FINANCIAL AND MONETARY AFFAIRS
lower than the yields at the beginning of the year. The average spread between 10- year Exchange Fund Notes and 10-year US Treasuries in the last quarter of 1998 also narrowed to 238 bps as compared with an average of 374 bps in the first nine-months of the year.
The overall exchange value of the Hong Kong dollar, as measured by the trade- weighted Effective Exchange Rate Index (EERI), is predominantly affected by the exchange rate of the US dollar vis-à-vis other major currencies. The US dollar strengthened against the Deutschmark and the Japanese Yen in the first half of the year. Coupled with a stable Renminbi, the EERI of the Hong Kong dollar rose to 140.2 in mid-June. As the US dollar gradually weakened in the second half of the year, the EERI fell to 131.8 at the end of the year, compared with 138.1 at the beginning of 1998.
On the back of the sluggish economic activity, the sharp correction in asset markets and a scaling down in operation of some foreign banks in Asia, deposit and credit expansion remained subdued in the first half of 1998. During this period, total deposits only grew by 1.7 per cent, of which Hong Kong dollar and foreign currency deposits increased by 1.3 per cent and 2.3 per cent respectively. Total loans and advances contracted by 12.8 per cent, with domestic loans falling by 1.4 per cent. To ease the credit tightening, the government introduced several measures to improve the liquidity of the banking system. In June, the government exempted interest income derived from deposits placed in Hong Kong from profits tax. As the tax incentive for placing deposits offshore fell away, some funds were repatriated back to the Hong Kong banking system. The HKMA also repatriated some of its overseas deposits to Hong Kong and placed them with banks in Hong Kong. Secondly, the HKMC introduced the Forward Commitment Facility in late May and committed to purchase $15 billion of mortgages from the banks within the next 12 months. This facility has provided banks with greater certainty on the amount of loans they could sell to the HKMC within the specified period, thus giving them assurance about the availability of liquidity and helping them to plan their new loan business more effectively. Moreover, the HKMA kick-started the development of the Hong Kong dollar repo market to relieve banks' concerns over counterparty credit risks and facilitate interbank lending, especially at the longer end.
Partly aided by these developments, the growth of deposits accelerated since late June. In the second half of the year, total deposits increased by 9 per cent, taking the annual growth to 10.9 per cent. Both Hong Kong dollar and foreign currency deposits increased by about 9.6 per cent and 12.6 per cent respectively. The share of Hong Kong dollar deposits to total deposits slightly decline from 57.7 per cent at end-1997 to 57 per cent at the end of 1998. Despite signs of acceleration in deposits growth, lending activities remained subsided in the second half of the year. For the year as a whole, total loans and advances fell by 19.8 per cent. Of these, offshore loans recorded the most significant decline of 36.7 per cent, mainly attributable to a contraction in Euro-yen Impact Loans. These are loans made to customers in Japan by a domestic branch of a Japanese bank but booked in an overseas branch of the bank. Domestic loans also saw a modest decline of 5.5 per cent in 1998. Since Hong Kong dollar deposits rose but Hong Kong dollar loans fell during the year, the Hong Kong dollar loan-to-deposit ratio of the banking system decreased significantly from 113.3 at end-1997 to 100.6 at the end of 1998.