The Hong Kong dollar has been pegged against the US dollar since October 1983, after it hit an all-time low in the wake of speculation about the region’s eventual transition from British to Chinese control. That has taken the most basic tool of monetary policy — the setting of interest rates — out of the hands of Hong Kong Monetary Authority officials, which also means that inflation in the territory is a constant risk.
While the peg is far from perfect, it has largely worked. Hong Kong analysts and investors can look to the US Federal Reserve when gauging the risk of inflation, and few think that Hong Kong — which has now been part of China for well over a decade — will attempt to change its currency arrangements before its mainland neighbour does the same.
But a recent paper by Eric Wong and Jim Wong, two analysts at the Hong Kong Monetary Authority, made clear that the system comes with risks — in particular, the risk that Hong Kong’s interbank market will get out of line with its counterpart in the US.
Banks can usually expect Hong Kong interbank rates to closely follow those in the US, but they may not be able to rely on this for long. Hong Kong banks have been lending aggressively this year, and they are now approaching loan-to-deposit ratios (LTDs) where the relationship between Hibor and Libor rates will start to change.
The two researchers found a direct correlation between loan-to-deposit ratios and the spread between Hibor and dollar Libor rates — but only when loans are worth more than 90% of deposits. Hong Kong dollar-denominated LTDs were 84.2% at the end of June, the most recent data used in the research. They have kept rising since. The latest data from the HKMA shows that LTDs were 85.9% at the end of August.
The researchers assumed an LTD of 90%, and then asked what the impact would be of another 10% rise, leaving deposits and loans directly matched. They found that overnight Hibor rates would rise by around 95bp, and one month Hibor rates would increase by 195bp. But they said there was a “material chance” the effect would be even bigger; as much as a 320bp rise in one month Hibor.
That would drastically affect the funding costs of a slew of borrowers paying spread over Hibor rates, and would in all likelihood lead to a rush to refinance Hong Kong dollar loans with funds raised in other currencies. That in turn would put further pressure on banks to find commitments at a time of tight liquidity, pushing the loan-to-deposit ratios of individual banks even higher — and forcing banks to choose between relationships and liquidity.
That’s the bad news. The good news is that banks have already started scaling back lending, making the rise of loan-to-deposit ratios beyond 90% — and certainly as high as 100% —an unlikely scenario. Several loans syndicate bankers claim to be done for the year, and already complain of strained liquidity.
The risk, however, is that banks start lending heavily next year, especially if the topsy-turvy path to a resolution of the Greek crisis is solved before the end of the year. Loan-to-deposit ratios have been on an upward trend since October 2009, and if banks want to keep their clients happy by funding Asian growth, this rate could continue to rise.
But banks be careful to grow loans and deposits at an equal pace, at the very least. This is not just good risk management; it is good market management too. The last thing lenders, borrowers, investors or politicians want to see is Hibor rates ballooning against comparable rates in the US.