HONG KONG FOLLOWS US INTEREST RATE CUT

The Chamber's Chief Economist, Ian K Perkin, comments on the Hong Kong Association of Bank's "unsurprising" decision on April 20 to follow the "surprise" 0.5 per cent cut in US short term interest rates, announced on April 18.

The US central bank, The Federal Reserve Board, lowered short-term interest rates by another 0.5 per cent on Wednesday (April 18) and the Hong Kong Association of Banks announced Friday (April 20) that it would follow the US cut from Monday (April 23).

The move from the Association of Banks resulted in the local deposit rate being cut to 2.75 per cent from 3.25 per cent and the best lending rate offered by the banks to 7.5 per cent from 8 per cent. But with deflation running at 2 per cent, the local real prime rate is still 9.5 per cent.

The US rate cut, the fourth since the beginning of the year, all of which have been followed in Hong Kong, came as a surprise to financial markets, as it was the second time this year that the Federal Reserve had lowered rates between meetings of its Open Market Committee.

The immediate response to the rate cut was positive for the US markets, with a big increase in US share prices across-the-board and an instant lowering of interest rates on short dated US bonds, although longer term bond rates remained fairly steady.

There was also some volatility of the US dollar against other major currencies as foreign exchange markets reacted to the unexpected news of the short-term interest rate cut.

Once there has been greater reflection on the Federal Reserve's latest move, however, there is likely to be some concern develop over whether the latest cut signals that the US economy has slowed, and is slowing, much faster than had previously been apparent.

The question is really one of whether the central bank was stampeded into another cut between its official meetings to consider short-term interest rates because it was worried that the US economy was slipping more determinedly into recession.

For Hong Kong it was inevitable that the US interest rate cut would be followed locally. With the local currency tied directly to the US dollar peg, local interest rates cannot get too far out of line with those in the US without risking substantial capital movements.

For the Hong Kong, too, the rate cut is mostly positive. This was shown in the equity markets as they responded to the rate cut with an instant rise. Hong Kong also needs the further cut to help stimulate the local economy, both in terms of consumption and the residential property market.

In other words, the monetary policy needs of both the US and the SAR are back in sync, with both needing the potential stimulus that lower interest rates and looser money should bring.

If the US rate cut does, however, mean that the US central bank is worried about the prospect of a recession in the US, it is not a positive sign for Hong Kong, China, or the entire Asian region for that matter. The US is still the major market of final demand for goods out of Asia.

A further US slow down, especially in terms of consumer spending, would certainly not be in the SAR's best interest, as it would be likely to have a negative impact on external trade, particularly the important re-export business out of the Mainland.

In its statement announcing the latest interest rate cut, the US Federal Reserve again expressed concern that the available economic evidence suggested the US economy was inclined towards further weakness rather than the resumption of stronger growth.

It also appeared to hint that a further rate cut might be forthcoming at its next Open Market Committee meeting in late May.

In any further move to lower rates, however, the Federal Reserve may have to weigh more heavily the prospect that they could (a) fuel future inflation (b) possibly cause some weakening in the US dollar exchange rate and (c) worsen the already large US external deficit.

In its statement overnight on April 18 (April 19 Hong Kong time), the Federal Reserve said:

"The Federal Open Market Committee (FOMC) decided today to lower its target for the federal funds rate by 50 basis points (0.5 per cent) to 4-1/2 percent. In a related action, the Board of Governors approved a 50 basis point (0.5 per cent) reduction in the discount rate to 4 percent."

Commenting on economic conditions, it added: "The FOMC has reviewed prospects for the economy in light of the information that has become available since its March meeting.

"A significant reduction in excess inventories seems well advanced. Consumption and housing expenditures have held up reasonably well, though activity in these areas has flattened recently. Although measured productivity probably weakened in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact.

"Nonetheless, capital investment has continued to soften and the persistent erosion in current and expected profitability, in combination with rising uncertainty about the business outlook, seems poised to dampen capital spending going forward.

"This potential restraint, together with the possible effects of earlier reductions in equity wealth on consumption and the risk of slower growth abroad, threatens to keep the pace of economic activity unacceptably weak.

"As a consequence, the Committee agreed that an adjustment in the stance of policy is warranted during this extended inter-meeting period.

"The Committee continues to believe that against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are weighted mainly toward conditions that may generate economic weakness in the foreseeable future. "

For further information, contact Ian K Perkin on 2823-1242.