Time for Hong Kong to embrace higher rates, and perhaps lower asset prices

With HKMA and major Hong Kong banks increased their base lending rate on September 27, Hong Kong has finally embraced higher rates after twelve years of muted low rate environment. The abundant liquidity in Hong Kong and the seemingly decoupled rate cycle with the US has been the trending question in the market. Not only during the era of the global quantitative easing, rates in Hong Kong have stayed at an ultra-low level even after the FED started its hiking cycle. But the recent sudden appreciation of the HKD seems to be a wakeup call to carry trade participants.

In fact, although the HKD has finally rebounded recently due to tighter liquidity condition, the HKD has hovered around the weakest point of its 1 percentage band since March 2018, which has prompted the Hong Kong Monetary Authority (HKMA) to intervene increasingly frequently to ensure that the HKD remains pegged to the USD. Such intervention has reduced the HKD liquidity in the banking system and, thereby, the monetary base. Liquidity has also contracted as HIBOR started to react despite less market activities than 2015. We believe the time has come for a rapid increase.

First of all, frequent carry trades have been putting depreciation pressure on the HKD. Ever since the Fed kicked off its rate hiking cycle for the first time after the Global Financial Crisis (GFC) in December 2015, the yield differentials between Hong Kong and the US have widened. With a currency peg, the interest rate in Hong Kong should ideally follow the path of the US, but the transmission is not functioning perfectly in reality. Hong Kong’s monetary base has expanded 5 times as a result of global quantitative easing and capital outflows from China that have, to quite a large extent, being parked in Hong Kong. Such massive liquidity has fueled equity prices until recently and real estate prices still today. The side effect is that abundant liquidity and high demand for the HKD have compressed the rate in Hong Kong, which provides lucrative carry trade opportunities.’

But things have changed. Since March 2018, the yield differential between Hong Kong and the US has narrowed despite HKD continues to flirt with the lower trading band, which has reduced the return for carry trade. In addition, our calculation for the carry-to-risk ratio, measuring the incentives for carry trade to happen, suggest that the incentive for engaging in carry trade between USD and HKD has been sliding significantly since May. Therefore, carry trade is no longer the sole reason to explain the depreciation pressure and possible rate raising.

Beyond the carry trade, there is another reason for us to believe that the HKD interest rates will be rise more rapidly. The quick decline in deposit growth has stretched the HKD loan-to-deposit ratio to 85% in July 2018 from 77% in end-2016, but bank loans are still expanding at a much quicker pace. In light of this, higher rates are needed to attract more deposits for banks to continue lending, i.e. banks have recently started to secure funding through time deposits ahead of further rate hikes in the US. The driver behind the lending boom is higher exposure to Chinese firms with liquidity channeling back to China or overseas for acquisitions.

Going forward, we expect the HKD interest rates to move up quicker due to the capital outflows from carry trade activities and loans to Chinese corporates, especially when deposit growth is decelerating. A shrinking monetary base and higher interest rates should put pressure on different asset classes. After the recent correction in the stock market, we should not be surprised to see other asset classes, namely the real estate, to be affected. This may not be such a bad outcome as the HKMA has been unable to control the asset bubble (especially in properties) with macro-prudential tools. There was quite some delay in following the FED but Hong Kong will do and at a much faster pace than expected.