Journal Issue

People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues

International Monetary Fund
Published Date:
January 2018
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Impact of Fed Tightening on Capital Flows in Hong Kong SAR1

Historically, Fed rate hikes have been associated with capital outflows from emerging markets. A strengthening U.S. dollar and widening interest rate differentials between the U.S. and domestic economies have encouraged capital outflows. This paper examines the drivers of capital flows in Hong Kong SAR and finds that growth differentials between Hong Kong SAR and the U.S. as well as relative asset price performance matter the most. While Fed rate hikes and interest rate differentials between Hong Kong SAR and the U.S. have an effect on capital flows, the impact is limited. In addition, as a large financial center, the abundance of global liquidity and swings in risk appetite – which both support local asset prices and enable Hong Kong SAR’s role as a financial intermediary – also drive capital movements in and out of Hong Kong SAR. While many external factors that affect Hong Kong SAR are outside of its control, a robust, flexible domestic economy can serve as a bulwark against sharp swings in capital flows and help contain the attendant impact on domestic financial markets. In particular, a flexible price and wage system, combined with robust supervisory and regulatory infrastructure that ensures financial stability, can provide buffers against volatile capital movements.

A. Introduction

1. As the Federal Reserve begins to normalize U.S. interest rates and unwind its portfolio holdings accumulated during Quantitative Easing, there is renewed focus on the potential impact of increased U.S. rates on capital flows to and from Hong Kong SAR. As a small, open economy, with a peg to the U.S. dollar, Hong Kong SAR imports the U.S. monetary stance, with changes in the Fed Funds rate affecting domestic financial conditions, and by extension, domestic interest rates and capital flows. This paper assesses the drivers of capital flows into Hong Kong SAR, including the extent to which movements in the Fed Funds target affect flows. Both “push” and “pull” factors are considered. In addition, in line with work from Forbes and Warnock (2011), we consider both net and gross flows. The paper also considers whether the current rate hike cycle might be different, reflecting the possibility that tapering from the high-liquidity, low-interest rate environment since the GFC could be different from past episodes. The key takeaways are as follows:

  • In line with recent literature, the results suggest that capital flows in Hong Kong SAR are affected by a confluence of factors, most importantly, relative asset performance, growth differentials, global risk aversion, and global liquidity.
  • The policy implications of these results are several. First, both push and pull factors matter for capital flows. This means that while external – push – factors, including changes in the Fed funds rate, global risk appetite and global liquidity, are outside of Hong Kong SAR’s control, domestic – pull – factors such as domestic growth prospects and related policies are important in supporting inflows and bolstering financial stability. Second, against this context and as suggested by the results, a robust, flexible economic system remains the best bulwark against volatility from capital fluctuations.

2. The paper is organized as follows. We outline the behavior of different financial flow components over the past three Fed rate hike cycles since 1999. Our observation spans the four quarters before and after the first Fed rate increase in a cycle. We find no discernable patterns across different asset and liability components of financial flows (Section II); this finding suggests that factors other than interest rate movements might dominate. We then identify the different push and pull factors and discuss the empirical strategy (Section III). Section IV concludes.

B. Overview of Capital Flow Patterns During Past Fed Rate Hikes

3. On net, capital flows into Hong Kong SAR have been dominated by portfolio outflows and deposit inflows (see text charts on net capital flows and net other investment flows2). Moreover, direct investment into Hong Kong SAR has increased in recent years, likely attributable to the booming housing market and associated inflows, though data related to the source of such investments are not available. Another notable feature of capital flows is the sizable swings in the years immediately post GFC. At a time when risk aversion reached multi-decade highs (the VIX index reached its record high in late March 2009), both inflows and outflows increased. While Hong Kong SAR residents accumulated sizable portfolio assets, non-residents also placed a large volume of deposits in Hong Kong SAR.

4. Capital movements during Fed rate hike cycles have been varied. Although Hong Kong SAR saw net capital outflows during the most recent 2015 rate hikes, it had seen net positive inflows during previous cycles (text chart on net capital flows during Fed rate hikes). Past episodes indicated that Hong Kong SAR growth and exports rose in the periods post Fed rate hikes. This suggests that any increases in interest rates – and the corresponding tightening in financial conditions – were offset by stronger U.S. growth and the associated positive spillovers to Hong Kong SAR.3

5. The current rate hike cycle may be different from others, as evidenced by the movements in net deposits and loans. Both net loan and deposit outflows picked up since mid-2016, the first time since 2008 with net acquisition of loans and deposits offshore, though the magnitude remains modest. Anecdotal evidence suggests that robust growth in the Mainland likely played a role in recent outflows. Indeed, Hong Kong SAR banks’ exposure to Mainland entities rose since mid-2016, with total exposure to Mainland non-bank corporates at about 200 percent of GDP as of 2017Q1. Also, widening interest rate differentials between the U.S. and Hong Kong SAR suggests that the opportunity cost of keeping cash in Hong Kong SAR has increased in recent months. The current interest rate spread between the 3-month Libor and Hibor is about 60 basis points, near its widest level since the GFC (though still narrow historically).

Figure 1.Hong Kong SAR: Net other investment flows

(percent of GDP, 4Qma)

Source: CEIC; staff calculations.

Figure 2.Capital Flows in Hong Kong SAR

Sources: CEIC Data Co. Ltd.; and IMF staff calculations.

Direct Investment

6. Direct investment tends to increase post Fed rate hikes. The direction of these flows suggests that factors other than interest rate differentials might be driving direct investment. Studies suggest that improving U.S. growth during rate hikes and the positive spillover to Hong Kong SAR likely dominated.4 Moreover, a recent survey indicated that a favorable and simple tax system, security and political stability, free flow of information, corruption-free government and rule of law are the five most important factors attracting investments into Hong Kong SAR (BIS Papers No. 44). Interestingly, direct investments abroad also increased on average, likely boosted by positive prospects elsewhere, including higher U.S. growth. Moreover, direct investments, compared to other investments such as portfolio flows, tend to have longer investment horizons and are therefore less affected by changes in financial conditions that can be frequent and volatile. On net, our analysis finds that global risk aversion is the most significant driver affecting direct investments in Hong Kong SAR (Appendix, table 1). Not surprisingly, increases in risk aversion are associated with large declines in direct investments in Hong Kong SAR.

Direct Investment - Assets

(percent of GDP)

Source: CEIC Data Co. Ltd.; and IMF staff calculations.

Direct Investment - Liabilities

(percent of GDP)

Portfolio Investments

7. There were no discernable patterns to portfolio flows in response to Fed rate hikes. Equity and debt investments have mostly remained positive, regardless of rate movements. Moreover, the absolute amount of portfolio assets has increased in recent years. These developments likely reflect Hong Kong SAR’s role as a fund-raising center for Mainland firms. CPIS data indicated that Hong Kong SAR residents’ equity investment in China rose more than 33-fold between 2001 to 2015 to HKD 1.5 trillion. By contrast, non-residents’ holdings of Hong Kong SAR debt and equities have mostly declined post Fed rate hikes. Such behavior is in line with the general trend of net portfolio outflows (as indicated by the chart on net capital flows). A tightening un financial conditions in Hong Kong SAR, coupled with stronger U.S. growth, likely dampened portfolio inflows.

Portfolio Investment - Equity Liabilities

(percent of GDP)

Portfolio Investment - Debt Liabilities

(percent of GDP)

Portfolio Investment - Equity Assets

(percent of GDP)

Portfolio Investment - Debt Assets

(percent of GDP)

8. Financial derivative flows – both into and out of Hong Kong SAR– tend to increase following Fed rate hikes, with investors taking offsetting positions to hedge against potential losses (e.g. selling foreign assets to protect against possible losses in foreign holdings). This is likely related to the need to adjust portfolio exposures and to hedge against higher U.S. rates and the corresponding fluctuations in currencies.

Other investments

9. These “residual” items, mostly in the form of loans and deposits, have been large and volatile. While Hong Kong SAR residents reduced their deposit accumulation offshore post the Fed rate hike in 2004, they increased these assets in 1999 and during the current cycle. The fact that Fed rate hikes have not decisively pulled deposits out of Hong Kong suggests other factors play a greater role; we discuss these in Section III. Another notable feature is the changing pattern of loan asset and liability accumulation in recent years. While Hong Kong SAR residents have lent more following the 2015 rate hike, reflecting in part increased lending to Mainland firms, non-residents have lent less to Hong Kong SAR over the same period.

C. Drivers of Capital Flows In and Out Of Hong Kong SAR

Empirical Strategy

10. Empirical analysis considers the impact of “push” and “pull” factors in driving capital flows;

The left hand-side, Yt, represents the ratio of flows relative to Hong Kong SAR’s nominal GDP. The right-hand side consists of variables representing domestic (pull) or external (push) factors as widely used in literature. The push factors consist of changes in the Fed funds target, global risk aversion, as proxied by the VIX index and global liquidity, proxied by the annual growth rate of M2 in G7 countries.5 Domestic “pull” factors include the growth differential relative to the U.S., differences in the real exchange rates, interest rate differentials for 3-month rates as well as differences in equity market returns between these two economies. We consider quarterly observations (from March 1999 to March 2017) from balance of payment statistics, focusing primarily on financial flows as they represent the bulk of cross-border flows in Hong Kong SAR. We excluded observations from the Asian Financial Crisis and the two years – 2007 and 2008 – that spanned the Great Financial Crisis in our baseline analysis.6 In a separate robustness check, we included all observations; the results are qualitatively the same.

11. Before discussing the findings, we note a few important caveats in our analysis. We recognize that capital flows react to macroeconomic conditions, investment considerations and swings in market sentiment. Interpreting these results as a causal link between capital flows and growth, currency movements, risk sentiment as well as global liquidity warrants caution. To mitigate some of these concerns, a different robustness test used lagged domestic pull variables to minimize the problem of reverse causality. This test finds similar results on the impact of currency differentials, equity returns and external “push” factors such as global liquidity and risk aversion. The notable difference is the role of interest rate differentials; in contrast to findings from the baseline model, Hibor--Libor spreads do affect equity portfolio and deposit flows into Hong Kong SAR, though the degrees of sensitivity are limited.


12. Push/Pull factors: On net, cyclical factors such as growth differentials, equity and currency differentials matter for financial flows, though the magnitude of impact differs according to types of flows. Surprisingly, interest rate differentials do not have a significant impact on overall capital flows while changes in the Fed funds target only has a limited impact on debt portfolio flows. This finding is in line with equity performance in the last two rate hike cycles, with the Hang Seng Index rising following Fed rate hikes (and was generally far more volatile than the S&P). Hang Seng’s performance suggests that more fundamental drivers, including corporate profitability and a positive growth outlook, likely played a bigger role in asset performance. These results underscore the fact Hong Kong SAR is not an emerging market; factors that typically buffet flows into EMs have limited impact on Hong Kong SAR.

We discuss notable results in more detail below:

  • Interest rate differentials do not have a significant impact on financial flows in the baseline analysis. This is in line with a number of recent findings.7 Under the Hong Kong SAR’s Linked Exchange Rate System, domestic interest rates adjust and counteract the impact from the original capital movements. That said, an alternative test where domestic conditions – including interest rate differentials – are regressed on a lagged basis finds that interest rate differentials have a statistically significant, though limited, impact on portfolio and deposit flows (Appendix Table 2). The muted response to interest rate differentials relative to currency differentials (bullet below) could be a result of the close interplay between changes in interest rates and movements in the Hong Kong dollar. It appears that the currency impact outweighs the interest rate impact when the two factors are considered together. Moreover, recent record-low interest rates could have also dampened the overall impact of interest rates on capital flows. Although the 3-month Hibor has risen sizably since 2016, it remains low by historical standards – it had risen to around 0.75 percent by mid-October 2017. Domestic liquidity has remained ample – the Monetary Base is well over HKD 1 trillion, significantly higher than in the years before the GFC. Against this context, the pace of interest rate increase – and associated capital flows – are likely to be modest. It is possible that as rates rise in the future, the role of interest rate differentials could begin to have a larger impact on capital flows.
  • Currency differentials. Movements in the Hong Kong dollar relative to the U.S. dollar in real terms are highly correlated with both inflows and outflows. We find that a one percentage point increase in the pace of HKD appreciation relative to the USD is associated with net financial inflows into Hong Kong SAR by about 1.8 percentage points (see “Currency Differential” text chart below). Specifically, such HKD appreciation is correlated with an increase in the pace of financial inflows by more than 7 percentage points, while the pace of outflows slowed, by 5.6 percentage points. Specific responses are more nuanced: a strong Hong Kong dollar pulls capital into Hong Kong SAR, including deposits, but loan growth also tends to fall, likely due to the fact that a stronger HKD at loan maturity would have lowered the return on those loans extended to Hong Kong SAR residents.
  • Growth differentials. High growth in Hong Kong SAR relative to the U.S. also has a significant impact on net inflows. In general, a one percentage increase in Hong Kong SAR’s growth differential relative to the U.S. boosts net deposits in Hong Kong SAR by about 3.5 percentage points of GDP. Generally, growth differentials have a similar impact on capital flows as currency differentials. This is not surprising. All else equal, capital flows gravitate towards markets that offer higher returns, such as those with better growth expectations.

13. Push factors:

  • Risk aversion. The model finds that global risk aversion dampens direct investments while boosting deposit inflows into Hong Kong SAR. The sensitivity to increases in global risk aversion is relatively high: a one percentage point increase in VIX lowers gross direct investment into Hong Kong SAR by 18.7 percentage points, while boosting gross deposit inflows by more than 29 percentage points. These sizable flows are not surprising. As a global financial center, financial flows into Hong Kong SAR are high and volatile, susceptible to changes in risk sentiment. Net direct investments swung between +39 percent and -5 percent of GDP since 2011 and for net portfolio investments, movements were flat to -45 percent of GDP over the same period. Movements in gross flows can be several times larger. To the extent that deposits are seen as a safe and liquid asset, heightened risk aversion could increase inflows into these assets while curtailing direct investment – which includes items such as significant real estate transactions.
  • Global liquidity. An increase in G7 M2 is associated with large swings in capital flows in and out of Hong Kong SAR. The definition of “global liquidity” warrants some discussion in this analysis, particularly for a global financial center such as Hong Kong SAR. In general, “global liquidity” is loosely defined as financial conditions that facilitate access to international funding. Drivers of global liquidity include policies, risk appetite and bank leverage. These drivers are transmitted through bank funding – typically shadow credit or “noncore” funding as well as cross-border bank and portfolio flows. Their cumulative impact can be seen in credit growth and asset prices of local economies (IMF, 2014). As there is no one accepted indicator of “non-core” funding, we focus on M2s – “core” funding that banks draw on during normal times.8 Since core does not include inter-bank deposits and the endogenous liquidity created through financial innovation, it does not capture leverage created in the financial system and much of the attendant increase in liquidity that could flow to an open financial system such as Hong Kong SAR.9 The response of capital flows in this analysis, therefore, reflects sensitivity to changes in G7 policy rates as well as central bank liquidity support. We find that increases in core funding in G7 is associated with increases in deposit flows into Hong Kong SAR, likely reflecting search for higher return but safe and liquid investments found in Hong Kong SAR. At the same time, this increase in G7 M2s is associated with a decline in loans lent to Hong Kong SAR residents; this could reflect the more dominant impact of deposit inflows. Others factors, including the possibility that such flows took place during periods of strengthening HK dollar, could have also dampened loan inflow (Appendix table 1).

Figure 3.Impact on Net Capital Flows

(percent of GDP)

Source: IMF staff calculations.

Note: The Y-axis represents coefficients of selected indicators where the underlying regressions explain the extent to which flows are a function of these variables, as outlined in the Appendix. Shapes that are filled are statistically signficiant at least at the 10% level. Unfilled boxes are not statistically significant.

D. Implications on Monetary and Financial Stability

14. Hong Kong SAR remains sensitive to changes in global financial conditions. Global risk appetite and global liquidity play a significant role in capital flows into Hong Kong SAR; these factors are beyond Hong Kong’s control. That said, findings here also suggest that fundamental, domestic drivers, including growth differentials and domestic asset performance, could also affect capital flows into Hong Kong SAR. Hong Kong SAR’s long-standing price and wage flexibility, for example, has been found to have a positive correlation with growth (Guo, 2017). These results underscore the crucial role economic policies play in bolstering financial stability and the buffer that strong, resilient growth can provide against volatile capital movements.

Appendix I. Regression Results
Net Financial Account Flows (Share of GDP) – Excluding AFC and GFC

TotalDirect InvestmentPorfolio-EqutiesPorfolio -DebtFinancial DerivativesOther Investments -DepositsOther Investments -Loans
Interest rate differential0.016







Change In Fed Fund rate target-0.000







Currency differential1.848***







Equity return differential0.3191***







Global risk aversion






32 672***


Growth differential-0.789







Global liquidity















Number of observations65656565656565
Standard errors in parenthesis*** p<0.01, ** p<0.05. *<0.1
Standard errors in parenthesis*** p<0.01, ** p<0.05. *<0.1
Net Financial Account Flows (Share of GDP) – Excluding AFC and GFC; Lagged Variable

TotalDirect InvestmentPorfolio-EqutiesPorfolio -DebtFinancial DerivativesOther Investments -DepositsOther Investments -Loans
Interest rate differential








Change in Fed Fund rate target-0.014







Currency differential


0 115

-2 394**





Equity return differential








Global risk aversion








Growth differential








Global liquidity















Number of observations64646464646464
Standard errors, in parenthesis*** p<0.01, ** p<0.05, *<0.1
Standard errors, in parenthesis*** p<0.01, ** p<0.05, *<0.1

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Prepared by Sally Chen, with research assistance from Daniel Law


Other investment flows are mostly deposits and loans.


IMF (2014) “Fed’s Tapering and Implications on Hong Kong SAR” IMF Country Report No. 14/132




There is no one definition of “global liquidity”. The common measure of “global liquidity” involves both quantity and price-based indicators that assesses the “ease of funding” at a particular point in time (IMF 2014). In our analysis, global liquidity captures “core” funding – traditional monetary aggregates – and ignores the role of “non-core” funding, which is more affected by the shadow banking system. We chose a quantity-based core measure as price-based indicators and the shadow system are captured by other variables such as VIX and interest rates in our analysis.


Consistent with HK-SAR Census and Statistics Department’s practice, a positive value indicates financial inflow (liability) while a negative value indicates outflow (asset investment). Net positions are therefore the sum of assets (debit entries) and liabilities (credit entries).


Non-core liabilities can be calculated from aggregate liabilities of securities (other than shares) and loans. A detailed measure of shadow banking computed by the New York Fed on U.S. shadow credit is one such measure. However, such disaggregated measure across different credit instruments is not available in other major economies, preventing the construction of a consolidated measure of global non-core liquidity.


Core, though occasionally move in tandem with non-core, can also behave different from non-core. Prior to the GFC, core funding across the major economies was flat, while noncore liquidity rose, as financial institutions relied increasingly on endogenous “money” creation to fund their expansion. Once the crisis struck, noncore funding contracted, and core funding partially filled the gap—reflecting the exceptional policy support during the crisis—provided by central bank liquidity injections (Chen et al., 2012). It is important to note that a decline in core funding growth does not necessarily correspond to increases in noncore funding. For example, currently, while major central banks have begun to normalize rates and trim accommodation, regulatory tightening since the GFC has also contained the growth of noncore funding in major economies.

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