Andy Xie (Hong Kong)
Liquidity Boom Fuels the Stock Market
The Hang Seng Index has surged since the US Federal Reserve cut interest rates in September 1998. The index is now up around 100% from the bottom and is only 20% off the all-time high reached just before the Asian crisis. Some large index stocks have made new highs. In the short term, the average valuation of financial assets is driven by liquidity, while the relative valuation is based on fundamentals. Hong Kong is clearly enjoying a liquidity boom.
A rapidly falling loan-deposit ratio (LDR) is the best indicator of a liquidity boom; the LDR has been declining precipitously since January 1998, having fallen 15 percentage points over the period. A falling LDR pushes up the stock market in two ways: (1) banks cut interest rates as they need fewer funds, and (2) banks buy more liquid paper, pushing funds into the equity market.
The tight correlation between the Hang Seng Index and the LDR broke down between May and September 1998 as a weakening yen and the Russian crisis reduced the relative demand for risk assets. The rapid surge in the index since September appears to be a catch-up with the liquidity situation as demand for risky assets has reverted to the level prior to the yen's weakness.
Negative Loan Growth Fuels Liquidity Boom
The excess liquidity is mainly a function of negative loan growth as deposits continue to rise moderately. Hong Kong dollar deposits are still rising despite the sharp contraction in nominal GDP, for three reasons. First, the savings rate has risen in the aftermath of the financial crisis in 1997. Second, the Hong Kong government swapped part of its foreign exchange reserves for Hong Kong stocks, and some of this money has been kept in Hong Kong dollars. Third, the government is funding its budget deficit by reducing its foreign exchange reserves, which adds about HK$3.5-4.0 billion to the money supply every month. These factors, however, are still insufficient to cause the rapid surge in liquidity.
The negative loan growth, therefore, is the key to the current liquidity boom. In a deflationary environment, banks are less willing to lend and they put a higher premium on collateral visibility. This is why banks prefer to lend to the property and financial sectors. Hong Kong dollar loans are down 3% from the year-ago level while Hong Kong dollar deposits are up 9%. The difference implies additional liquidity of HK$160 billion, or 12% of GDP.
Can the Liquidity Boom Last?
As investment demand is still weak in view of the deflationary environment, fund-raising through the stock market has so far been limited. At the same time, however, the government continues to add liquidity as a result of the budget deficit. This suggests that liquidity can remain at the current level for the remainder of the year. We maintain our forecast that the prime rate will be cut by a further 50 bps to 8% by year-end.
Can the liquidity level rise further? There could be more liquidity if depositors switch their foreign currency deposits into Hong Kong dollars. Hong Kong dollar deposits now account for 55.5% of total deposits compared with 58.2% at the peak in June 1997. If this share reverts to the peak level, it would add a further HK$80 billion to the liquidity pool, increasing the level of liquidity by a further 50%.
Will Hong Kong depositors switch into local currency deposits? This decision obviously depends on sentiment, which the government and property developers are managing remarkably well. Such a scenario is possible but not likely, given the relatively negative outlook for income.
Asset prices are volatile under a fixed exchange rate regime because the change in relative asset demand is not buffered by currency movements. Hong Kong's asset prices are even more volatile because depositors can amplify the volatility by shifting between foreign currency and Hong Kong dollar deposits. The large share of foreign currency deposits and the peg hugely exaggerate asset price volatility.
Can the Stock Market Revive the Economy?
Hong Kong's economy is bottoming: retail sales are stabilizing at around HK$15 billion a month; tourist arrival numbers have recovered from the post-handover crash. In the second half of 1999, Hong Kong will probably experience a statistical rebound, which is likely to turn many people bullish on the economic outlook. However, a decline in trade and anti-corruption measures in China are eroding Hong Kong's external income, preventing the territory from experiencing a quick rebound.
This situation could change if asset prices rise enough to generate a sufficient wealth effect to reflate the economy. Hong Kong has the potential to achieve this if depositors switch sufficient money into Hong Kong dollars. Foreign currency deposits are currently large enough to sustain such an economy for several years.
When asset inflation pushes the economy into inflation, this is an indicator that the wealth effect has generated sufficient demand. To achieve inflation, aggregate demand needs to rise by 8%, the current output gap. To achieve 8% of GDP in demand from the wealth effect, household wealth would have to rise by 160% of GDP, if we assume a 5% wealth effect. The household sector probably owns 30% of the stock market and has achieved a wealth increase of about 50% of GDP since the market bottomed. However, the stock market is not large enough to generate much additional wealth. Property prices would have to rise by around 30% to achieve this.
This scenario is possible but not likely. It could happen if the government continues to talk up property prices. However, it is difficult to see why the government would want to create a bigger problem for itself. Hong Kong does have sufficient foreign assets of its own to create an asset market boom again, but without real fundamental support from an upturn in China, it is difficult to imagine that people in Hong Kong would believe in and act on such a scenario.
Good Economy May Drive Down the Liquidity-Driven Market
If Hong Kong's economy does recover strongly at some point, banks would start lending again and liquidity would be reduced. The loan-deposit ratio would rise. This would probably lead to a market correction. We do not anticipate such a scenario within the next 12 months.
The weak economy is now a necessary condition for a buoyant stock market. When the economy recovers and deflation shifts to inflation as a result, the stock market would likely be weak for some time, unless Hong Kong's external income from China trade increases again.
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