China's Reserves - Hong Kong's Part in Their Downfall

Between the end of August 2014 and the end of June 2015 China’s foreign exchange reserves fell by US$275bn.  Where did the money go?  Probably more than half of it was accounted for loans being repaid to Hong Kong’s banking system: latest data shows that Hong Kong’s net lending to China fell by US$91bn between September 2014 and April 2015.   The huge inflow of Hong Kong bank lending, which saw loans to China rise from a low of US$122bn in September 2012 to a high of US$342bn in March 2014, went sharply into reverse just as the US dollar began to strengthen in the second half of 2014.

Part of the reason for this withdrawal is doubtless a change in perception of risk as the dollar strengthened.  But heightened risk aversion is not the only story: Hong Kong’s own liquidity situation has been sufficiently compromised that retrieving capital from the mainland was almost certainly a commercial necessity.

The reason is that Hong Kong is no longer generating the private sector savings surpluses which historically  have funded the build-up of net foreign assets in Hong Kong’s banking system.  Whilst a savings surplus results in the private sector piling cashflow into the banking system, which by definition can only be invested in government debt or foreign assets.  By contrast, a savings deficit results in cash flow from the banking system back to the private sector, with the banks able to generate the cash only by selling government or foreign assets. 

In 4Q14, Hong Kong generated a private sector savings deficit of HK$56.4bn, equivalent to 9.2% of GDP, and this was followed by a HK$47bn deficit in 1Q15, equivalent to 8.2% of GDP. Now, Hong Kong’s private sector savings position is highly seasonal, with large deficits usually seen in 4Q, usually recovering to an offsetting surplus in 3Q.  However, the deficits of 4Q14 and 1Q15 were big enough to leave the 12m position as a modest deficit of 1.5% of GDP.    

The trade and government budget deficit/surplus for April-June are now in, so we can see the extent to which the underlying savings situation is developing.  Hong Kong’s reported a June budget deficit of HK$11.3bn, bringing the fiscal balance for 2Q  to a deficit of HK$15.92n, equivalent to an estimated 2.8% of GDP. Meanwhile, with June’s trade balance showing a deficit of HK$45.8bn, the 2Q deficit came to a deficit of HK$115.4bn, which implies a 2Q current account balance of approximately HK$8.4bn.  

Taken together, this suggests that Hong Kong produced a private sector savings surplus of HK$24.4bn, equivalent to 4.4% of GDP. This represents something of a recovery, as it compares with a 2% surplus in 2Q14, and a 8.2% deficit in 1Q15. However, on a 12m basis, the SAR is still running on a modest private sector savings deficit (equivalent to about 0.9% of GDP). Whilst this is hardly disastrous for Hong Kong itself, and implies little in the way of currency pressure or interest rate premiums to the dollar, it does mean that the now ‘normal’ conditions for Hong Kong is that it no longer produces a savings surplus that can  be re-invested in the mainland. Rather, Hong Kong’s underlying savings balances require that it sells down a modest portion of its accumulated foreign assets, which effectively means repatriated capital from the mainland. Hong Kong, in other words, is no longer a net source of capital for China in its own right, but rather is one of the factors generating capital outflow from China