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HK wrestles with QE3 implications
By Denise Yam |
November 2, 2012, Friday
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Print Edition
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THE Hong Kong Monetary Authority's recent purchases of US dollars in the foreign exchange market have gathered significant market attention. Seven purchases, totaling US$2.85 billion, have taken place in the past two weeks, with the bulk of them recorded in New York trading.
As with most of the previous episodes, we believe the latest purchases are a form of passive rather than active intervention. The Hong Kong dollar/US dollar spot exchange rate has indeed reached the strong end (7.75) of the convertibility undertaking, unlike the active intervention purchases to inject liquidity to the interbank market at the height of the global financial tsunami during September and October 2008.
We had expected limited direct impact from the US Federal Reserve's QE3, given the muted impact of QE2. The timing of the latest inflows certainly prompted many to attribute them to the new QE efforts, since recent US dollar weakness and lower US dollar rates have given support to HK dollar-backed assets. Nevertheless, we believe that the recent stabilization in the European markets and the evidence of green shoots in the Chinese mainland economy have also made a significant contribution. Similar to 2008-09, we believe that funds are coming to this region in search of returns amid economic outperformance.
Currency mismatch
The latest inflows to the HKMA have excited markets because they are the first such flows in nearly three years. However, they are not the only inflows to Hong Kong. We would like to remind investors that, because of the banking system's confidence in the linked exchange rate system, banks have been willing to "absorb" capital inflows and outflows through tolerating some currency mismatch on their balance sheets, without squaring their position with the HKMA.
In tracking capital flows into and out of Hong Kong dollars, we aggregate the changes in the monetary base with those in the net foreign asset positions of the banking system. The sum of monetary base and net foreign assets would be a proxy for Hong Kong's total liquidity stock.
Interestingly, while there had been no inflows through the monetary base since December 2009, Hong Kong has already been receiving respectable inflows in recent months, with the net foreign assets jumping by US$2.2 billion in July and US$6.2 billion in August, even before QE3 was announced.
Inflows has totaled US$42 billion since the recent bottom in the total liquidity stock in September 2011, way larger than the amounts that the HKMA just bought over the past two weeks. We strongly suspect that far larger inflows have taken place in recent weeks and had remained absorbed in the banking system.
As Hong Kong has surrendered monetary policy to the Fed, there is, by definition, no "sterilization," so any capital inflow goes directly into expansion of the monetary base. From the experience over the past few years, the HKMA could issue more exchange fund papers to bring down the excessive size of the aggregate balance, giving the impression that the inflows have been sterilized.
Needless to say, the latest inflows have again stirred speculation that Hong Kong could break its link to the US dollar. We, nevertheless, hold our view that now is not the time for change. We do not rule out an eventual change in the exchange rate system, possibly toward a link with the yuan.
Still, we do not think that any interim solution would bring sufficient benefits exceeding the associated costs. At the current juncture, allowing the Hong Kong dollar to appreciate against the US dollar would likely attract even more capital inflows and market volatility.
The linked exchange rate system, while minimizing foreign exchange risks for the externally oriented Hong Kong economy, sacrifices the city's policy flexibility in cushioning the growing impact from cross-border capital flows on asset and consumer prices.
Aside from standing by the convertibility undertaking and intervening passively, we do not expect the HKMA to do much in response to the inflows, sustaining support to asset markets. The recent inflows likely brought the Hong Kong dollar loan-to-deposit ratio further down, after easing by two months to 82.4 percent in August. Interest rates have remained at historical lows and we expect little change throughout our forecast horizon.
In the property market, on the other hand, we should stay alert for policy risks. Anti-speculative measures such as mortgage tightening and the special stamp duty on short-term trading have done little to stem the rise in prices, while the pledged increase in land supply takes time to reach the market.
However, the Hong Kong government is continuing to look for more policy options amidst the social resistance against a further price rally. Nevertheless, all in all, Hong Kong's asset markets will likely to see sustained support from the easy monetary conditions in the next few months, in our view.
Limited impact
The direct economic impact from the recent inflows could be limited, given the small incremental expansion in the liquidity stock relative to its huge size. Meanwhile, bank lending does not seem to be constrained at the current juncture, so it may not necessarily expand in response to the inflows.
However, we should not overlook the economic impact of further asset price inflation. On the one hand, it could give a confidence boost to consumption and investment (through the wealth effect).
On the other hand, it could once again spill over to consumer inflation, bucking the disinflation trend since early this year, hurting consumers' purchasing power and exacerbating income and wealth redistribution in Hong Kong.
Denise Yam is a Hong Kong-based analyst with Morgan Stanley. The article was adapted from a research note dated October 25. The opinions are her own.
As with most of the previous episodes, we believe the latest purchases are a form of passive rather than active intervention. The Hong Kong dollar/US dollar spot exchange rate has indeed reached the strong end (7.75) of the convertibility undertaking, unlike the active intervention purchases to inject liquidity to the interbank market at the height of the global financial tsunami during September and October 2008.
We had expected limited direct impact from the US Federal Reserve's QE3, given the muted impact of QE2. The timing of the latest inflows certainly prompted many to attribute them to the new QE efforts, since recent US dollar weakness and lower US dollar rates have given support to HK dollar-backed assets. Nevertheless, we believe that the recent stabilization in the European markets and the evidence of green shoots in the Chinese mainland economy have also made a significant contribution. Similar to 2008-09, we believe that funds are coming to this region in search of returns amid economic outperformance.
Currency mismatch
The latest inflows to the HKMA have excited markets because they are the first such flows in nearly three years. However, they are not the only inflows to Hong Kong. We would like to remind investors that, because of the banking system's confidence in the linked exchange rate system, banks have been willing to "absorb" capital inflows and outflows through tolerating some currency mismatch on their balance sheets, without squaring their position with the HKMA.
In tracking capital flows into and out of Hong Kong dollars, we aggregate the changes in the monetary base with those in the net foreign asset positions of the banking system. The sum of monetary base and net foreign assets would be a proxy for Hong Kong's total liquidity stock.
Interestingly, while there had been no inflows through the monetary base since December 2009, Hong Kong has already been receiving respectable inflows in recent months, with the net foreign assets jumping by US$2.2 billion in July and US$6.2 billion in August, even before QE3 was announced.
Inflows has totaled US$42 billion since the recent bottom in the total liquidity stock in September 2011, way larger than the amounts that the HKMA just bought over the past two weeks. We strongly suspect that far larger inflows have taken place in recent weeks and had remained absorbed in the banking system.
As Hong Kong has surrendered monetary policy to the Fed, there is, by definition, no "sterilization," so any capital inflow goes directly into expansion of the monetary base. From the experience over the past few years, the HKMA could issue more exchange fund papers to bring down the excessive size of the aggregate balance, giving the impression that the inflows have been sterilized.
Needless to say, the latest inflows have again stirred speculation that Hong Kong could break its link to the US dollar. We, nevertheless, hold our view that now is not the time for change. We do not rule out an eventual change in the exchange rate system, possibly toward a link with the yuan.
Still, we do not think that any interim solution would bring sufficient benefits exceeding the associated costs. At the current juncture, allowing the Hong Kong dollar to appreciate against the US dollar would likely attract even more capital inflows and market volatility.
The linked exchange rate system, while minimizing foreign exchange risks for the externally oriented Hong Kong economy, sacrifices the city's policy flexibility in cushioning the growing impact from cross-border capital flows on asset and consumer prices.
Aside from standing by the convertibility undertaking and intervening passively, we do not expect the HKMA to do much in response to the inflows, sustaining support to asset markets. The recent inflows likely brought the Hong Kong dollar loan-to-deposit ratio further down, after easing by two months to 82.4 percent in August. Interest rates have remained at historical lows and we expect little change throughout our forecast horizon.
In the property market, on the other hand, we should stay alert for policy risks. Anti-speculative measures such as mortgage tightening and the special stamp duty on short-term trading have done little to stem the rise in prices, while the pledged increase in land supply takes time to reach the market.
However, the Hong Kong government is continuing to look for more policy options amidst the social resistance against a further price rally. Nevertheless, all in all, Hong Kong's asset markets will likely to see sustained support from the easy monetary conditions in the next few months, in our view.
Limited impact
The direct economic impact from the recent inflows could be limited, given the small incremental expansion in the liquidity stock relative to its huge size. Meanwhile, bank lending does not seem to be constrained at the current juncture, so it may not necessarily expand in response to the inflows.
However, we should not overlook the economic impact of further asset price inflation. On the one hand, it could give a confidence boost to consumption and investment (through the wealth effect).
On the other hand, it could once again spill over to consumer inflation, bucking the disinflation trend since early this year, hurting consumers' purchasing power and exacerbating income and wealth redistribution in Hong Kong.
Denise Yam is a Hong Kong-based analyst with Morgan Stanley. The article was adapted from a research note dated October 25. The opinions are her own.
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