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The world is moving forward in two different ways. On the one hand we have developed nations such as the U.S., Europe, and Japan. They're mired by deflationary forces and sluggish growth. Their central banks are trying to keep interest rates extremely low in a bit to stave off outright deflation, and to stimulate their economies.

On the other hand we have rapidly developing nations such as Brazil, China, and India. Deflation and slow growth isn't their problem, inflation and economic overheating is. As such their central banks are trying to cool their economies and need tighter, rather than looser, monetary policy.

Yet ultimately the world economy's key structural distortion lies in the pegged exchange rate between the Chinese yuan and U.S. dollar. This peg binds China to U.S. monetary policy, and unfortunately America's deflation-fighting monetary policy is completely unsuited to China's rapidly growing economy.

Thus these two currency-linked economies are pulling in opposition directions, and caught in the very middle is Hong Kong. Hong Kong represents the point of maximum distortion for the economic mismatch described above, since its economy is feeding off of China's rapid growth, yet it is even more tightly bound to U.S. monetary policy than mainland China.

It's thus no surprise that business for Hong Kong banks is booming. Goldman's Roy Ramos highlights the HK lending surge below (click to enlarge):


Why the surge?

As bank lending restrictions are tightened on the mainland, Hong Kong banks offer an alternative funding source for Chinese businesses. Moreover, these businesses are incentivized to borrow in Hong Kong dollars since most expect the mainland China's yuan to be hiked in the future, which would make their Hong Kong dollar-based loans suddenly cheaper. In addition, Hong Kong takes its interest rates from the U.S. basically, and thus Hong Kong borrowing rates are lower than on the mainland.

Goldman:

The fourth relates to lower (c.250-400bp) nominal borrowing costs in HK$/US$ (1.37% for a 3-mo HIBOR + 100p loan) versus Rmb (c.5% for a short-term loan), on top of our ECS view of no US (and therefore HK) rate hikes in 2010 and for the most part of 2011, again making it advantageous for both HK and China borrowers to borrow in HK$ or US$.

Net-net, and this isn't necessarily Goldman's view (it's our own at least) -- Watch business soar for HK banks going forward as the U.S. remains beset by deflationary forces while China fights off inflation and potential economic overheating. Hong Kong banks are the focal point for arbitrage of the economic distortion that is the yuan-dollar peg.

(Via Goldman Sachs, Loan surge/back to growth, Roy Ramos, 18 June 2010)

Disclosure: No positions

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Source: American Deflation, Chinese Inflation Stoke the Ultimate Hong Kong Arbitrage