HKMA cuts rates to bolster the banking system

Hong Kong leads other central banks in cutting interest rates to boost liquidity and stem the plunge in global stockmarkets.
The Hong Kong Monetary AuthorityÆs (HKMA) one percentage point cut in its benchmark interest rate yesterday is seen by many economists as a move to unlock liquidity and to help bolster confidence in the local banking system.

Hong KongÆs move was followed by a slew of other central banks, including the Federal Reserve, which eased rates in a coordinated effort to stem the sharp falls in the global stockmarkets. China too announced a rate cut, its second in a month. In the US, the Dow Jones index plunged 12.9% in the five sessions to Tuesday, wiping out trillions of dollars of wealth, while the Hong Kong market (closed for a holiday on Tuesday) lost 7.7% on Friday and Monday and another 8.2% yesterday. Investors are selling off as they worry that more financial institutions will fall victim to the credit crunch which is keeping banks from lending to each other and pushing up short-term interest rates.

HKMAÆs chief executive, Joseph Yam, said in a press release that Hong Kong will reduce the spread of its base rate, or discount window rate, to 50 basis points above the prevailing US federal funds target rate from today (Thursday) from the current 150 basis points under a modified formula. As per the new formula, Hong Kong will cut its base rate (the reference that the HKMA uses to calculate interest charged to licensed banks borrowing through its discount window) to 2.5% from 3.5%, Yam said.

"We hope the new formula could help stabilise the interbank rates in the long run and lower the pressure on banks to lift lending rates," Yam added.

This is the first time in a decade that the de-facto central bank has reviewed the formula for its base rate, thus it did come across as a somewhat desperate attempt to soothe the liquidity squeeze in the territory.

Because of the dollar peg, Hong Kong has limited control over monetary policy and hence tends to follow the Federal Reserve in the setting of interest rates. This partly explains why the Hong Kong government has been relatively aggressive in using fiscal stimulus to ease the liquidity crunch.

Hong KongÆs rate cut comes just a day after Australia stunned the markets by cutting key lending rates by one percentage point on Tuesday to prevent the seizure of the credit markets and avoid the economy from spiraling into a recession.

Other central banks that are using rate cuts to prevent mayhem in the banking system include the European Central Bank, the Bank of England and the central banks of Canada, Sweden and Switzerland.

The fact that the HKMA cut rates before the Fed shows that it is both nervous (about the current situation) and determined to prevent the local banking system from catching the contagion thatÆs sweeping the European banking system, with governments in Iceland, the United Kingdom and Belgium all being forced to step up efforts to save their banks.

ôHKMA did not have any other option but to cut rates. It shows that HKMA is getting nervous about monetary policy,ö says Sydney-based Sherman Chan, an economist with ratings agency MoodyÆs. She says that HKMA will keep a close eye on the financial markets in the coming weeks for any signs of weakness.

A Singapore-economist says that, around the world, a lot of traditional formulas have been thrown on their head by this turmoil and credit freeze.

With banks not lending to each other short-term, lending rates between banks have soared as banks have been hoarding cash to prop up their balance sheets and to shelter them from the credit freeze and slumping equity markets.

Hong Kong's three-month interbank offered rate, or Hibor, rose 4 basis points to 3.85% on October 6, the highest since December last year.

HKMA has previously said that the city's money market was orderly despite rising concerns about credit risk, but that it was ready to provide more liquidity if necessary.

Chan says that the rise in borrowing costs will hurt all business sectors, but the property market will be one of the most severely hit. Both residential and commercial property prices soared in the past two years, and are now facing pressures for a substantial correction. Higher interest rates coupled with subdued investor sentiment will see property transactions continue to decline for the rest of the year. Moreover, a weaker sense of job security amid a slowing economy will further discourage mortgage commitments in the near term, according to Chan.
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