Despite feeble growth momentum, Hong Kong’s banks have expanded their credit significantly in recent months. While it is perceived that the rise is driven by the mortgage business, the reality is otherwise.

Data suggest increasing Chinese mainland demand for credit from Hong Kong banks.

By the end of May, Hong Kong’s loan growth rose by 12.3 percent year-on-year. However, mortgage lending contributed only 1.5 percentage points. This trend is consistent with the expected impact of macro-prudential measures and government housing policies targeted to curb real estate bubbles.

Loans by Hong Kong banks grew 3.3 percent, month-on-month, in June, triggering concerns about rising risks to the banking system. It reportedly prompted the Hong Kong Monetary Authority to enquire about the reasons behind the growth and how banks are managing the associated credit and liquidity risks.

In fact, credit expansion has not subsided in Hong Kong despite the sluggish domestic economy. The loan-to-GDP ratio has risen dramatically, suggesting that banks’ exposure has decoupled from the city’s economic growth.

In recent months, banks’ claims on overseas entities have grown significantly. Much of the credit was pledged to mainland entities.

According to the latest available statistics, banks saw a 4.2 percent year-on-year rise in foreign exposure in April. The mainland alone contributed 8.7 percentage points to the expansion, more than offsetting the decline of other overseas exposure. While direct lending to non-bank mainland entities has been stable, claims on mainland banks have risen significantly in the first few months of 2013. Onshore banks could be acting as an agent bank for tapping offshore funds.

Cross-border borrowing

Tight liquidity in the onshore market has prompted cross-border borrowing. China’s lending rate has been maintained at a high level, with the one-year benchmark rate staying at 6 percent. Tight liquidity was also reflected in the over-the-counter markets, with one-year interest rate swaps climbing from 3.2 percent at the end of July 2012 to 4.6 percent a year later.

Since the People’s Bank of China decided not to ease the tight liquidity condition, interest rates in the onshore market will continue to stay high. Thus, the low interest rate level in the offshore market, especially in Hong Kong, has become an attractive and viable source of funding.

There are two principal ways for mainland entities to raise yuan — offshore yuan borrowing, either through banks or Dim Sum bond issuance, or US dollar or Hong Kong dollar funding swapped to yuan through a cross-currency swap. 

Lately, the Dim Sum market has become very quiet. Excluding the Ministry of Finance’s issuance in late June, there have been no other offshore yuan issues since June 21, reflecting the gloomy market condition for primary issuance and the intensifying worry about China’s credit quality. As a result, bank lending becomes a more handy option for fundraising.

Against this backdrop, loan growth of Hong Kong’s banks has exploded, either in yuan, US dollars or Hong Kong dollars. In fact, yuan loans outstanding at Hong Kong banks reached 88.2 billion yuan (US$14.4 billion) by the end of April, an 11 percent increase from the end of 2012.

However, the scale of direct yuan lending remains small. Much of this lending is trade loans. In practice, the offshore affiliates of onshore entities will find it more cost saving to borrow in US or Hong Kong dollars and swap the funds into offshore yuan. Compared with the high onshore interest rate, this option can result in cost savings of roughly 1.7 percentage points (two years) to 1.9 percentage points (one year).

We believe that cross border trade settlement is the major culprit behind the rising loan position of Hong Kong banks. The expectation of yuan appreciation started to rise in the fourth quarter of 2012 on the back of a transitory economic pickup in the same period. Since then, many onshore and offshore entities have begun to be engaged in cross-border arbitrage transactions through round-tripping trade.

As a result, the expansion of foreign currency positions of Hong Kong banks might mirror the capital inflows, either masked by the well-known over-invoicing of trades or cross-border flows through other legitimate channels.

Positive association

This point is evident by the positive association between offshore yuan deposits and loan exposure to mainland entities. For banks and non-bank entities that consider tapping the Hong Kong liquidity pool, the key issue is repatriation channels.

Even though China has launched a number of liberalization measures, including foreign direct investment and the Qualified Foreign Institutional Investor program, cross-border remittance of both yuan and foreign currency is still tightly controlled. The current-account channel may be improperly used. 

Technically, the loan position to mainland entities should be no different from lending to other foreign entities. Hong Kong has been and will continue to be one of the global banking centers for foreign borrowing. Those economies that have had high interest rates can raise funds in Hong Kong. The ongoing liberalization of China’s capital accounts offers Hong Kong’s banking sector a unique advantage.

Although the rising credit and liquidity risks in the onshore market are worrying, staying away from lending to mainland entities is certainly an ostrich policy.

Since the People Bank of China’s monetary policy is beyond the control of Hong Kong’s regulator, banks will need to observe the risk of duration and currency mismatch.

The Hong Kong dollar loan-to-deposit ratio picked up in the second quarter, suggesting an increasing imbalance of the currency structure on the balance sheet.

By June, yuan deposits represented 10 percent of total deposits. More effort is needed to facilitate the lending, and to price and manage these risks properly.

Likewise, onshore and offshore regulators should not curb cross-border lending through administrative tightening. The rise of mainland borrowing at Hong Kong banks highlights the need for China to adjust its monetary policy stance.

With onshore yuan funding costs rising, Hong Kong will continue to be a dollar supplier for onshore borrowers. The removal of the lending rate floor in China on July 19 has proven not to be a way to lower funding costs. Onshore liquidity remains tight.

The People’s Bank of China and the Hong Kong Monetary Authority will need to accept this reality unless they are willing to resolve tight liquidity in the onshore market.

The writers are economists with Australia & New Zealand Bank.