Excess Liquidity And Interest Rates (2)

In my previous post I set out some of the effects of excess liquidity in Hong Kong's banking system and the consequential effect on interest rates for both depositors and lenders.

A related point is inflation. Interest rates have been traditionally viewed as being linked to inflation or, to be slightly more accurate, expected inflation. Lenders expect to receive a premium above the expected rate of inflation to ensure that they get a real return on their loan capital. In practice they do not always get this (especially after taxes and defaults are taken into account). The situation where a lender does not achieve a rate of return at least equal to the rate of inflation is known as negative real interest rates.

Inflation in Hong Kong is currently getting close to 3% per annumn. Deposit rates are generally less than this. For depositors, negative real interest rates are a reality. Depositors are losing money in real terms. For lenders we have not quite got back to the late 1980s and early-mid 1990s when interest rates for borrowers were less than the rate of inflation for an extended period of time. However, with mortage rates currently below 5% (my lowest loan is currently 4.6%) and inflation at 3%, the real cost of borrowing is very low.

I draw the following conclusions:

1. deposits are a bad investment. From a return on investment perspective, deposits are losing money in real terms, so why hold them?

2. the cost of borrowing is very low. So why should I be in a hurry to repay my loans?

The answer to both questions is that I shouldn't. I should not hold money on deposit and I should not be in a hurry to accelerate loan repayments. I suspect that the reason why most people hold money on deposit and try to repay loans as quickly as possible is risk aversion. Deposits are seen as being safe (but not from inflation) and debt is seen as being risky.

Of course, if I do not wish to hold money on deposit and am not going to repay my loans early it raises the question of what will I invest in and what risks am I taking in doing so?