- This article explores the risks of a financial crisis after an extended period of ultra-loose monetary conditions in Hong Kong. It finds these risks to be small.
- Outstanding credit was much higher in the past and yet Hong Kong avoided any bank failure or bank recapitalization during the Asian crisis. Also, prudential measures on the asset side are much tighter than they used to be.
- Hong Kong's loan-to-deposit ratio is moderate by regional and historical standards and banks’ liquid assets are well above the mandatory minimum.
- Also, Hong Kong's capital account tends to improve when global emerging markets face heightened risk aversion. And, Hong Kong banks have not encountered any problems during previous episodes of Fed tightening.
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.
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.
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).
Despite these developments, it seems that the credit risk of the Hong Kong banking sector is manageable. To begin with, outstanding credit was significantly higher in the past – it was 355% off GDP in 1995 – and yet Hong Kong avoided any bank failure or bank recapitalization during the Asian crisis.
Vulnerabilities on the liabilities side
Strong credit growth and a new fondness for RMB deposits have also put strains on banks’ balance sheets: the HKD loan-to-deposit ratio increased from 69% in October 2009 to 81.7% in March 2010, exposing banks to greater liquidity risk (Figure 6).
Banks’ liquidity risks need to be taken particularly serious in the context of a currency board. This is because the authorities no longer control the amount of money under a currency board and, hence, can no longer act as lender of last resort. But I am not too concerned about Hong Kong banks’ liquidity risk for a number of reasons.
Despite the recent rise, Hong Kon’s loan-to-deposit ratio is still moderate by regional and historical standards. At 80% Hong Kong's loan-to-deposit ratio is just a whisker above the regional median (Figure 7).
Moreover, banks’ liquidity ratio remains well above the regulatory minimum. The HKMA monitors banks’ liquid assets (debt securities and loans due within a month) to short-term liabilities (due within a month) and requires that this ratio stay above 25% on a monthly average basis. The liquidity ratio for retail banks fell from above 50% in 2007 to 36.7% in the first quarter of 2011, but remains it well above the statutory requirement.
Currency mismatch is no major concern. Data on banks’ long and short positions as of March 2011 shows that FX risk is well contained (Figure 9). The aggregate net open position of the banking sector (across all banks and all currencies) amounted to 0.1% of banking sector assets.
Hong Kong has usually been spared during episodes of major capital reversals. Figure 10 shows capital flows to global emerging markets and Hong Kong since 1998, excluding relatively stable FDI flows. While it is probably an exaggeration to call Hong Kong a safe heaven, it has shown remarkable resilience in the face of major risk reversals.
Based on past experience, US monetary tightening should pose no challenges for Hong Kong banks. Monetary tightening in the US is seen by some as the catalyst that could put severe strain on an overleveraged banking sector. Also HKMA Chief Executive Norman Chan warned that capital could flow out of Hong Kong once the US starts raising interest rates. If past experience is any guide, banks should do fine.
In conclusion, Hong Kong is one of the most open and most flexible economies in the world. Its citizens and regulators are well accustomed to large and sudden reversals in economic fortunes and capital flows. If the past 30 years are anything to go by, Hong Kong should withstand a reversal of the current episode of ultra-loose monetary conditions. The findings complement my argument that strains on Hong Kong won’t be large enough to force an abandonment of the currency peg.