The monetary systems of Hong Kong and the mainland are converging. This means the system loan-to-deposit ratio (LDR) for Hong Kong indicates an increasingly tight level of Hong Kong dollar liquidity. Cyclical, structural and regulatory factors are all at work and unlikely to abate any time soon.

As a result, a period of unparalleled deposit competition is expected, resulting in the need for banks to re-price credit for both mortgage and corporate customers. This will come as a surprise to borrowers in Hong Kong, many of whom still perceive the US Federal Reserve as determining their interest burden.

The effective outsourcing of monetary policy in Hong Kong to the US Fed has meant, historically, that liquidity in Hong Kong has largely been a function of US dollar interest rates (dollar rates). The benchmark lending rate in Hong Kong, known as the Prime Rate, has tended to move largely in line with the US Fed Funds rate.

The market has remained too focused on dollar rates - resulting in a general view that an increase in the Fed Funds rate will result in margin benefits, and a modest slowdown in mortgage growth (as a result of a modest correction in property prices). But I argue dollar rates now have a significantly smaller influence on Hong Kong dollar liquidity, as a result of the ongoing convergence of the mainland and Hong Kong monetary systems. This is happening because: 1) the mainland is a crucial market for investment by Hong Kong companies; 2) funding for that investment is largely sourced in Hong Kong; 3) depositors have an increasing preference for yuan due to a consensus expectation for ongoing appreciation; and 4) the availability of credit on the mainland continues to be restricted by ongoing administrative and monetary tightening. Furthermore, ongoing regulatory tightening will mean the ability of Hong Kong banks to further leverage current funding is limited.

Let's see how the cyclical, structural and regulatory factors have impacted the banking sector.

Firstly, cyclical influences: Corporate loan demand has coupled with strong residential mortgage volumes to drive the LDR for the Hong Kong banking system from a low of around 49 percent in mid-2009 to 63 percent today. And Hong Kong dollar liquidity has tightened further, from an LDR of 70 percent in mid-2009 to 80 percent now.

The strong mortgage credit growth is largely a result of abundant liquidity in the system in 2008-09, which, coupled with a poor economic outlook (ie, weak corporate loan demand), resulted in mis-pricing of mortgage credit and subsequently strong growth of 4.9 percent in 2008, 9.6 percent in 2009 and 15.6 percent in 2010.

The corporate portfolio, surprisingly, rebounded sharply in 2010 as the local, Chinese and global economies proved far stronger than earlier expectations, in part due to aggressive fiscal stimulus from most governments. More recently, sustained low Hong Kong dollar and US dollar lending rates have attracted ongoing high demand for corporate credit, a large portion of which is investment on the mainland, where the cost of funds is considerably higher.

Secondly, structural risks: The growth of yuan deposits in Hong Kong is not currently positive for bank earnings, and even less positive for liquidity. It has only served to drive margins lower and reduce Hong Kong dollar liquidity. Many retail depositors are exchanging up to 20,000 yuan ($3,057) daily from Hong Kong dollars to yuan and this trend will likely continue given a fairly consensus view of further yuan appreciation.

On the corporate deposit side, recent trade settlements-driven growth of yuan corporate deposits is encouraging, but corresponding yuan lending activity is still lacking. Hong Kong banks may benefit from incremental yuan trade settlements business from trade that would otherwise have bypassed Hong Kong, although I suspect that the bulk of current yuan trade settlement transactions is simply a redenomination from what would otherwise be Hong Kong dollars or US dollars.

Thirdly, regulatory influences: Tighter liquidity regulation, as well as tighter underwriting standards at banks, will limit the ability of banks to further leverage their balance sheets (or their mortgage customers). From the liquidity and funding perspective, the last few years has taught us that liquidity is king, and the king of funding liquidity is customer deposits. Where banks have insufficient customer deposits, the market charges significantly higher rates for additional funds (i.e. wholesale funding). Even for the highest-rated banks in the world wholesale funding spreads remain in the order of 50-100 basis points (bps). Pre-crisis, the best banks in the world would have funded at 15-20 bps spreads.

The Hong Kong regulator has acted well ahead of global regulators and regulatory bodies (e.g. the Basel Committee) in tightening liquidity regulations. In a 2004 presentation, the Hong Kong Monetary Authority outlined a series of new liquidity guidelines that focused on a risk management approach. The aim of those regulations was to implement more dynamic funding run-off assumptions; focus on total and single currency maturity mismatch; introduce and monitor behavioral maturity mismatches (in addition to contractual maturity mismatches); introduce stress testing of the portfolio; and introduce institution-specific liquidity coverage ratios.

The author is an analyst at Barclays Capital Asia Ltd. The opinions expressed here are entirely his own.

(HK Edition 04/13/2011 page2)