Hong Kong's monetary authority raised the city's borrowing cost by 75 basis points for the second consecutive month, in lockstep with an increase of the same amount overnight by the US Federal Reserve.

Hong Kong's base rate will rise to 2.75 per cent effective immediately, according to a statement by the Hong Kong Monetary Authority (HKMA), the city's de facto central bank. That's the highest level since 2019, which was itself an 11-year high.

Hong Kong's rate increase, conducted in concert with US monetary policy to preserve the city's currency peg to the US dollar since 1983, comes at an inopportune moment for the local economy. Unlike the US economy's runaway inflation - prices rose by 9.1 per cent in June, the most in 40 years - Hong Kong is on the brink of a recession, weighed down by social distancing rules to combat the Covid-19 pandemic.

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Months of social distancing rules and disrupted businesses have caused the city's economy to shrink by 4 per cent in the first quarter. Analysts expect gross domestic product to contract by as much as 1.6 per cent in the second quarter.

A pedestrian sought shelter from the heat wave in Hong Kong's Kwun Tong district on 8 July 2022. Photo: Xiaomei Chen alt=A pedestrian sought shelter from the heat wave in Hong Kong's Kwun Tong district on 8 July 2022. Photo: Xiaomei Chen>

Full-year growth forecast, estimated at between 2 per cent and 3.5 per cent in 2022, may have to be cut, Financial Secretary Paul Chan Mo-po said this week in an interview with South China Morning Post. Chan is scheduled to hold a press briefing at 10:15am today about implications of higher rates.

The Fed raised its key rate for the fourth time this year, lifting it to a target range of 2.25 per cent to 2.5 per cent, from 1.5 per cent to 1.75 per cent. The Fed has delivered two 75-basis point blows in as many months, raising the cost of money by the biggest one-time quantum unseen since November 1994, to douse the inflationary pressure unleashed by the trillions of dollars of cheap funds released during the onset of the Covid-19 pandemic.

Eddie Yue Wai-man, chief executive officer of the Hong Kong Monetary Authority (HKMA), at the de facto central bank's office in Central on 10 June 2022. Photo: Xiaomei Chen alt=Eddie Yue Wai-man, chief executive officer of the Hong Kong Monetary Authority (HKMA), at the de facto central bank's office in Central on 10 June 2022. Photo: Xiaomei Chen>

"As the US continues to raise interest rates to tame the high inflation, Hong Kong will need to follow under the linked exchange rate system," HKMA's chief executive officer Eddie Yue Wai-man said during a press briefing. "With the expectation of further rate hikes, borrowers must be aware of the risks of [higher cost of funds] when they decide to invest in property, or other [assets].

Capital will also be expected to flow out of Hong Kong, as arbitrageurs engage in a so-called carry trade where they sell low-yielding assets (Hong Kong dollar) for higher-yielding instruments (US dollar).

The outflows are expected, in line with previous interest rate cycles, Yue said, adding that the Hong Kong government's HK$4.6 trillion (US$586.14 billion) Exchange Fund is well prepared to defend the city's currency.

"The Fed has increased the interest rate by 2.25 percentage points during the past four months, which is the same as the last rate rise cycle from 2015 and 2018," Yue said.

The pace of rising rates, coming harder and faster this cycle, will accelerate the outflow of capital, compelling the HKMA to intervene in the currency markets to preserve the local dollar within its trading band of 7.7500 and 7.8500 per US dollar.

"The aggregated balance [of HKMA's financial assets] may decrease more quickly in the current interest rate rise cycle, but there is no need to worry," he said. "The rate rise would not affect the banking system or bad debts as the HKMA has introduced measures to make sure mortgage borrowers have the ability to repay their loans even amid a rising rate environment."

Entrance of the Hong Kong Monetary Authority's office in Central on 27 October 2017. Photo: Nick Bevens alt=Entrance of the Hong Kong Monetary Authority's office in Central on 27 October 2017. Photo: Nick Bevens>

Hong Kong's benchmark Hang Seng stock index rose 0.4 per cent in recent trading, following a 437-point rise overnight in New York, as traders were relieved that monetary authorities eschewed the full percentage point increase.

All eyes are now on the city's commercial banks to see if they raise their prime rates to pass the higher cost of money to their best customers. The prime rate is currently kept at between 5 per cent and 5.25 per cent by five of the largest banks, left unchanged during the two previous rate hikes by the monetary authorities.

Still, higher prime rates may arrive in Hong Kong by September, said Tommy Ong, the managing director of T.O. & Associates Consultancy, as the cost of borrowing among local lenders, indicated by Hong Kong interbank offered rates or Hibor, has risen in recent weeks.

"The rising mortgage financing cost due to higher Hibor rates may discourage investors in rental properties," Ong said. "For the stock market, the Hong Kong market's reaction to a 0.75-percentage point hike will be muted. The market's focus probably is how well the China economy will perform in the second half."

The higher base rate has already pushed up the one-month Hibor to 1.19 per cent on Tuesday, a 10-fold increase from 0.14 per cent at the beginning of the year.

Long-term funding cost rose even higher, with three-month Hibor rising to a two-year high of 2 per cent on Tuesday, from 0.25 per cent at the start of 2022. The 12-month rate hit a three-year-high of 3.5 per cent, compared with 0.43 per cent in January.

The US interest rate rise has led to capital outflow from Hong Kong and forced the HKMA to intervene in the market 23 times this year, buying a total of HK$172.64 billion and selling US$21.99 billion, HKMA data showed. Previous high-water marks saw the authority buy HK$103.48 billion in 2018 and HK$22.13 billion in 2019.

"The increasing borrowing costs will hurt people with high debt, while savers will benefit, as deposit rates will rise from rock bottom," said Kenny Wen, head of investment strategy at KGI Asia, who expects commercial banks to increase their prime rates in September. "We now have around 3 per cent for US dollar savings, which is much higher than Hong Kong inflation rate."

This article originally appeared in the South China Morning Post (SCMP), the most authoritative voice reporting on China and Asia for more than a century. For more SCMP stories, please explore the SCMP app or visit the SCMP's Facebook and Twitter pages. Copyright © 2022 South China Morning Post Publishers Ltd. All rights reserved.

Copyright (c) 2022. South China Morning Post Publishers Ltd. All rights reserved.