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Stay alert to external risks amid economic recovery

As the fifth wave of COVID-19 gradually stabilised, the restrictive social distancing measures imposed in the past months are now being eased by phases, including lifting the restrictions on cross-family gatherings, resuming nighttime dine-in services and 4 persons per table for restaurants, and allowing cinemas, theme parks and gym rooms to reopen. With more people coming out, many restaurants and shops have seen significant improvement in businesses, some restaurants have even been fully booked for dinner. The gradually subsided epidemic situation, coupled with the boosting effect of the consumption vouchers, will support a steady recovery of the economy since this quarter.

However, many enterprises and breadwinners are still facing the economic pressure and impact brought by the epidemic. Even the overall economy has been stabilised, their pressure can only be gradually relieved given a continuously stable environment and adequate time.

The performance of some economic indicators also takes times to show improvement. For instance, the latest unemployment rate (January to March 2022) announced last week surged 0.5 percentage point to 5%. The number of unemployed persons increased by around 27 000 to 188 000. The underemployment rate also rose to over 3%. The employment situation of most sectors has deteriorated. The unemployment rate of the food and beverage service activities sector increased by 2.6 percentage points to 11.0%, and that of the retail sector increased by 1.4 percentage points to 7.7%. Although the economy has been warming up, the unemployment rate to be announced next month, which covers the period of February to April, will still reflect the difficult situation under the fifth wave of epidemic. It will therefore take some time for the unemployment rate to recede.

The improving epidemic situation has provided us with some more breathing space. This could only be achieved by the support of the Central Authority, the core responsibility shouldered by the SAR Government and the concerted efforts made by the community. We have to make the best effort to sustain this hardly won trend.

In fact, our efforts in stabilising the epidemic and supporting the economy also affect our fiscal position. Over the past few years, the SAR Government has spent several hundred billions of public money to fight against the epidemic. The year-end financial result of the 2021/22 fiscal year is going to be announced this week. The revenue brought by the profit taxes is higher than our estimate due to the much lower-than-expected number of applications received for tax holdover. Also, the actual Government expenditure is slightly lower than our forecast. As a result, the year-end financial result will see a surplus of some HK$ 29 billion, slightly higher than the estimate of HK$ 18.9 billion mentioned in our Budget announced earlier. However, as the Accounts of the Government use cash basis accounting, they have covered the HK$ 29 billion raised from Government’s bond issuance, the HK$ 23 billion brought back from the Housing Reserve, and the HK$ 25 billion investment return of the Future Fund brought back for the first time. If we deduct these three factors, fiscal deficit can still be seen for the last fiscal year.

Although our economy has been stabilising and the local inflation rate is still staying at a mild level (1.7% at March), we have to stay vigilant to the turbulent external environment, particularly the geopolitical situation and the interest rate trend. The US is facing a high inflation rate of 8% and the Federal Reserve increased the interest rate by 0.25% mid last month, which was the first time in the past some three years. Taking into account the recent views expressed by the Federal Reserve officials, the market generally expects that the US will increase the interest rate to a much further extent within this year in order to tackle the high inflation. The investment market is paying close attention to the adjustment of interest rates of different economies, the changes of interest rate differentials between currencies, and their subsequent impact on the global economy, capital flow, changes in asset value and the fluctuation of the financial market.

As for Hong Kong, our concerns focus on the local interest rate and the trend of Hong Kong dollar exchange rate. We also need to monitor whether there will be a capital outflow, and the impact brought by interest rate hike on property owners and the quality of mortgage loan.

Under the Linked Exchange Rate System, HKD interest rate will inevitably increase following the US interest rate hike. Yet, the actual speed of HKD interest rate adjustment will be affected by the liquidity in Hong Kong. During the period between the global financial crisis in 2008 and 2015, a total of HKD 1 trillion fund inflow into Hong Kong was recorded, and most of which has remained in Hong Kong. In the last interest rate hike cycle in the US (ie the period between 2015 and 2018) where the Federal Reserve cumulatively raised the interest rates by 2.25%, the prime rate in Hong Kong increased only once in September 2018 by 0.125% (some bank interest rates rose by 0.25%) due to the abundant liquidity in Hong Kong. The one-month Hong Kong Interbank Offered Rate was also risen to about 2%, excluding seasonal factors.

As the returns on holding foreign currencies becoming more attractive with the rising interest rates in external markets, some capital outflows will be inevitable. Under the Linked Exchange Rate System, HKD must be exchanged for USD when funds flow out. If the HKD exchange rate falls to the weak-side Convertibility Undertaking of HKD 7.85 per USD, the HKMA will undertake these HKD sell orders to ensure that the HKD will not exceed the Convertibility Zone of HKD 7.75 to HKD 7.85 per USD. This mechanism aims to maintain the flexibility and free flow of capital, and at the same time avoid excessive exchange rate fluctuations that may adversely affect economic and commercial operations. For example, between 2018 and 2019, the HKD weakened along with the outflow of capital and hit the weak-side Convertibility Undertaking. However, the total amount of funds that effectively flowed out was only about HK$120 billion, which accounted for some 10% of the cumulative capital inflow since the financial tsunami in 2008.

The US rate hike cycle will not affect Hong Kong's financial and monetary stability. The Linked Exchange Rate System has gone through various economic and interest rate cycles in the past four decades, and has proven to be effective. With the interest rate hike in the US, the market expects that the interest rate spread between the HKD and USD will widen, and there will be gradual outflows of funds from the HKD to USD. In addition to the interest rate spread, the exchange rate of the HKD against USD is also affected by other market factors. For example, the sluggish Hong Kong stock market in recent months has led to a weakened demand for HKD, and the HKD exchange rate has been fluctuating rapidly recently. Therefore, it is difficult for us to accurately predict the specific timing of the changes in the HKD exchange rate and the flows of funds. However, it can be expected that with the US interest rate hike triggering a widened HKD-USD interest rate spread and hence related arbitrage activities, the HKD exchange rate will reach the weak-side Convertibility Undertaking of HK$ 7.85. Funds will flow out of the HKD market, and the HKD interest rate may also be adjusted according to market conditions. This follows the design of the Linked Exchange Rate System and is normal. And we also have a huge monetary base (HKD2.2 trillion) to serve as a buffer for capital outflows.

The increase in HKD interbank rates will affect residential mortgage interest rates and add the burden on property owners. However, the borrowing ratio of the property market in Hong Kong has been stable. According to HKMA’s data, more than half of the residential property owners in Hong Kong do not have mortgage loans, and the average payment-to-income ratio of bank mortgage lenders is at a low level of 36% with the eight rounds of macroprudential measures in place. Mortgage lenders are also stress-tested and have the ability to withstand pressure arising from rising interest rates.

In addition to changes in interest rates, other factors such as supply and demand, market expectations for the macroeconomic outlook and investment sentiment will also affect the asset prices in the stock and property markets. At a time of rising inflation and interest rates, investors have to exercise prudence in manage potential risks.

April 24, 2022