What is holding off the rise in Hong Kong's interest rate?
The US Federal Reserve has raised interest rates three times since the end of 2015, with the last one which took place in March this year. Local banks, however, have not adjusted their rates after the US rate hikes. Under Hong Kong's Linked Exchange Rate System, Hong Kong interest rates should theoretically follow changes in the US to maintain the stability of HKD exchange rate. Those who are keeping a close eye on interest rate movements cannot help but wonder why hasn't Hong Kong kept up with the interest rate hike in the US? When will interest rates in Hong Kong go up?
Local banks have not yet increased their rates for now. The most common reason being the abundance of liquidity in the banking sector which does not put pressure on the banks to follow the US rate increase in the short term. However, as the US is expected to further increase the interest rate, local banks will eventually increase their rates under the Linked Exchange Rate System. To understand what this means, we should first know more about the different interest rates in Hong Kong and look at the source of funds and funding costs of banks.
Interest rates in Hong Kong
If a bank is in need of funds, it can either borrow from the interbank market, or obtain HKD funds overnight from the Hong Kong Monetary Authority (HKMA) through the "Discount Window" mechanism. The base rate is the foundation to compute the interest rates of loans offered under the Discount Window. When the federal funds rate moves, HKMA will adjust the base rate accordingly. In March 2017, the base rate was raised by 0.25% to 1.25% after the federal funds rate rose 0.25%.
Although the base rate reflects the costs for banks to borrow HKD funds overnight from HKMA, base rate movements do not necessarily affect the lending and deposit rates of local banks immediately. The latter can be influenced by other factors such as the liquidity in the banking sector. Furthermore, as the base rate is usually higher than the overnight Hong Kong Interbank Offered Rate, banks do not always borrow funds from HKMA.
Hong Kong Interbank Offered Rate (HIBOR)
This is the rate of interest offered on HKD loans by banks in the interbank market for a specified period ranging from overnight to one year. The HIBOR rates are determined by the deposit rates of the interbank market, taking reference from the quotes of the reference banks designated by the Hong Kong Association of Banks.
Loans from the interbank market is one source of funding for banks. HIBOR, therefore, does reflect some of the funding costs of banks. If HIBOR goes up continuously, it is possible that it will be transmitted to the lending and deposit rates of banks. While HIBOR has shown signs of rising since the US began lifting its interest rate at the end of 2015, it is still at the low levels. This is associated with the abundance of liquidity in the local banking sector. As of end of April, there was a recorded HKD260 billion in the aggregate balance of Hong Kong's banking sector. In April, the overnight and three-month HIBOR averaged at 0.07% and 0.9%, respectively.
Best lending rate (Prime rate)
The topic of interest rate increase usually refers to the upward adjustment of deposit and lending rates in local banks. Regarding lending rates, the best lending rate is one of the benchmarks that banks use to compute the rates they offer for customer loans. At present, major banks are offering best lending rates of 5% and this could range to 5.25% for other banks and financial institutions. These two best lending rates have remained unchanged since the end of 2008.
Local banks lack the motivation to increase their rates because the deposit base of banks is still massive. Savings deposits from customers is the main source of funding for retail banks. As a result, funding costs for banks are maintained at a low level. As of end of April, the composite interest rate, which reflects the average funding costs for Hong Kong dollars in retail banks, is 0.32%; it is only slightly higher by 0.06% and 0.01% when compared to end of 2015 and end of 2016, respectively.
Impact of rate increase
The different interest rates can affect one another. As the US interest rate is expected to increase further, it is only a matter of time for Hong Kong's rates to rise. If the gap between the Hong Kong and US rates widens and results in a continuous increase in HIBOR, or if the local bank system experiences a massive outflow of funds, the deposit and lending rates of local banks may increase.
When banks raise the prime rate, the amount of mortgage payment will naturally increase if your mortgage plan is linked to that rate, i.e. the so-called prime rate-based mortgage. Since HIBOR also increases with the cycle of interest rate increase, and it is more volatile than the prime rate, mortgagees who have chosen the HIBOR-based mortgage plan will also need to repay a bigger amount. Besides, HIBOR-based mortgage is usually protected by an interest rate cap, which is linked with the prime rate-based mortgage. In other words, when banks raise the prime rate, the interest rate cap of HIBOR-based mortgage plans will also go up.