Hong Kong Hibor and Singaporean SOR interest rates have climbed in tandem with US Libor over the past few years – but their upward trajectory has not always been steady (Fig 1a) and they have frequently lagged Libor. Recently, more dovish Fed comments have triggered a decline in US Libor – however, influenced by domestic factors the ascension of Hibor and SOR has actually increased (Fig 1b) – with positive implications for local currency cash investors.
Singapore MAS: Looser monetary policy implies higher rates
Consistent with other central banks, the Monetary Authority of Singapore’s primary policy objective is price stability. However its monetary policy is unusual in that it focused on managing the exchange rate (via the SGD nominal effective exchange rate – S$NEER) rather than interest rates (Fig 2a). Given this focus, the four Federal Reserve target rate hikes in 2018 exerted significant upward influence on SOR yields which recently hit a decade high.
Historically, expectations of a stronger SGD propel the S$NEER above the mid-point of its trading band, which, consequently exerts downward pressure on local interest rates (Fig 2b). Since 2015, core inflation has gradually moved towards the MAS’s target range, allowing the central bank to assume a more hawkish policy stance. This culminated in two S$NEER slope increases (approximately +0.5%) at both its April and October 2018 monetary policy meetings, which curtailed the upward momentum of SOR yields.
Recent domestic economic activity has been weaker than the MAS’s forecast with slower growth, exports and private consumption. Meanwhile, the fall in oil prices and sluggish wage growth have muted core inflation – restricting the central bank’s hawkish mandate.
At its upcoming monetary policy meeting in April, the MAS is likely to leave the S$NEER slope unchanged while assuming a more neutral policy stance. This will negatively impact expectations of future SGD appreciation, push the S$NEER lower and place upward pressure on SOR yields.
Hong Kong: Escaping the liquidity trap
Unusually, Hong Kong does not pursue an independent monetary policy, rather it maintains HKD currency stability within the framework of the Linked Exchange Rate System (LERS). This is guaranteed by ensuring the HKD monetary base is fully backed by USD reserves held in the exchange fund at a fixed exchange rate of HK$7.80 to US$1 (Fig 3a).
Therefore, the four Federal Reserve target rate hikes in 2018 also exerted significant upward influence on Hibor yields, which recently hit a decade high. Linked exchange rate theory suggests that Hibor should be higher (or lower) than Libor when the HKD is trading at the weak (or strong) side of convertibility. Yet, despite the HKD trading on the weak side of convertibility (between HK$7.80 to HK$7.85) for the past two years, Hibor yields remain stubbornly lower than their Libor equivalents.
The main culprit is Hong Kong’s monetary base, which has tripled in size over the past decade as liquidity, mainly from China, flooded Hong Kong’s banking system.
In the past several weeks, liquidity outflows combined with the arbitrage opportunity triggered by the wide Hibor/Libor spread caused the HKD to repeatedly hit the weak side of convertibility at HK$7.85 (Fig 3a) versus the US$1. This forced the Hong Kong Monetary Authority (HKMA) to intervene in the forex markets on five occasions, purchasing a total of HK$11.586bn (US$1,746bn) to defend the peg. This represents the fourth in a series of FX interventions (Fig 3b) over the past year and has reduce the aggregate balance to an 11-year low of HK$64.7bn.
Following the HKMA actions, Hibor rates increased and the spread versus Libor contracted. Yet, the HKD remains very close to the weak side of convertibility – suggesting further HKMA intervention and additional upward pressure on Hibor.
Conclusion: The dovish paradox
For Singapore and Hong Kong cash investors the recent higher SOR and Hibor yields are welcome following an extended period of low returns and negative real yields. As the positive momentum triggered by previous Federal Reserve rate hikes fades, domestic factors are assuming increasing importance and paradoxically pushing local interest rates higher –closing the gap with US Libor and providing additional benefits to investors.
What’s a China “policy put”?
Unlike most developed markets, Chinese central bank (PBOC) operates more like a part of the government rather than an independent organization. Its official objectives include maintaining financial stability and performing functions prescribed by the State Council. Along with the major state-owned banks and policy banks, PBOC has funded government’s fiscal expansion in the past decade, attempting to smooth the economic cycles and to stabilize job market. While most of the traditional central banks in developed markets have similar goal at the end, inflation target has been their main priority. China however is a command economy with the state, rather than the market, being the most influential force driving growth and cycles. It’s easier and more promising for the government to coordinate the funding for its fiscal projects, instead of leaving this task to the invisible hands. As the banks’ credits were channeled to infrastructure and community projects undertaken by state-owned enterprises and local governments, China’s excess credit – as measured by the credit growth, or the growth of total social financing (TSF), in excess of nominal GDP growth – swung in the opposite direction of the fundamental economic trend (chart 1). Investors see this proactive government strategy as a “policy put”.
Lesson of previous policy put
The most obvious result of China’s policy put is the surge of leverage (chart 2). Between 2007 and 2018, TSF rose from about 120% of GDP to almost 215%, and debt to GDP rose from about 160% to over 260% (2017). In the first wave of stimulus in 2009, the government successfully cushioned the economic downturn. After the economy was stabilized and real GDP growth landed at 10% levels, the country only managed to slow down the leverage increase but didn’t reduce the leverage built up in previous years. Then the second wave of economic downturn arrived in 2012 as real GDP growth dropped to high 6% range till 2015. In this period, the leverage resumed and although this soft landing was successful in stabilizing growth, it eventually contributed to one-notch downgrade of its sovereign rating by both S&P and Moody’s in 2017. In this period, consumer prices remained very steady given that the government was actively controlling the prices of goods and services, but the wages rose steadily nevertheless. To the contrary of the consumer prices, asset prices have been volatile. China newly built commercial residential price index (new-built is the most active market in China) went through 3 major cycles ranging from about -5% to +10% during this period, despite of an extraordinary amount of austerity measures put in place for the property market. The wealth effect created by the excess credit growth boosted demand of foreign goods, foreign investments and outbound tourist spending. This partly contributed to gradual dissipation of current account surplus, decline of the foreign exchange reserves, and pressure on the exchange rate. On 11 Aug 2015, USDCNY depreciated by 3% to 6.39 in a single day, and the exchange rate further tested 7.0 in 4Q 2016. During the period, the government introduced various administrative measures on the currency exchange and capital control, which successfully stabilized the exchange rate.
The credit fueled fiscal stimulus orchestrated by the PBOC is a powerful counter-cyclical policy tool and it is very effective in creating jobs and stabilizing economic growth, but ultimately, we think the capacity for China to implement its policy put is constrained by the layman maintaining their confidence in the currency. Accordingly, it’s essential for the government to maintain a tight capital control. As the government institutionalizes tight capital control, surplus liquidity trapped in the country could be difficult to be contained and it could result in volatile asset prices.
Investment implication for 2019: Don’t fight PBOC
In 2019, China’s economy faces new challenges from many facets both internally and externally, and this underpins our view that we should see another policy put. In fact, we might have already seen a bit of it, given that for the first two months in 2019, net new credit deployed to long term corporate loans has already reached the level of 2H 2018 (chart 3). PBOC and the Chinese banks are ready to support the economy by extending credits to government projects and mending the credit transmission mechanism so that credits could be flowed to the required segments of the economy, in case of further risk escalation such as the trade negotiation with the US turning sour. The key investment implication of this policy put is that we should not be too bearish about China, including CNY, China government bonds and China credits. In particular, China government has a tight control on the exchange rate through administrative measures, and the CNY may or may not fluctuate along with the country’s fundamental.
We need to be watchful that some of the policy put may already be in the price, and there are a few moving parts globally, such as US-China trade negotiation and expectations of Fed’s policy stance. Among the major FICC asset classes in China, we see decent asymmetry in RMB-denominated bonds due to a dovish PBOC and potential appreciation if a deal is reached, which is the reason why we are moderately constructive towards such bonds on an unhedged basis. Outside China, we expect the policy put, if we see one, may benefit capex commodities (e.g. copper, iron ore and steel) and the countries exporting these commodities.