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Following is a question by the Hon Fred Li Wah-ming and a written reply by the Secretary for Financial Services, Mr Rafael Hui, in the Legislative Council today (Wednesday):

Question:

In connection with adjustments to the best lending rate and the deposit rates offered by banks in Hong Kong, will the Government inform this Council:

(a) whether consideration will be given to removing the stipulation that the rates cap for bank deposits with a maturity or call period of less than seven days are to be determined by the Hong Kong Association of Banks in accordance with the Interest Rate Rules, so as to allow the relevant rates to be determined by the market; if so, of the specific timetable; if not, why not;

(b) whether any assessment has been made to determine if the current differential between the one-month interbank interest rate and the best lending rate is at a reasonable level;

(c) whether measures will be adopted to narrow down the current differential between the deposit rate and the lending rate to the 2 per cent level which was the prevailing interest rate spread prior to the financial turmoil; if so, what the details are; if not, why not; and

(d) whether any assessment has been made as to the effects of the best lending rate on economic growth; if an assessment has been made, what the details are; if not, why not?

Reply:

(a) The Hong Kong Monetary Authority (HKMA) is committed to greater liberalization of the banking system to promote competition and product innovation. However, it is equally important to strike the right balance between healthy competition and the stability of the banking and monetary systems. Such a prudent approach is appropriate especially in the light of the current volatile and uncertain environment surrounding the financial sector.

Since the advent of the Asian financial crisis, we have witnessed significant volatility in the banking market and the competition for time deposits has placed banks under severe pressure. If the remaining Interest Rate Rules (IRRs) were to be removed in this kind of environment, there is a real risk that it will add to the uncertainty and volatility in the banking system. This runs against the public interest of Hong Kong.

Although interest rates have moderated recently, the market remains uncertain. There are also a number of other policy issues which are being reviewed at present, e.g. the three tier system, market entry requirement, "one branch condition" for foreign banks etc. These will also have impact on the competitive environment of the banking sector.

Accordingly, it seems clear that decisions towards further deregulation should not be taken in isolation. Instead, they should be reviewed in the broader context of the strategic direction of the Hong Kong banking sector, the state of the economy as a whole, and other possible policy changes. Consequently, the HKMA has commissioned a consultancy study on the future direction of the banking sector. The study will address various policy issues including the IRRs. The result of the study should be finalised by the end of the year. After considering the consultant's findings and recommendations, the HKMA will publish a report in due course.

(b) Although the HKMA does not assess whether the interest spreads are at a reasonable level, it does monitor the net interest margins (Note 1) of Hong Kong banks which are published on a quarterly basis in the HKMA's Quarterly Bulletin. The general observations arising from these statistics are that the average net interest margin of Hong Kong banks is lower than that of the United States and is comparable with those in the United Kingdom and Australia for the period 1995 - 1997. In other words, the net interest income earned by banks in Hong Kong does not seem to be out of line with their international counterparts.

It should be noted that it may be misleading to look at the interest spread at any one point in time. During the Asian financial crisis, banks in Hong Kong have experienced tremendous pressure arising from interest rate volatility. For example, the spread between the Best Lending Rate (BLR) and 1-month time deposit rates (Note 2) varied between 4.37 per cent and 1.42 per cent from July 1997 to September 1998. In fact, there were instances where time deposit rates were higher than the BLR. This has particularly been the case for the larger deposits where banks have been prepared to offer preferential rates well in excess of Hong Kong Dollar Interbank Offered Rates (HIBOR) in order to attract deposits. Although the interest rate environment has recently become more stable, the time deposit rates are still higher than pre-crisis levels.

In addition, the interbank market is also a significant source of funding for banks. The spread between the BLR and 1-month HIBOR (average monthly figures) has fluctuated in the range of 4.6 per cent in March 1998 to minus 2 per cent in August 1998. These average figures actually mask the substantially higher daily volatility of the interest spread.

(c) The HKMA does not attempt to regulate the interest margin earned by banks. In fact, the interest margin in the recent period is lower than that before the financial crisis. The spread between 1-month HIBOR and BLR averaged 2.98 per cent in 1995, 3.22 per cent in 1996 and 2.55 per cent in the first nine months of 1997, prior to the financial crisis. In the year to September 1998, the same spread has averaged only 1.53 per cent, i.e. much lower than pre-crisis levels. In addition, as noted in part (b), the banks have been offering rates above HIBOR for much of their deposits during the past year, further compressing interest margin. This has contributed to the sharply lower profits reported by the banks in the first half of 1998.

(d) In our regular economic analysis, interest rates (including the BLR), are treated as a variable that will affect private consumption expenditure as well as private sector investment. Given that consumption and private sector investment are important components of domestic demand and hence of GDP, the level of interest rate has a direct bearing on overall economic activity. But interest rate is only one of the many factors that will affect our economic performance. Other significant factors include the economic situation in our major export markets, the movement of exchange rates, price competitiveness, inflation in our major import supplier economies, the pace and nature of structural change, etc. The impact of interest rate movements on our economic performance is therefore often intertwined with those from the various external and domestic factors, and hence not readily separable for assessment in isolation.

Note 1: Net interest margin is defined as net interest income (i.e. interest income less interest expense) divided by average interest bearing assets. This is one of the internationally recognised measures of bank profitability.

Note 2: The various interest rates quoted in this response represent their respective monthly average figures between July 1997 and September 1998. The average interest rates for 1-month time deposits were compiled based on the board rates for deposits less than HK$100,000 offered by ten leading banks. The BLR refers to the rate quoted by the Hongkong and Shanghai Banking Corporation Limited.

End/Wednesday, November 11, 1998

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