How Do Macroeconomic Developments in Mainland China Affect Hong Kong's Short-term Interest Rates?

This paper studies the significance of Mainland-related shocks in determining Hong Kong money market interest rates after controlling for the influences of US variables. Analysis using a vector auto-regression model suggests that an unexpected rise in the Mainland policy interest rate, or a higher-than-expected growth in Mainland output or money supply, in general produces a positive and hump-shaped effect on the three-month HIBOR. Forecast error variance decomposition shows that US shocks still dominate, but Mainland shocks have become more important in accounting for the unexpected fluctuations in HIBOR in recent years. A historical decomposition shows that from autumn 2003 to spring 2005 the large negative spread between HIBOR and LIBOR was mainly due to Mainland factors. Thus, while the HIBOR-LIBOR spread is expected to be bounded inside a band that reflects the width of the Convertibility Zone of the Linked Exchange Rate system, Mainland-related shocks could exert a significant influence on the actual size of the spread.