Monday, December 31, 2007

Negative Real Interest Rates

Among the week's worth of mail that was waiting for us when we returned from our Christmas holiday were notices of changes in interest rates on two of our mortgages. The new rates are 3.95% and 4.00%. Given that these are all tax deductible (at an admittedly low rate), this means that the cost of borrowing is very close to the most recent official inflation rate of 3.4%. In effect, the real cost of borrowing money in Hong Kong is approaching zero.

Looking at the issue from a different perspective, if you put money on deposit the interest rates at most banks will range from zero (for small amounts on call) to close to 3% (for large (HK$1.0 million +) 12 month deposits). There is no tax on interest in Hong Kong. In effect, putting money on deposit is a losing proposition. Every day that you leave money sitting on deposit, the real value of that deposit is declining by more than the interest that is being earned.

If you believe that the true rate of inflation is higher than the official rate (which it probably is) then the position is even better for borrowers or worse for depositors. There are widespread expectations of further interest rate cuts in 2008. At the same time most of the forecasts for the inflation rate are in the range of 3-3.5% (I have seen at least one forecast for inflation to rise to 5% in 2009). If these forecasts turn out to be accurate, then the real cost of leaving money on deposit will increase and the real cost of borrowing will shift from mildly positive to mildly negative.

The implication is that it is better to be a borrower than a lender/depositor.

Of course there is no such thing as a free lunch. Borrowing money carries risk. Money that is borrowed has to be invested somewhere that will show a better nominal return than the nominal cost of funds. If the investment fails to generate the required return or loses money then material damage to your wealth can result. My own view (and practice) is that it is better to take the risk of borrowing in moderation than accept the certainty of wealth erosion that comes with leaving money on deposit.

When you take the reality of negative real interest rates and add the huge build up of deposits in the Hong Kong banking system, it is hard not to be at least reasonably optimistic about investing in Hong Kong (credit crisis notwithstanding).

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