Hong Kong: Temporary Liquidity Measures, 2008

Following the collapse of Lehman Brothers on September 15, 2008, market participants increased their demand for Hong Kong dollars, which they saw as relatively safe as money markets tightened. Facing appreciating pressures on Hong Kong’s fixed exchange rate and shortages of HKD liquidity, the HKMA intervened directly in the forex market. After the HKMA first injected liquidity on September 18 through large purchases of US dollars, local interbank markets remained tight. A deposit run on the Bank of East Asia on September 25 further disrupted interbank lending (HKMA 2008h).

On September 30, the HKMA introduced five temporary liquidity measures, effective October 2, to improve banks’ access to liquidity (HKMA 2009d). These five measures were designed “to provide longer term funding for licensed banks against a wider-than-usual range of collateral” (HKMA 2008h). The first three measures amended the existing discount window while the fourth and fifth measures created new forex swap and discretionary term lending facilities. This case focuses on the enhanced discount window (measures 1-3) and the discretionary term lending facility (measure 5).

Under the Exchange Fund Ordinance, the Financial Secretary of Hong Kong has the right to set the policy objective for the HKMA. The Financial Secretary delegates to the HKMA the responsibility for achieving these objectives, “including determining the strategy, instrument and operational means for doing so” (Financial Secretary 2003). Since 1983, the overarching policy objective has been to peg the value of the HKD to the US dollar (USD). Under a currency board arrangement, the monetary base is fully backed by USD reserves. The HKMA utilizes its Exchange Fund “to maintain the stability and integrity of the monetary and financial systems of Hong Kong” (Legislative Council 1997). Provided that the HKMA honors the currency board arrangements, the HKMA has legal authority to administer emergency liquidity support to the banking system via the Exchange Fund when circumstances threaten the stability of the monetary or financial systems (HKMA 1999, 77).^FIn the currency board system, lender of last resort (LOLR) activities follow the convention that Hong Kong Dollar liquidity provision is “matched either by a decline in another component of the monetary base (i.e., the Exchange Fund paper) or an increase in US dollar assets” (HKMA 1999).

In addition to the temporary liquidity measures announced on September 30, the HKMA supported banks through intervening (passively and actively) in foreign exchange operations, supplying additional Exchange Fund paper (treasuries), lowering the Base Rate for calculating discount window borrowing costs, and allowing flexibility for capital adequacy requirements.

Foreign exchange operations: In the fourth quarter of 2008, appreciating pressures on the HKD triggered automatic exchange mechanisms^FHong Kong’s Linked Exchange Rate System uses the HKMA’s automatic stabilizers to ensure that the HKD stays within a convertibility zone of HKD 7.75 and HKD 7.85 to the USD (BIS 2019). whereby the HKMA passively sold a total of HKD 154 billion in exchange for USD (BIS 2019). Additionally, the HKMA manually intervened through foreign exchange operations by actively selling HKD against USD within the convertibility zone to ease HKD liquidity strains (HKMA 2008i).

Expansion of the Exchange Fund Bills Programme: The HKMA also issued a total of HKD 12 billion in additional^FThe HKMA on occasion paired the tap issue of Exchange Fund bills with the within-zone foreign exchange operations to partially offset the increase in the Aggregate Balance (HKMA 2009e).^,FSince banks use Exchange Fund paper as collateral in discount window and discretionary term loan borrowings, the issuance complemented the temporary measures rolled out on October 2. Exchange Fund Bills amidst increased demand for Exchange Fund paper that had driven yields below zero (HKMA 2009e; HKMA 2009j).

Base Rate Reduction: To further enable banks’ access to liquidity via the enhanced discount window, the HKMA revised the calculation of the Base Rate formula downward on October 8, 2008. Effective on October 9, the downward revision lowered the Base Rate calculation’s 1.5% premium over the Federal Funds Target Rate to 0.5%. Coupled with US Federal Funds rate cuts over the quarter, the Base Rate, which determines the discount window fees, declined from 3% at the beginning of October to 0.5% by year end (HKMA 2009e).

Flexible capital adequacy ratio: The HKMA also lifted the 8% statutory minimum capital adequacy ratio applied to all locally incorporated banks on November 21, 2008, to ease lending conditions in the interbank market (Legislative Council 2008b).

Along with HKMA’s efforts to promote confidence in the banking system, the Financial Secretary introduced two new measures on October 14: (1) the Contingent Bank Capital Facility^FThe Contingent Bank Capital Facility provided an opportunity for banks to receive capital injections via the Exchange Fund (HKMA 2008h). and (2) 100% deposit protection to all licensed banks.^FPrior to the full guarantee, the Exchange Fund covered up to HKD 100,000 per depositor at licensed banks (Legislative Council 2008a).

For both the enhanced discount window and the discretionary term lending facility, the HKMA provided liquidity after banks filed requests to the HKMA’s dealing room that were approved upon confirmation of requisite documentation and securities for repurchase agreements (repos). The eligible participants for the five temporary measures, all licensed banks, maintained Real Time Gross Settlement (RTGS) accounts with the Exchange Fund (HKMA 2008d). The RTGS is the interbank payment system whereby licensed banks hold clearing accounts with the HKMA (HKMA 2008i). Through the RTGS, the HKMA provided liquidity to the clearing accounts of these banks, increasing the Aggregate Balance. While RTGS facilitated currency transfers, the HKMA used the Central Money Markers Unit payment system to manage the collateral side of the liquidity transactions (HKMA 2009c).

Consistent with the LOLR arrangements and the existing monetary policy framework, the HKMA operated and supervised the new measures for liquidity provision (HKMA 2009c). For the enhanced discount window, the HKMA reserved the right to obtain additional information from banks “to reduce possible abuse” of discount window borrowings (HKMA 2008d).

The HKMA supervises a three-tier banking system, which, in 2008, consisted of 145 licensed banks, 27 restricted license banks (generally merchant banks), and 28 deposit-taking companies with a limited scope, collectively termed “authorized institutions” (HKMA 2008f). Licensed banks, the eligible participants for liquidity assistance, represent most of the financial activity among authorized institutions, providing 97% of the loans and receiving 99% of deposits in 2008 (HKMA 2008i).

In a Legislative Council panel on November 21, 2008, the Chief Executive of the HKMA, Joseph Yam, provided additional information about the types of licensed banks receiving most of the liquidity assistance from the new measures. Yam noted that liquidity to date was “mainly targeted at Hong Kong branches of foreign banks without a deposit base in Hong Kong and also local banks” (Legislative Council 2008b). At the time, 122 of the 145 licensed banks were foreign, domiciled outside of Hong Kong (HKMA 2008i).

As noted previously, the HKMA must conduct monetary policy consistent with the Currency Board Rule, which requires at least 100% backing of the monetary base with US dollars (HKMA 2008a). Hong Kong relies on its Exchange Fund to maintain credibility in adhering to this currency board arrangement. The Exchange Fund is a large portfolio of Hong Kong’s foreign reserve assets used to affect the exchange rate of the local currency (BIS 2019).

The HKMA generally makes discount window lending available on an unlimited basis, and the temporary enhancements did not change this. There was also no indication of a limit to the availability of credit through the discretionary term lending facility. The HKMA did, however, stipulate an HKD 20 million minimum transaction size for term discount window repos (HKMA 2008d).

The liquidity provided through the discount window totaled HKD 8.4 billion for the six months that the enhanced facility and revised Base Rate were effective. Utilization of the discount window predominantly occurred in the first month (October 2008) and on the final day (March 31, 2009) of the period. Discount window borrowings totaled HKD 5.6 billion in October, HKD 2.6 billion on the last day of March, and only HKD 0.1 billion in the almost five intervening months (HKMA 2009g; API 2007–2009; HKMA 2009f).

The Exchange Fund’s Currency Board Sub-Committee also reported the number of banks using the discount window and the corresponding frequency in two periods, September 20 through November 20, 2008 (the first period) and November 21, 2008, through March 30, 2009 (the second period). In the first period, nine banks used the facility once, while two borrowed on three occasions (HKMA 2009e); in the second period, which excludes March 31, only four banks accessed the facility (HKMA 2009f). In both periods, HKMA noted that Exchange Fund paper was the sole instrument used as collateral.

Included in Figure 3 for context are the total discount window borrowings from the prior and following six-month periods.

When the liquidity facilities were introduced, the HKMA did not explicitly mention a participation limit for individual banks.

Although not explicitly linked to the liquidity arrangements in 2008, the HKMA’s 1999 policy statement on its LOLR framework established precedent for limits to potential borrowings from the enhanced discount window and discretionary term lending facility. The statement set a limit on liquidity support per institution between “100% to 200% of the capital base…subject to a cap of HKD 10 billion” and conditional upon meeting a minimal capital adequacy ratio of 6% (HKMA 1999). To lend in excess of 200% of a bank’s capital, the HKMA would need approval from the Financial Secretary (Carse 2008). On March 26, 2009, the HKMA slightly revised the policy statement on LOLR arrangements, days before the expiration of the five temporary liquidity measures, which raised the cap to HKD 25 billion per bank (HKMA 2009c). To additionally limit moral hazard, the HKMA emphasized its discretion to lend less than the maximum amount for which an institution may qualify (HKMA 1999).

The enhanced discount window repo operations added a 0.25% fee on top of the Base Rate for pricing overnight funding (HKMA 2008d). Before the October 8 revision, the calculation for the Base Rate was the US Federal Funds Target Rate (FFTR) plus 1.5%. On October 8, the HKMA revised the Base Rate calculation down to the FFTR plus 0.5% (HKMA 2009e).

The Base Rate plus 0.25% applied equally to all eligible collateral. Consequently, the price at which banks borrowed from the discount window against collateral declined further with the Base Rate revision introduced October 9, 2008 (HKMA 2008b).

The fourth measure, forex swaps, were priced according to market rates (HKMA 2008d). The HKMA initially priced the fifth measure, the discretionary term lending facility, according to market interest rates; however, it announced on November 6, 2008, that it had discretion to charge a below-market rate, since such lending was secured by collateral (HKMA 2008i).

The enhanced discount window expanded eligible collateral for discount window credit from Exchange Fund paper to include US Treasuries. Exchange Fund paper collateral, like US Treasuries, included bills and notes of various maturities. In the same announcement, the HKMA noted that it would “keep the list of US-dollar assets of credit quality acceptable to the discount window under review” and “consider refining it if necessary” (HKMA 2008d). The HKMA did not add to the list of eligible collateral during the term of the enhanced discount window’s operations. A schedule for haircuts on the Exchange Fund paper and US Treasury collateral is outlined in Figure 4.

Source: HKMA 2008d.

Like the enhanced discount window, the discretionary term lending facility also accepted Exchange Fund paper and US Treasuries for collateral using the same haircut schedule. The HKMA also noted in the statement that eligible collateral under the discretionary lending facility may include “other assets of acceptable quality to the HKMA” (HKMA 2008d). In the 1999 LOLR statement, the HKMA specified other eligible collateral for LOLR repo as investment-grade securities with minimum ratings listed in Figure 5; such securities did not qualify for discount window collateral, which remained confined to Exchange Fund paper unless otherwise noted (HKMA 1999).

Source: HKMA 1999.

These investment-grade securities established precedent for the eligible collateral at the discretionary term lending facility. At the time of the 1999 statement, “other investment grade securities” were separated from those “eligible for rediscount at the Discount Window” (HKMA 1999). The “other investment grade securities” were subject to a minimum haircut of 10%, but the actual haircut applied would reference “factors including the [maturity], the quality of the security and actual terms of the repo arrangement” (HKMA 1999).

When the five temporary measures expired, the HKMA formally adopted the forex swap and discretionary term lending facilities as standing liquidity instruments (HKMA 2009b). In the March 26, 2009, updated LOLR statement, the HKMA retained this minimum haircut for other investment-grade collateral and used an almost identical table to identify the minimum acceptable rating for such discretionary term lending collateral, given in Figure 6 (HKMA 2009c).

Source: HKMA 2009c.

The enhanced discount window permitted banks to request loans with one- and three-month maturities, in addition to overnight (HKMA 2008d). Similarly, the foreign exchange swap facility offered loans with a maximum maturity of three months. The discretionary term lending facility initially offered a maximum term of up to one month but was extended to three months on November 6, 2008 (HKMA 2008e).

Other than as discussed elsewhere in this case, we did not identify any other conditions that applied to the lending under the enhanced discount window, discretionary term lending, and swap facilities.

In its initial announcement, the HKMA emphasized that the temporary liquidity measures would conform to the currency board arrangement, ensuring full backing of the monetary base with US dollar assets. Since these liquidity measures could temporarily increase the Aggregate Balance, the HKMA noted that it would conduct sterilizing measures, if necessary, to offset corresponding expansions in the monetary base (HKMA 2008a).

When compared to HKMA’s forex operations, the enhanced discount window and new liquidity facilities were significantly smaller in the scale of liquidity injections. From mid-September to the end of December 2008, the Aggregate Balance increased from around HKD 4.7 billion to HKD 158 billion; during this period the HKMA sold HKD 182.8 billion in forex injections, while the liquidity provided through the temporary measures peaked at a modest HKD 11.4 billion (HKMA 2008i).

In November 2009, the significant increase in the monetary base, through the expansion of the Aggregate Balance, required a transfer of US dollar assets from the Investment Portfolio to the Backing Portfolio as the backing ratio^FThe backing ratio is defined as ratio of Backing Assets (highly liquid USD securities) to Hong Kong’s monetary base (HKMA 2008i; BIS 2019). hit its lower trigger at 105% for the first time ever (HKMA 2009h).

The HKMA heavily relied on foreign exchange operations in both passive and active forms, detailed in Key Design Decision No. 3, Part of a Package, to aid efforts in providing liquidity to the interbank market.

The three enhancements to the discount window and introduction of two new liquidity facilities (forex swap and discretionary term lending) were all deployed together as one unique program. The subsequent Base Rate reduction also played in important role to facilitate discount window borrowing. Without reducing the entire program down to individual measures, it is hard to find cross-country comparisons.

The HKMA announced the five temporary measures in a press release on September 30, 2008, which included a technical annex detailing the mechanics of the new liquidity provisions (HKMA 2008c). The HKMA subsequently issued a press release on October 8, announcing the Base Rate reduction effective the following day, lowering the discount window borrowing costs (HKMA 2008b). These two announcements appeared to have immediate impacts on short-term interbank interest rates (Fung and Yu 2009).

The only apparent change to these measures was also detailed in a press release on November 6th, 2008. In that press release, the HKMA refined the fifth measure, allowing three-month term loans and scope for below-market rates (HKMA 2008e).

When the program was first introduced, the HKMA explained that although it had provided ample liquidity injections through foreign exchange intervention, the temporary measures would “further mobilise liquidity in a targeted manner to banks that may find themselves in need” (HKMA 2008a). The HKMA also emphasized that the liquidity measures would be temporary in nature, lasting only six months through the end of March 2009 (HKMA 2008c). According to the HKMA, the pre-defined length of the program would help limit moral hazard— “so that individual banks would not become overly dependent on the specially arranged liquidity facilities and undesirable business behaviour would not be promoted” (HKMA 2009a).

In a December 2008 report that included an assessment of Hong Kong’s crisis response, the IMF staff commended financial authorities’ swift announcement of crisis response measures, particularly in regard to their “effective communication strategy to reassure investors and clearly explain the rationale behind each new policy step” (IMF 2008).

The HKMA notifies the public quickly following monetary-policy actions through press releases and daily reports of monetary figures. For that reason, the Bank for International Settlements has said that the HKMA operates with a “high degree of transparency” (BIS 2019). In this case, the HKMA reported the borrowing activity from the enhanced discount window and discretionary term lending facility in aggregate amounts that included other credit instruments, making it difficult to determine the size of the temporary operations.

When the five measures were introduced, the HKMA noted its intention to announce any changes in the Aggregate Balance corresponding to the temporary liquidity measures through standard publication channels (HKMA 2008c). This included daily publications of interbank liquidity on HKMA’s Reuters pages. However, in these releases, HKMA did not explicitly distinguish the liquidity provided through the temporary liquidity measures from other traditional instruments (HKMA 2008d). Reports from the Currency Board Sub-Committee, published twice over the temporary liquidity program’s six-month duration, provided additional information on discount window activity. These two reports detailed the total number of banks segmented by frequency of discount window visits; the figures anonymized the banks and only presented the aggregate borrowings over the periods (HKMA 2009f).

While the HKMA did not mention a stigma strategy in its discussions of the temporary liquidity measures, the utilization of the discount window during the duration of the enhanced measures may indicate that stigma perception was not a factor in banks’ borrowing activity. Unlike the U.S., discount-window lending in Hong Kong occurs more frequently, and the HKMA does not discuss stigma concerns often. The HKMA’s note that banks disproportionately used the discretionary term lending and swap facilities rather than the enhanced discount window terms may indicate other deciding factors such as collateral flexibility or pricing (HKMA 2009b). Nevertheless, the HKMA’s aggregate reporting of loans provided through the enhanced discount window and discretionary term lending facility makes it difficult to determine the quantity and frequency of borrowings from these facilities.

On March 26, 2009, the HKMA announced that it had decided to allow the enhanced discount window lending to expire as previously announced (HKMA 2009b). It reverted to its normal function, accepting only Exchange Fund paper as collateral for overnight liquidity “so as to safeguard exchange rate stability under the Currency Board system” (HKMA 2009c). As for the Base Rate revisions set to expire at the end of March, the HKMA reinstated the HIBOR leg of the calculation while making permanent “the narrower 50-basis point spread over the federal funds target rate… compared with the previous spread of 150 basis points” (HKMA 2009b).

The HKMA also announced that it would continue to offer a forex lending and a discretionary term lending facility as standing facilities after the temporary measures expired on March 31, 2009. In announcing the decision to permanently incorporate the discretionary term lending and forex swap facilities into its liquidity framework, the HKMA noted that the “utilisation of the five temporary measures [were] mainly confined to the fourth and fifth measures” (HKMA 2009b).