What we know about what’s going on in Hong Kong is limited. That’s a real shame because I have no doubt what has been transpiring is important for a lot more than Hong Kong and the short run. The connections are too obvious for it to run any other way.

I’ve been asked several times to diagram or further explain what I think is happening. There’s just no way to do so, no matter how much anyone might want to. I certainly do, believe me. Information is at best highly limited, and more likely than not the transactions will never come to light.

Despite these limitations, there is enough evidence in price movements and rates to sketch out some rough contours. Keeping more toward general rather than specific ideas, we can reach reasonable conclusions as to the overriding nature of the issue.

It’s almost like astrophysics, where physicists detect massive objects not by observing them directly, rather by spotting the effect they have on other objects that can be observed. Mass means gravity, and gravity means distortions that can be studied, measured, and better understood.

If we start with a simple banking premise of a fractional reserve system, the mess in HKD money markets (HIBOR) can only be a true outlier.

If we assume a Bank A (pictured above) with a stylized balance sheet, confronted with rising money rates Bank A would prefer to mobilize excess reserves to satisfy the demand. The reason they would do so is profit; that is, the expected additional interest for other considerations including risk (which in this setting, especially HKD, should be low, perhaps close to nil).

Thus, what will happen is excess reserves will be exchanged with (unseen) Bank C for its purposes. The effect on Bank A’s balance sheet is a higher balance of deposit liabilities corresponding to the increase in loan assets, in this case interbank loans.

That raises the possibility of one constraint, or bottleneck. If Bank A held no excess reserves on its balance sheet, it would be unable on its own to meet Bank C’s demand for money. If we assume Bank C is in demand for reasons of risk (liquidity or credit), meaning Bank A can borrow interbank funds at a rate Bank C cannot, then Bank A would itself, all else equal, borrow in interbank markets to redistribute to Bank C at a risk-adjusted spread.