency liquidity in the banking system - has soared to record levels. When yesterday's trades settle tomorrow, the HKMA forecasts the aggregate balance will rise to an unprecedented HK$97 billion (see the first chart below).
In normal times, such vast amounts of money sloshing round the Hong Kong banking system would depress local currency interest rates below equivalent US dollar rates, encouraging opportunist investors to sell Hong Kong dollars for the higher yielding US currency, draining the excess liquidity from the market.
But with US dollar interest rates approaching zero, the mechanism has broken down. Following heavy cash injections into the US system in response to the credit crisis, the effective federal funds rate - the rate at which banks lend to each other from their balances held at the Fed - has already fallen to 0.13 per cent, even though the official Fed funds target rate remains at 1 per cent ahead of the Fed's statement later today.
With the overnight Hong Kong interbank rate a shade higher (see the second chart below), there is no incentive for investors to sell the Hong Kong currency.
That's reducing the effectiveness of the HKMA's interventions in the market. For the time being, the most likely course of action is for the HKMA to continue selling ever greater quantities of the local currency to meet demand.
But HSBC currency strategist Richard Yetsenga points out that the HKMA has another tool at its disposal. Back in 1987 the HKMA drew up plans to defend the economy against overheating and inflation caused by heavy fund inflows. Among the measures designed to encourage funds to flow out again was a charge on bank deposits of more than HK$1 million: effectively a negative interest rate.
Granted, with the economy in recession, overheating seems a distant prospect right now. Nevertheless, as US interest rates fall towards zero, there is a possibility - even if only a theoretical one - that we could just end up having to pay our banks for the privilege of depositing money.
