Hong Kong is likely to see a contraction in liquidity, rising domestic interest rates and possibly falling asset prices once the United States starts raising its interest rates, causing over US$100 billion that has flowed into the Hong Kong dollar since August 2008 to flow out, the Hong Kong Monetary Authority warned on Monday.
“The most important task is to ensure our financial system will be able to withstand the shocks arising from volatile fund flows in this process,” chief executive Norman Chan said in his blog inSight on the HKMA website.
The US Federal Reserve has kept short-term rates near zero since December 2008. It plans to start raising them next year as the country’s economic recovery and employment situation continue to improve.
The HKMA has launched several measures to tighten residential mortgage lending and control rapid credit growth.
“These measures are designed to enhance the resilience of Hong Kong’s financial system against possible shocks that may hit Hong Kong in the process of interest rate normalization in the US,” Chan said.
Nevertheless, the normalization of interest rates would be good for Hong Kong, as well as the Exchange Fund.
The current dismal interest income of the Exchange Fund will change after the US raises interest rates. The normalization of the rates will improve the return of the Exchange Fund as it has substantial holdings of short-term US dollar debt instruments and bonds.
In the past, when US inflation was around 2-3 percent, short-term interest rates were, on average, around 4 percent and the average yield on 10-year US Treasuries was around 6 percent.
As dollar bond yields pick up, the mark-to-market value of the bond holdings in the Exchange Fund will decline. But this will only be a one-off correction in the process of interest rate normalization, Chan said.
The regulator is looking to diversify the portfolio in the Exchange Fund as well. “We expect to have fully invested a portfolio of around HK$210 billion in private equity and real estate with an aim to achieve higher rates of return than the traditional bond and equity investments over the medium and longer term,” Chan said.
“As private equity funds generally begin to generate distributions five to eight years after initial investment, the HKMA will need to continuously identify appropriate assets to reinvest the distributed funds in order to maintain the HK$210 billion target portfolio size,” he said.
Meanwhile, to uphold Hong Kong as an international financial center, Hong Kong should aim to become a full-fledged asset management center by rolling out appropriate policies and measures to attract more upstream activities in the next five years, the regulator said.
“While the sector has seen growth following the abolition of estate duties years ago, around 70 percent of the asset management activities conducted in the city involve customer relationship management or sales intermediation,” Chan said.
“As compared with other financial centers like London and New York, sales and distribution accounts for a higher proportion, reflecting a sizable and growing investor base in the city, while the rapid rise in the number of intermediaries is also a reason to applaud, but it also suggests an underdevelopment of upstream value-added chain.”
Upstream value-added chain refers to the formulation of investment decisions, asset allocation, research and analysis, product development, risk management, as well as legal, accounting and other professional services, which are high value-added activities in the asset management chain.
Developing asset management as well as wealth management business requires a good “branding”. The challenge for Hong Kong in the coming five years lies in building Hong Kong as a brand, Chan said. This means the city should endeavor to turn itself into a wealth management hub that stands for quality, reputation and confidence.
In order to achieve this, the city must meet three major conditions: banks and financial institutions that can offer a diversified range of wealth management products and services; availability of highly professional wealth management practitioners with knowledge on different wealth management products; and strict adherence to regulatory standards of conduct, he said.
On treasury management centers, the HKMA is working closely with the Financial Services and the Treasury Bureau to review relevant taxation arrangements to encourage more multinational and mainland firms to set up their centers in the city.
Chan said the development and the competitive advantage of the city as the world’s biggest and most competitive offshore renminbi center will be strengthened by providing diversified services for local companies and financial institutions, as well as supporting other offshore renminbi centers on their business.
Hong Kong banks have extended HK$810 billion (US$104 billion) in loans for mainland-related financing at end of 2013, or 30 percent of the total mainland-related loans at HK$2.6 trillion. At the end of 2013, loans extended by Hong Kong banks to mainland enterprises for overseas investment and other uses amounted to HK$870 billion, the HKMA said.
Hong Kong branches of foreign banks are also active providers of financing services to mainland customers by taking advantage of Hong Kong’s platform. Together, foreign banks’ Hong Kong branches provided 37 percent of total mainland-related loans.
Chan reminded lenders to maintain their prudent underwriting standards, have sufficient and stable funding to support their credit growth and withstand the stress arising from liquidity shortage, as well as strengthen their ability to withstand the adverse impact of a worsening credit environment.
The HKMA chief disagreed with the view that Hong Kong will lose its competitiveness when China fully opens its market, noting that recent mainland initiatives such as the Shanghai-Hong Kong Stock Connect and the establishment of free trade zones in Shanghai and other cities will mean even more opportunities for Hong Kong.
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