Prolonged periods of loose monetary conditions can sow the seeds of financial meltdowns, as the subprime crisis and the European debt crisis have once again proven. Nowhere does this lesson resonate more clearly than in Hong Kong, which is growing along with high mainland Chinese rates and but has to set monetary policy at super low US interest rates.

 

This article takes a closer look at the Hong Kong banking sector and asks what might happen if growth rates come down or interest rates go up.
 
Monetary conditions in the territory have been ultra-loose for an extended period. Figure 1 shows the difference between the real growth rate and the real interest rate since 1982.

 

 

This gap should be negative in equilibrium, because people face unlimited incentives for leverage when the return on investment (the real growth rate) exceeds the costs of financing (the real interest rate). Currently, investment returns exceed financing costs by 6 percentage points. The last time that monetary conditions were this loose was in the early 1990s.

 

When monetary conditions eventually reversed during the Asian crisis, banks experienced a liquidity crunch and nonperforming loans soared from 2% to 10%. Looking at higher frequency data I find that monetary conditions have been this loose for about 1.5 years. By comparison, the period of monetary accommodation in the early 90s lasted for 4 years.
 
Vulnerabilities on the asset side
Low interest rates have led to significant build-up in leverage, thereby raising banks' credit risk. Credit has been growing at 30% year-on-year over the last 7 months. The last time we saw these growth rates was at the outset of the 1980 debt crisis, in the lead-up to the 1997 Asian crisis, and on the eve of the 2008 Lehman collapse (Figure 2).