In January 2008, Hong Kong's composite consumer price index (CCPI) rose 3.2% after factoring in the Government's rates concession. Without it, the consumer inflation was already as high as 4.3%. Yet, Hong Kong still has to follow the US to cut interest rates further under the Currency Board System, which will result in deeper negative real interest rates.

The Historical Comparison

Since 4Q07, Hong Kong's deposit rates, mortgage lending rates, interbank rates, the yields of the Exchange Fund Bills and Notes and the composite rate have all slipped below the inflation rate. Thus, Hong Kong has officially entered a period of broad-based negative real interest rates.

How far will the negative real rates go? The answer hinges largely upon the run-up in inflation as the Hong Kong dollar benchmark deposit and lending rates have little room to go down further. The US Fed Funds Rate, which is at 3.00%, will likely to be cut by 50bp or more in the upcoming FOMC meeting in March. During the 2001 to 2003 interest rate cut cycle, the Fed Funds Rate was reduced to 1.00%, a 40-year low. As the subprime-induced economic and market crisis are more severe this time around, the US interest rates will likely revisit that level.

Nonetheless, Hong Kong rates simply do not have an extra 2.00% room for cuts. The current benchmark deposit and lending rates for larger banks are 0.50% and 5.75% respectively. When the nominal deposit rates are close to zero, which is half a percentage point away, Hong Kong rates will freeze no matter how many more cuts the US will have. That is because the nominal rates will not go into negative territory, and lending rates will not be cut any more in order to maintain the spread. In this case, the benchmark Prime lending rates will likely bottom at 5.00-5.25%. During the last rate cut cycle, Hong Kong banks did not follow through the last four US rate cuts totaling 1.25%. The Hong Kong dollar Prime Rate never went below 5.00%. As such, the degree of negative real interest rates largely depends upon the inflation run-up in the future.

In mid 2005 when Hong Kong first emerged from deflation that lasted 68 months, the benchmark deposit and lending rates were held at zero and 5.00% respectively, creating a short period of negative real interest rates. But it drew little attention and had little impact. It was earlier in the 1990s when Hong Kong experienced years of negative real interest rates because of the long lasting high inflation that created an environment for economic and asset price bubbles. The annual inflation during the 1990 to 1997 period averaged 8.8%.

From 4Q90 to 3Q95, even the Prime Rate was below inflation, the bubbles were finally busted following a substantial external shock around the Handover. Slightly different though, mortgages loans were mostly priced at P+, ranging from tens to 100 basis points or more, as opposed to the current practices of P- pricing. Yet, the real mortgage rates were still negative due to high inflation, which helped push the property into frenzy and bubble in the earlier part of 1990s.

Negative Real Interest Rates and the Economy

So far, Hong Kong's negative real interest rates are still early and shallow in its current stage. But it will continue to deepen based on the consensus forecast of higher inflation down the road. Although the Government proposed unprecedented tax cuts and concessions after it racked up huge fiscal surplus in the previous year, soothing effects from such measures on inflation are technical and temporary. However, these cuts and concessions are simulative in nature, which will add to the inflationary pressure when implemented. Therefore, they are less effective in curbing inflation.

If we break down the negative real interest rate into interest rates reduction and inflation, the impacts from rate cuts on the economy should be neutral. It is the rising inflation that will be simulative to the economy, but with growing risks. Once growth slumps, these risks will be fully exposed.

Interest rate cuts itself is considered simulative. Hong Kong, whose economic fundamentals are deemed healthy, cuts rates simply out of the Peg's requirement, and should react more favorably from such measures. But, the reason for such cuts needs to be examined closely. The US cuts rates to fend off recession and credit and stock market crisis. A weak US economy will no doubt impact Hong Kong's small and open economy, and the decouple talk could prove to be short-lived. Currently, Hong Kong's goods exports are equivalent to 1.7 times of GDP, a slowdown of which will have magnified impacts on growth. Rate cuts could only help domestic consumption and investment instead of exports. In addition, the spillover of the subprime crisis to the stock market is bad for Hong Kong stocks as well, which are also teetering on the verge of a bear market. Thus, the economic impacts from rate cuts could simply be neutral, as the crisis-induced rate cuts could only help avoid a major slowdown at best.

As a result, the simulative effects of negative real interest rates come mainly from the inflation component. Nowadays, Hong Kong's GDP deflator is even higher than the CCPI, suggesting that overall inflation covering the investment and trade sector is even more acute than consumer inflation. But under such circumstances, Hong Kong still has to follow the US rate cuts and let the HK dollar depreciates under the Peg regime, and cut taxes due to substantial surplus. Such a powerful stimulus package will undoubtedly further boost inflation.

During the 1990s, the persisting high inflation contributed to the long lasting and comprehensive negative real interest rates. As a result, the Hong Kong economy as well as its stock and property assets all had huge bubbles. As such, although the inflation driven negative real interest rates might fuel resilient growth in the short run amid external weakness and a possible US recession, the risks inherent will grow accordingly. With regard to asset prices, Hong Kong stocks used to track closely the US stock market's ups and downs in the 1990s. But the Mainland companies now dominate the Hong Kong stock market in terms of turnover and market capitalization, the Mainland policies assume a greater role in influencing the stock market performance here than the negative real interest rates. As for the property market, it is benefiting a great deal from negative real mortgage rates. But in the same token, inherent risks are also rising. History proves time and time again that the resulted asset price run-up and economic prosperities are always superficial and vulnerable. The whole society will pay a heavy price when the trend becomes unsustainable.

Negative Real Interest Rates and the Banking Sector Operations

The extra impetus that negative real interest rates put on consumption and investment will partially offset the slowdown in trade due to global economic uncertainties. Economic growth, in this case, should remain healthy, providing supports to the overall banking sector operations. But negative real interest rates will have different effects on different banking operations.

Regarding deposits, the deepening negative real deposit rates will likely fuel less savings and more consumption and investment. When savings deposit rates drop closer to zero, which will likely happen by mid year, there will be major shifts from savings to time deposits, and from Hong Kong dollar and US dollar deposits to other foreign currencies. As a result, loan to deposit ratios for the banking sector could improve, and banks would usher in another low funding costs period, which benefit larger banks with better deposit base.

In 2003 when the US rates were cut to 40-year low, Hong Kong's deposit rates were reduced to zero. Due to the still prevailing deflation, real rates were still positive. In the 1990s, the nominal deposit rates never touched zero during that negative real deposit rate period. The lowest level reached was 1.50% between 1992 and 1993. Therefore, Hong Kong will experience a very rare combination of zero nominal deposit rates and negative real deposit rates in the near future.

Under such circumstances, deposit growth will unlikely stop because Hong Kong's economic growth, wealth accumulation, financial center development and capital inflows, etc. These will more than offset the shift from deposits to consumption and investment, just like the 1990s when deposit consistently registered double digit growth. However, the Hong Kong dollar continues to depreciate along with the US dollar, Hong Kong residents will likely shift a significant portion of their deposits from Hong Kong dollar and US dollar to other foreign currencies with higher interest rates and/or greater prospects for appreciation such as the RMB. But for those inflows for Hong Kong dollar assets investment, the incentive for the shift is small. Moreover, the shift from savings to time deposits was quite obvious in the 1990s, and it will likely repeat when nominal deposits rates are cut to zero. Such a shift will lower the proportion of banks’ low cost funding sources.

On the loan business, the experience of consistent twenty to thirty percent increase in mortgage loans during the 1990s will be less likely to repeat today. During the local property market's recovery in the past several years, the highest mortgage loan growth was the 5.4% recorded in early 2008. Negative real mortgage rates and a weakening Hong Kong dollar will likely make the property market attractive for both domestic and international investors. Accordingly, mortgage loan growth could accelerate. But negative real mortgage rates may not be the major driver, let alone the repayment issue. As the froth in the high end property market spills over to other sectors of the market, the risks in mortgage business will increase, and their asset quality will also deteriorate, especially for loans extended during the peak of the property market.

Everything else remains constant, negative real interest rates are the positive force in driving loans growth while not so much for deposit growth. Consequently, the persistently declining loan to deposit ratio for the Hong Kong banking sector will have a breather in the coming year. Yet, banks will still have to cope with the issue of having more money to invest than to lend. Even when the benchmark deposit and lending rates hit the bottom, market rates such as interbank rates and Hong Kong dollar bond yields, as represented by the Exchange Fund Bills and Notes, will decline further following the US rate cuts. When the returns from such safe investments under-perform inflation, banks will have to either extend bond investment duration or take on more credit risks if they want to enhance yields. Unfortunately, one of the causes of negative real interest rates is the spreading of US subprime crisis. Banks simply do not have the stomach for credit risks even when they need to take on more. Therefore, the deepening negative real interest rates will put an end to a period when fixed income investment contributes a major proportion to banks’ earnings.

Dai Daohua
Senior Economist

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