Friday, January 19, 2007

Excess Liquidity And Interest Rates (1)

The world economy is awash with liquidity. Central banks in many countries have been promoting economic growth or staving off an economic downturn by increasing the money supply at very high rates.

Although Hong Kong does not have a central bank as such, the story is no different here. The Hong Kong money supply has kept growing. The combined effects of growth in the money supply and a high savings rate have led to a situation where commercial banks continue to hold deposits greater than the value of outstanding loans. The excess of loans over deposits continues to grow. Put differently, banks are receiving deposits faster than they can lend them out. The most recent figures show the value of bank deposits as being about HK$2.2 trillion greater than the value of loans made by the same banks. Three years ago the excess was about HK$1.3 trillion. This is a huge sum for an economy the size of Hong Kong's.

The excess liquidity has a number of consequences. Banks offer lower rates for deposits and charge less for loans. The mortgage wars discussed in earlier posts is one example of this. Even with the Hong Kong dollar being pegged to the US dollar, both lending and deposit rates are lower in Hong Kong than in the US. The gap is about 1.39% for 3 month interbank offer rates which is creating arbitrage opportunities even for small investors like me. It has reached the point where I can borrow in Hong Kong dollars and earn a small spread by investing in a US dollar money market fund. It is also making Hong Kong an attractive centre for international borrowers to raise debt finance. Lastly, the resulting capital outflows (depositors switching to US dollars and lenders remitting the proceeds of Hong Kong dollar loans) have started putting some very slight downward pressure on the Hong Kong dollar. The latter is a bit surprising given that there was some speculation that the Hong Kong dollar could be revalued upwards on the back of a rising remninbi.

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