1. If formed, a Maehara government would likely improve the chances of getting pro-growth, anti-deflation policies implemented.
2. If Maehara is popular in the early stages of his government, he has an incentive to call a snap election, and minimize DPJ loss of seats. If successful in this strategy, there is a possibility that the DPJ might form a coalition with Your Party, and accelerate pro-growth, anti-deflation policies.
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Several news sources have reported that Seiji Maehara, former Foreign Minister, will run to succeed PM Kan. If Maehara runs, he is seen by many as likely to be the front-runner. The DPJ desperately needs popularity, and according to the polls, Maehara seems to be the only DPJ candidate who has enough to give a sense of forward momentum to the party. Maehara would certainly be a fresh start for the DPJ.
While market sentiment could improve if there was a Maehara government and a fresh start, there are several remaining issues:
(a) What political agreement did Maehara reach with party-boss Ichiro Ozawa, in order to get Ozawa's support? Depending on the nature of the political deal, Ozawa may be an obstacle to Maehara's policies. While Maehara and Ozawa are both pro-growth, the latter is very reluctant to alter the DPJ's 2009 manifesto, which is itself a barrier to pro-growth policies. Maehara is much more willing to alter the manifesto.
(b) Would Maehara be able to implement the aggressive growth strategy that he talks about? For example, Maehara has said that the only way to pay for rising social welfare costs is for the economy to grow rapidly. He wants a profit-friendly environment to make this growth happen. In contrast, Ozawa, Hatoyama and other parts of the DPJ still retain an anti-business tilt. One note to cheer investors: A Maehara government would likely take tax hikes off the table, at least for a few years.
(c) Who would Maehara appoint to which Cabinet posts? The balance among factions is less important than the policy opinions of the individuals. Note that Maehara has taken an aggressive stance on demanding more BoJ easing. In order to accomplish this, Maehara would need a finance minister who is sympathetic to pressuring the BoJ. The METI minister appointment will be important for the signals it sends about energy policy.
(d) Would Maehara centralize decision-making again, e.g., by reviving the Council on Economic and Fiscal Policy? If so, the government decision apparatus would be more coherent and transparent than during Hatoyama and Kan governments. It would be particularly aggressive for Maehara to revive the idea of a National Strategy Council.
A Maehara government would raise a difficult problem for the LDP: Should the LDP cooperate with Maehara? There is a dilemma: On one hand, Maehara's policies are closer to the LDP's than were those of the Hatoyama and Kan governments. On the other hand, the more successful Maehara became as PM, the lower the LDP's incentive to cooperate.
Looking further forward, a Maehara government would likely postpone any scenario for a break-up and reformulation of the major political parties. Thus, the next general election would be fought on largely the same party structure as now. A DPJ led by Maehara would presumably mean a less severe loss of seats for the DPJ (e.g., 300 to 200) than would have been the case with Kan (e.g., 300 to 150). This observation implies that the Lower House could also end up without a clear majority. The smaller parties would become important. It might also give a PM Maehara a reason to call a snap general election, while his early and presumably high popularity ratings continued, in order to minimize DPJ losses.
What could happen in such an election? Most observers believe that the DPJ will lose seats. The question is how many. The scenarios in our main note show different degrees of decline for the DPJ, offset exactly by increases for the LDP. Small, left-wing parties are held near their current strength, and the Komeito is raised slightly, in light of the loss of DPJ seats in these scenarios. In addition, we assume that Your Party, a pro-growth splinter party, capitalizes on popularity shown in the 2010 Upper House election, and gets 25 seats.
When looking at potential coalitions, an intriguing possibility arises: So long as the DPJ loss of seats is limited to about 50, then a DPJ coalition with Your Party would garner a majority in the Lower House. An added benefit would be that such a coalition comes closest (but not quite) to a majority in the Upper House as well. In contrast, if the DPJ loses much more than 50 seats, then an LDP+Komeito government becomes the default, potentially with Your Party. Such coalitions would work in the Lower House, but would still face a large gap in the Upper House.
All in all, a Maehara government would likely improve the chances of getting pro-growth, anti-deflation policies implemented. However, the structural problems in the political world (e.g., fragmented parties, twisted Diet) would remain. Only when some clarity about the future of policies emerged would investors have a clearer picture of likely macroeconomic and structural policies.
Much has taken place since our May 2009 report, Hong Kong Economics: Q&A on Monetary Conditions. In stark contrast to two years ago - when global monetary easing and capital inflows buoyed asset prices and pulled Hong Kong promptly out of recession - markets are now suffering from sovereign credit woes in the developed world, anxiety over inflation, monetary and fiscal tightening. Many of the questions previously raised in the Hong Kong monetary space are being asked again, while the latest developments have raised several new questions. In this report, we again compile the commonly asked questions at the current juncture and provide our answers to them, in relation to Hong Kong's currency board and monetary system, latest developments with regard to liquidity conditions, and longer-term fundamental considerations for monetary management in Hong Kong amid the changing macro and financial landscape.
1) How Do We Measure Capital Inflows/Outflows?
Under the currency board system, capital inflows in the conventional sense lead to an expansion of the monetary base (MB), which - in the case of Hong Kong - consists of the aggregate clearing balance of the banking system, currency in circulation and outstanding Exchange Fund (EF) papers. Hong Kong's monetary system differs from that in the rest of the world in the sense that EF papers are fully transferrable into aggregate balance and are included in the definition of MB. Meanwhile, it is customary - since the introduction of two-way convertibility for the HK$ in May 2005 - for the Hong Kong banking system to serve as the counterparty for capital flows driven by the non-banking sector, absorbing the capital flows on its balance sheet instead of passing them on to the HKMA. In other words, capital flows no longer show up readily only in interbank liquidity and changes in official foreign reserves but instead in the change in the banks' net foreign asset (NFA) position. Therefore, we stack up the MB and NFA as our proxy of the total liquidity stock, and monitor the changes in this total as an indication of the size of capital inflows and outflows in a given period.
2) How Much Capital Inflows Has Hong Kong Seen Since September 2008? Where Have They Shown Up in the System?
While it is not possible to identify the gross amount of inflows, we can simplify things and assume that the peak the total liquidity stock netted against the level before QE gives us the maximum inflows we have had. Our proxy for the total liquidity stock (MB + NFA) totaled US$77.2 billion at end-August 2008, peaking at US$197.1 billion at the end of October 2010, implying total inflows of US$119.9 billion. While changes in the NFA became the main channel through which capital flows were absorbed between mid-2005 and mid-2008, the financial crisis in late 2008 and the temporary breakdown in interbank financing heightened banks' preference to ramp up liquid HK$ assets. Hence, of the US$119.9 billion total inflows, only US$28.7 billion showed up in the increase in NFA, and the remainder (US$91.2 billion) in the expansion in the MB. Initially, all the inflows into the MB entered through the aggregate balance, but ‘additional' issuances of EF papers by the HKMA helped absorbed some of the inflows (approximately US$65 billion) between October 2008 and May 2010.
In addition, even though clearing balances held with the HKMA earn no interest, the low interest rate environment has kept the opportunity cost low for maintaining the large aggregate balance thus far.
3) How Much of the Inflows Have Already Reversed?
By the end of June 2011, the total liquidity stock has retreated to US$167.8 billion, so we can say that we have had outflows of US$29.3 billion, which is 24% of the inflows. So far, the outflows have come out of the NFA alone.
4) What Should We Expect Ahead upon Capital Outflows?
As explained in questions 1 and 2, capital inflows and outflows can be absorbed by changes in either: a) the monetary base (in HK$ terms) and foreign reserves (in US$ terms), or b) the banking sector NFA position. The capital inflows since September 2008 have ended up in both these channels. Likewise, when the situation reverses, the capital outflow could be absorbed through the same channels, i.e., we could see a) a drop in foreign reserves, which is mirrored in the decrease in monetary base (which can be a drop in the aggregate balance and/or net retirement of EF papers), and/or (b) a drop in the banking sector NFA position. As mentioned in question 3, outflows in the past year have come out of the NFA alone, which has been drawn down to US$32 billion at the end of June, from the peak of US$86 billion in October 2007, or US$15 billion above the level in May 2005 (when two-way convertibility was introduced). It is only reasonable to expect that further outflows ahead would start to drain on the monetary base.
5) How Does HIBOR React to Capital Outflows?
As mentioned in question 3, part of the QE-induced inflows since September 2008 have already reversed. However, we have seen a minimal impact on interbank interest rates so far, because the total liquidity stock has remained large. Moreover, HIBOR responds more readily to the size of the aggregate balance (interbank liquidity) than to NFA. However, NFA is retreating further to a more normalized level, while banks may be finding better yields in the money market (e.g., LIBOR and UST). When facing further outflows from HK$, banks may resort to running down their aggregate balance. When this happens, such news could come as a discomforting shock to the market initially and lead to some overshooting in HIBOR. Nevertheless, the HKMA could well mitigate the impact by replenishing the aggregate balance by gradually retiring EF papers. All in all, the size of the monetary base should be expected to normalize upon the gradual reversal of global quantitative easing. HIBOR could occasionally overreact to dips in the aggregate balance, but the upside should be capped by the respectable liquidity buffer.
Moreover, we should note the possibility of banks deciding to run down their holdings in the HK$ clearing balance/EF papers should they see better yield opportunities in NFA, even in the absence of net capital outflows, triggering a reaction in HIBOR. In fact, we have been alerting investors to this risk and - noting how the NFA has been run down in recent months - see increasing likelihood of this taking place in the near future.
6) What Is Our Interest Rate Outlook for This Year and Next?
Given the HK$-US$ link, we continue to forecast HK$ interest rates with reference to the US interest rate outlook. For policy rates, the quick formula is that Hong Kong's Discount Window Base Rate (DWBR) = Fed Funds Target Rate (FFTR) + 50bp. Of course, Hong Kong could move independently by changing the formula, which it did in October 2008. However, we attach a very low probability to another such independent move. Our US economics team currently forecasts that the Fed will not hike until 2013, and so we forecast the same for DWBR. With regard to money market rates, on the other hand, the HIBOR-LIBOR discount has been limited by the near-zero level of LIBOR, even though economic fundamentals and the outlook justify a negative spread, like what had been sustained over much of the last decade. Looking ahead, as our US team forecasts that LIBOR (3M) will remain at around 0.25% until end-2012, we expect the same for HIBOR (3M). Even if we are surprised by a rise in LIBOR ahead, we could see the HIBOR-LIBOR discount widen again, keeping HIBOR low.
7) What Do Recent Trends in the Loan-to-Deposit Ratio Mean?
A convenient indicator of liquidity that we have always followed is the HK$ loan-to-deposit ratio (LDR), which is, to a certain extent, the mirror image of size of the excess liquidity pool. Although we have yet to see large outflows, the LDR has been squeezed up by rapid loan growth, causing us to turn more cautious towards the equity market since early this year, although the correction has only just come through. The steady uptrend in the past several months took the LDR to 84.3% in June 2011, the highest level since December 2005. The trend we have seen in the HK$ LDR certainly still spells more downside for the equity market in the immediate term.
8) Chinese Companies Have Turned to Hong Kong Banks for Loans amid Monetary Tightening on the Mainland. How Has This Contributed to Loan Growth in Hong Kong and Affected Monetary Conditions in General?
Chinese companies have indeed been borrowing in Hong Kong. Some are concerned that this type of borrowing is draining HK$ liquidity. However, we believe that their borrowings are predominantly in US$ rather than HK$, since the interest cost is about the same for both currencies, but the US$ is likely the more accepted currency on the mainland (in exchange for renminbi). In other words, we should safely assume that HK$ loans made generally are genuinely for domestic use and are not distorted by mainland demand. Indeed, foreign currency loan growth (+60.4%Y in 1H11) has far outpaced that in HK$ (+17.4%Y), bringing their share of the total to 37% in June, from a recent trough of 26% just two years ago. Although no currency breakdown is available from the HKMA data, we believe that US$ accounts for a good majority of the total foreign currency loans. Meanwhile, renminbi loans can be made only for trade finance, so they likely only account for a small portion of the total. In other words, as we believe that mainland companies primarily take out their loans in HK$, we are not concerned that this type of borrowing is draining or tightening HK$ liquidity. It is actually good news for the Hong Kong economy - from a business opportunity/service exports point of view - that Chinese companies are using Hong Kong as a fund-raising center, as long as banks are managing their balance sheets in a prudent way.
9) What Are the Implications of the US Sovereign Downgrade for Hong Kong?
With regard to the latest downgrade in the US sovereign credit rating by S&P, there is particular interest in its implications for Hong Kong, given the currency link between HK$ and US$. First of all, S&P affirmed Hong Kong's AAA sovereign credit rating on August 2 and also stated on August 8 that the US downgrade bears no immediate impact on the Asia-Pacific ratings. Nevertheless, the US downgrade, coupled with deteriorating sovereign creditworthiness in Europe, has severely hurt financial market sentiment and reduced risk appetite. This will potentially hike funding costs at a global level and drain liquidity from the Asian markets. Nevertheless, as mentioned in question 6, we believe that the huge liquidity buffer should shield HIBOR from meaningful upward pressure (notwithstanding short-term fluctuations).
Some investors are also concerned that the downgrade might weaken the US$ (and hence the HK$) against other major currencies, worsening inflationary pressure in Hong Kong through the import channel. Nevertheless, because of: a) the sustained status of the US$ in the international finance and trade, b) similar economic and fiscal problems in Europe and Japan, and c) lack of investment alternatives to US Treasuries, we do not expect the US$ to weaken noticeably because of the downgrade. Yields on US Treasury securities have even fallen substantially in the last few weeks.
Nevertheless, while the direct impact from the downgrade in the US sovereign credit rating by S&P on the Asian ratings is minimal, the ramifications from the weaker growth outlook - given higher funding costs and reduced capacity in monetary and fiscal stimulus compared to 2008-09 - are significant. While aggressive fiscal and monetary stimulus played a pivotal role in cushioning the downturn in late 2008, we cannot be optimistic that Hong Kong will enjoy the same magnitude of support from capital inflows this time around. Moreover, the volatility experienced in financial markets in the last few weeks has likely already hurt consumer and investment sentiment in the region and especially Hong Kong, given the asset-driven nature of the economy.
10) How Is Hong Kong's Expanding Role as an Offshore Renminbi Center Affecting the Currency Board System and Monetary Conditions?
The phenomenal growth in the CNH market since 2010 has raised a series of new questions with regard to monetary management in Hong Kong. For a start, we welcome the rapid development of the CNH market as a significant business opportunity for Hong Kong's banking sector and hence economic growth (in the form of service exports), independent of its impact on HK$ monetary conditions (see Monetary Conditions Monitor - Anniversary Issue, Adding CNH Section, February 1, 2011).
That said, some ask whether the capital inflows (into HK$) observed over the past couple of years reflect the growth of the CNH market. The answer is no. The growth of CNH circulation is just like any other foreign currency in Hong Kong, independent of HK$ monetary conditions. Moreover, the rapid expansion in the renminbi-denominated portion of the Hong Kong banking sector balance sheet does not necessarily affect the HK$ monetary base and the currency board system, unless increasing CNH circulation results in a meaningful reduction in the demand for HK$ as a medium of exchange. And even should that happen, it would not necessarily cause downward pressure on the HK$ exchange rate, as the supply of HK$ would be automatically reduced under the currency board system (upon ‘capital outflow') in response to the fall in demand.
11) Is the HK$ Being Marginalized? What Is the Future for the HK$?
Not yet. Needless to say, CNH deposits are claiming an increasing share of the total, having reached 9.2% at the end of June. CNH's share in interbank clearing has also grown rapidly (11.7% in June). Nevertheless, we have not yet seen any absolute contraction in HK$ deposits, interbank clearing volume and the HK$ portion of the banking sector balance sheet because of the growth in CNH.
That said, the structural trend towards closer economic, financial and monetary integration between Hong Kong and China over the long term is undisputable. Amid increasing cross-border linkages and progressive relaxation of China's foreign exchange controls, the renminbi will become more accepted as a medium of exchange in Hong Kong. Eventual full convertibility of the renminbi will also enable it to become a credible store of wealth. In other words, it is only realistic to expect that a fully convertible renminbi and its wider circulation in Hong Kong and the region will undermine the traditional functions of the HK$ as a medium of exchange, unit of account and store of value. So, the HK$ could be gradually and naturally marginalized in the long run.
12) Should Hong Kong Reconsider its Currency Board System? What Are the Key Considerations Behind Keeping or Scrapping the US$ Link?
Amid sustained and possibly increasing divergence in economic cycles between Hong Kong/China and the US, exchange rate inflexibility and the loss of monetary policy independence are being blamed for exacerbating cyclical fluctuations in the Hong Kong economy. Should the HK$-US$ link be reconsidered?
Hong Kong's currency board system is nearing 28 years old. Macroeconomic circumstances have undergone an immense evolution throughout this period, and it is always prudent to reassess continuously the benefits and costs of keeping the US$ link. The arguments for a fixed exchange rate have always been sound for a small and extremely open economy like Hong Kong's, where the value of cross-border trade and capital flows that involve foreign exchange is multiple times the size of the economy. The minimization of exchange rate risk has contributed to monetary and banking system stability and played a pivotal role in lowering uncertainty and costs associated with business transactions. Nevertheless, the costs of maintaining the fixed exchange rate are also substantial. Having surrendered monetary policy autonomy to the US Fed, Hong Kong has to adopt the US policy stance, which may not be most suitable when the two economies are at different stages of an economic cycle. Price stability, a common policy objective among other economies, is instead a luxury for Hong Kong. An obvious result is that Hong Kong has to endure more volatility in asset and consumer prices as well as more volatile business cycles.
With increasing globalization and Hong Kong's expanding role of financial intermediation between Chinese enterprises and international investors, cross-border trade and capital flows handled by Hong Kong's financial system have ballooned in the last several years. This development has further bolstered the benefit of exchange rate predictability, but the inflexibility has also intensified the destabilizing effects of capital flows on Hong Kong's asset markets. In our view, the benefits of exchange rate stability have outweighed its costs so far, but we believe that the government should continue to evaluate the benefits and costs of the fixed exchange rate system under varying macroeconomic backdrop conscientiously and regularly.
13) Should the Link to a Weak US$ Be Blamed for Surging Property Prices?
Many people, especially those having difficulties in purchasing homes in Hong Kong, are seeing the link to a weak US$ as the culprit behind property prices surging to unaffordable levels for the average household. In our view, however, every price in the free market is the result of supply and demand forces. The government responded to the Asian Financial Crisis and asset market correction in the late 1990s with a massive shrinkage in housing supply. This supply has not been revived again in reaction to the recovery in the Hong Kong economy and improvement in investment sentiment since 2003, and the increased southward flow of consumption and investment from the mainland to Hong Kong (in contrast with net northward flow before 2003). We believe that supply shortage relative to demand is the main reason behind the property price surge, and it is its surge relative to household income that is hurting housing affordability. The link to a weak US$ makes Hong Kong's goods, services, wages and assets appear cheaper to the rest of the world, but should have contributed little to the relative price movements among them. In an ideal situation where we have a uniform inflation rate (driven by strength/weakness of the local currency) across all goods, services, wages and assets, there would not be deterioration in housing affordability. Needless to say, nevertheless, relative price changes had been substantial in reality, and the redistributory effects of every inflation/deflation episode have exacerbated income and wealth inequality over the past decade-and-a-half. However, we can blame the US$ link only indirectly for amplifying the price level fluctuations and hence the redistributory effects, and not for the surge in property prices per se.
14) How Worried Are We about Inflation, Given the Sustained Dovish Monetary Stance in the Foreseeable Future, and Possibly QE3?
As Hong Kong does not exercise an independent monetary policy, it does have to suffer more volatility in the consumer price level than desired. Nevertheless, the fixed exchange rate system merely mandates that Hong Kong follow US policy interest rate moves but not necessarily mirror the US's quantitative easing (liquidity injections and government borrowing to finance the rescue package). Hong Kong's pace of monetary expansion depends on capital inflow/outflow, and not directly on US money printing (quantitative easing), nor the HK$ interest rate level.
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