By Hong Liang (China Daily)
Updated: 2008-05-06 07:15

Beware of negative real interest rates.

With the inflation rate staying at levels above the deposit rate, there is a strong incentive for consumers to spend, rather than to save. In doing so, consumers, especially those in an economy as open as that of Hong Kong, are well advised to exercise some restraint and keep an eye on the economic horizon where dark clouds of a looming US-led global slowdown are gathering fast.

More worrisome, at least to economic planners, is the impact that the negative interest rate can have on asset, particularly property, prices. This is of special significance to cities like Hong Kong where the supply and demand of properties are seldom in equilibrium because of the usually long time lag in the completion of large-scale housing projects.

Prospective home buyers are likely to take the plunge at any price point when the cost of money slips below the rate of inflation. This cheap-credit-induced buying spree can seriously distort the real demand and sow the seeds of an asset bubble that is hard to deflate without creating a financial mess.

Years of a negative interest rate before the onset of the Asian financial crisis in 1997 pushed Hong Kong property prices to levels that were widely considered to be unaffordable and unsustainable. The subsequent implosion of the asset bubble, marked by a 60 percent fall in property prices in two years after 1997, cracked the foundation of the domestic economy, which had remained in the doldrums for six long years.

Hong Kong people may be excused for their short memories as they count their blessings in the brisk economic recovery since 2003. But not our monetary chief Joseph Yam. In an essay at the website of the monetary authority, Yam wrote: "Generally speaking, negative real interest rates are an abnormal phenomenon that has implications for economic and financial stability. Given a choice, we'd prefer not to have negative interest rates."

But, of course, Hong Kong does not have a choice. Despite the rising inflation pressure from strong economic growth in the past several years, Hong Kong, bounded by the currency peg, must keep its interest rates low as the US, troubled by the fallout of the credit crisis, is cutting the cost of money to stave off a recession.

As Yam explained: "the monetary policy in the US, which we import through the Linked Exchange Rate system, is currently not entirely appropriate for Hong Kong."

It is therefore important for Hong Kong banks and other financial intermediaries to take extra precaution at a time when consumer and mortgage loan demands are on the rise. Many international institutions have published research papers supporting the widely-held view that the US economy is heading for a mild recession, which will become a drag on global economic growth.

Despite all the talks about economic "decoupling", few economists really believe that Asia can maintain the brisk growth rate of the past while the rest of the world is slowing down. The ripples of a global economic slowdown would have a most direct impact on the open economy of Hong Kong.

Perhaps we can take comfort in the fact that we have one of the best supervised banking systems in the world. In Yam's words: "Our banking system has a good track record and I am confident that we will be able to ride out this period of negative real interest rates as we did earlier ones."

E-mail: jamesleung@chinadaily.com.cn

(China Daily 05/06/2008 page8)