Address
Mr. Sheng looks at asset prices, capital flows and risk management
given by the Deputy Chief Executive of the Hong Kong Monetary Authority, Mr. Andrew Sheng, at
the Asian Securities Analysts Federation Conference in Bangkok, on 17/11/97 (slightly abridged).
1. I am very honoured to be invited today to address this distinguished Conference.
The title of my paper is "Asset Prices, Capital Flows and Risk Management". All these factors have
been the main players in the recent market turbulence in the region. I will therefore focus my
discussion today on the lessons from the recent Asian market turmoil and also the impact on Hong
Kong.
The Surge in Capital Flows
2. In the past decade, capital flows surged within the Asian region and globally.
According to IMF statistics, average annual net capital inflows to developing countries exceeded
US$150 billion in 1990-96, and more than 40% of which actually came to Asia. In the last two years
we saw even more capital inflows to the region, recording a net total of US$107 billion in 1996 and a
similar growth rate in the first half of 1997. In some Asian economies, net inflows have averaged
5-8% of GDP over long periods, with over half of such capital flows in the form of foreign direct
investment.
3. The growth in international capital flows is the result of greater financial
liberalization and sophistication in markets around the world, the rise of institutional investors such
as mutual and pension funds, and growing financial innovation and intermediation, especially in
derivative products. We all know that capital movements help growth through a more global efficient
allocation of resources and bring new knowledge and technology to emerging economies.
4. On the other hand, international capital flows can be very volatile in nature, with
the tendency of reversing direction when there is the slightest hint of risk, whether it is in the conduct
of macroeconomic policies or concerns over the fragility of the financial sector. Capital flows now
drive the balance of payments more than trade flows. Portfolio shifts operate on the basis of market
expectations of risk, return and liquidity. A high level of arbitraging, such as the borrowing of funds
from one market to invest in another market, leads to contagion effects. Losses in one market
therefore result in sales in another. This is a risk that should be addressed not only by those who are
now under the process of capital liberalization, but also by the whole international community.
Global markets mean global contagion. This is no longer a uniquely Asian problem.
5. Let us now consider the recent Asian market turbulence in the global context. Until
recently, Asia enjoyed the benefits of the high global liquidity, and recorded admirable levels of
capital inflows, as driven by the high global liquidity in G-3 economies. Indeed, high global liquidity
is also the consequence of strong productivity growth, low inflation and improved government
savings, especially in the United States, which has resulted in the strongest growth in world trade in
decades.
6. With well-behaved inflation, the ample international liquidity has resulted in a
global stock market boom in the 1990s, in both Europe and the US, as well as emerging markets in
Latin America and Eastern Europe. But this has also caused a global compression of interest rate
spreads and record levels of new issuance in both domestic and international bond markets. Such
narrowing of spreads did not reflect the potential credit and market risks associated with the emerging
markets. So when investors finally realize that the emerging markets are carrying more risks than
they have assumed, the risk premium as measured by the yield spreads will widen sharply to reflect
this.
7. This scenario was complicated by the fact that the flood of global liquidity has been
largely channelled to the bond, equity and property markets of East Asia. Buoyed by optimism about
the Asian miracle growth of the last decade, both domestic and foreign investors committed the
classic "fallacy of composition". Initially, each individual may perceive a high return and increase
their investments in assets, leading in aggregate to excess demand and a market overshoot. A reversal
of perception leads to a sharp market correction, which is exactly what is happening not only in Asia,
but globally. As Chairman Greenspan said recently, "in retrospect, it is clear that more investment
monies flowed into these economies than could be profitably employed at modest risk".
8. The strong Asian growth would have continued but for the fact that global
competition in external trade has emerged with newly industrialized and export-oriented economies
with cheap labour, such as China, India, Latin American and Eastern Europe. The failure of central
planning has brought at least three billion new workers and consumers into the global market. These
new markets began to benefit from the growing trade liberalization and inflows of foreign
investments, thus putting greater pressure on the markets of the earlier "tigers" of East Asia, leading
to a widening of their current account deficits as they continued their investments in infrastructure
and real estate.
Issues in Asia
9. If we look more closely at the situation in Asia, the economic fundamentals remain
intact. Asia has been the fastest-growing region in the world, recording growth rates of around
5%-9%. Asian economies have low inflation rates and exchange rates were stable until recently.
Current account for the region as a whole is broadly in balance, while the fiscal account, excluding
Japan, is in surplus. Asia has exceptionally high savings rates of above 30% of GDP. Official
savings, in terms of foreign currency reserves, were even higher. In Asia, 70% of the inflows
contributed to reserve accumulation. As a result, Asian central banks are now holding about 40% of
the world's foreign exchange reserves. Five of the top six foreign exchange holders in the world are
now Asians.
10. The strong fundamentals -- a young, educated, flexible workforce, stable
government, good natural resources and communications infrastructure, openness to trade and
innovation, and high savings and investment rates -- these have not basically changed. Asia is still
outward-looking, with open markets and openness to technology and innovation. The aspirations of
Asia are also real: an entrepreneurial approach to innovation, competition and better standards of
living for the rising urban population. Where Asians have perhaps kept their eyes off the ball is the
need to develop the services sector in complementary step with the manufacturing or export sectors.
Delays in opening the financial sectors to global competition make them vulnerable to real sector
excesses or imbalances, such as the overconcentration of risks in certain areas, including the asset
markets.
11. The momentum of growth depends critically on continued vigorous trade reform,
fiscal prudence and improvements in finance, health and education policies. Increasingly, exports are
changing from labour-intensive industrial production, and more toward higher value-added industries
and services. This poses the challenge of sustaining productivity growth.
12. The Asian turmoil being a financial turmoil on the surface, let me focus on the
interesting way Asia recycles its surplus savings. As my colleague Joseph Yam has consistently
pointed out, a large portion of Asian foreign exchange reserves is invested in assets of the OECD
countries, which provides safe and liquid instruments. These funds return to the region in the form of
foreign direct investment and foreign portfolio investment. This global recycling also exposes Asian
economies to volatile portfolio adjustments due to policy mistakes or shifts in the international
economic environment. Currently, there are no deep, liquid and mature debt markets in Asia for the
intermediation process to function more efficiently. The process has begun in the last few years, and
with the building of better financial infrastructure, this round of turmoil should add greater impetus to
greater cooperation in building better regional financial intermediation.
13. As we all can see in hindsight, the risks involved in international capital flows are
exacerbated when short-term capital flows are all attracted to the asset markets. This has led to asset
bubbles, with all the painful consequences of asset price deflation.
14. But what is much more evident in Asia is that the process of hedging, arbitrage
and "carry trade", whereby arbitrageurs borrow in one market and invest in another market that offers
higher interest rates, has created both regional and global contagion. Portfolio shifts mean that when
asset prices change (and in this I would include: consumer prices, interest rates, exchange rates, debt
and equity prices and property prices) funds will flow in and out to follow the "law of one price".
This suggests that open economies must adjust to global prices. The speed of such adjustments is
only determined by the degree of openness of the domestic economy and financial markets. In other
words, whether we like it or not, we are being priced globally by the market.
15. Many of us have not fully appreciated the full logic of this. The financial turmoil
suggests that while the real sector causes of the stress is global competition, the financial effect is
stress on domestic banking systems, as the banks intermediate the global portfolio adjustments. In an
open economy, capital inflows will increase the deposit base of domestic banks which may be
channelled through credit mistakes into fuelling domestic asset price bubbles. There are two
implications. First, asset price inflation eventually feeds into domestic inflation and erodes external
competitiveness. Second, excessive lending concentration into less productive assets, either real
estate or over-investment in infrastructure and production capacity, exposes the financial institutions
to huge risks.
16. From the viewpoint of financial intermediation, there are three major risks in Asia
that underlie the shocks there:
First, maturity mismatch -- Asian markets made the mistake of borrowing short-term capital
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flows to finance illiquid non-tradables, such as property, thus exposing themselves to huge
liquidity needs when capital flows reversed.
• Second, currency mismatch -- corporations who borrowed foreign currency funds to finance
investments that do not generate sufficient foreign exchange to repay the debt run a currency
mismatch.
• Third, credit risk -- lending or investments ultimately must be against sound profits that generate
long-term returns higher than the borrowing rate or prospective dividends. Undue exuberance on
the part of investors, when price-earning ratios grow beyond fundamentals, or on the part of
bankers who failed to assess the impact of high interest rates on collateral or cash flows, would
expose both the investor and the lender to asset losses.
17. Specifically, banks in Asia, having easier access to funds as a result of high global
liquidity, were able to expand lending much more quickly and, thereby, incurred higher risks in their
portfolios that they need to manage more soundly. Ironically, domestic banks may have been induced
to move into more risky lending due to increased competition in the form of new entrants and
financial intermediation. There is no question that they need to manage these new risks better.
18. There is also one distinguishing feature of the Asian turmoil. The debt problems
have not been those of the public sector. On the contrary, the fiscal positions of Asian governments
have by and large been quite sound. East Asia, excluding Japan, ran a fiscal surplus of US$5.4 billion
or 0.1% of GDP in 1996. The debt burden, in fact, has been largely one of private sector
overborrowing. The resolution of the debt of the private sector makes the Asian problems quite
different from the experience of the sovereign debt issues of the 1980s.
19. In essence, the Asian problem is the age-old question of efficient resource
allocation. Asia has no shortage of funds, only that its high level of savings are invested in less liquid
long-term investments. Thus, one of the more pressing issues in Asia is to build a more competitive,
stable financial system and a robust infrastructure to facilitate efficient financial intermediation. The
better risk management of the financial system would also assist both corporations and investors to
manage also their risks better. Ultimately, a balanced and flexible economy with sound risk
management will then be in a better position to withstand global shocks and avoid crisis.
The need for national risk management
20. We are all aware of the complexities of risks in financial markets. Aside from
credit risks, market risks such as interest rate, exchange rate, legal risks, operational risks and
systemic risks all have to be managed, both at the micro level and at the macro level. All markets
suffer from the "fallacy of composition". Mistakes at the corporate or bank level will add up to
national mistakes, which now may add up to regional or international crisis through contagion.
Traditional risk management at corporate or sectoral level simply shift risks from one sector to
another. Risks still remain in the economy as a whole. Thus, increasingly in the 1980s, there emerged
the awareness that financial sector regulation was all about national risk management.
21. National risk management covers six major aspects:
• Credible policies, with monetary and fiscal policies consistent with each other, and applied
consistently.
Capital account liberalization should be phased appropriately.
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Sound fundamentals include a high domestic savings rate, sustainable fiscal and balance of
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payments positions, high foreign exchange reserves and prudent debt management.
• Good supervision involves the maintenance of solid capital adequacy and liquidity requirements
for the financial sector, as well as regular examination and monitoring of financial institutions and
markets. The banking system must have the capacity to avoid excessive credit concentrations and
risks, and to manage market risks well.
• A robust financial infrastructure would encompass an efficient payments and settlements system
for domestic and international transactions. In essence, the world is moving towards Real Time
Gross Settlement (RTGS) system, which support Delivery vs. Payment (DvP) and Payment vs.
Payment (PvP). RTGS reduces payment risks and allows central banks to monitor flows in
domestic currency as well as exposure of banks on a real time basis.
A non-distortive incentive structure, such as taxation or regulatory restrictions that would not
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encourage risk concentrations or excessive leverage in any economic sectors.
22. Put simply, managing national risks is equivalent to achieving three objectives.
First, lower national gearing, because leveraging adds risks, especially if this is leveraged from
external borrowing. The more you borrow abroad, the more you become vulnerable to external
shocks. Second, the higher the level of domestic savings, which should be reflected in higher bank
capital, lower credit/GDP ratio, and higher fiscal surpluses, the greater the resilience to the pain of
adjustment to external or internal shocks. Third, irrespective of the exchange rate regime, there must
be a commitment to a stable currency, and this means strong external reserves, low inflation and a
sound banking system.
Asset prices and the exchange rate regime
23. The Asian market turmoil also raises the question as to whether the exchange rate
regime matters. I believe the debate about whether the nominal exchange rate should be floating or
fixed misses the point in Asia. The real issue is the real effective exchange rate of the economy,
namely, its underlying productivity and global competitiveness.
24. For example, there is a mistaken perception that fixed exchange rates give rise to
asset bubbles. But if you look at the recent evidence of asset price bubbles in advanced economies,
asset price bubbles also occurred in the 1980s in countries with flexible exchange rates, such as
Japan, Scandinavia and the United Kingdom. Asset price appreciation cannot be tackled alone by
interest rates, since there are multiple reasons for such appreciation
25. In Asia, we can perhaps identify four main reasons:
• First, the Asian household has always looked upon house ownership not only as a social
necessity, but also as the best hedge against inflation.
Second, Asia is a young market, experiencing a high rate of urbanization. The strong demand for
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housing arising from demographics alone will fairly quickly eliminate excess capacity in many
economies.
• Third, housing supply constraints also gave rise to high housing costs. Examples are inadequate
supply of land, excessive tax burden on housing and construction, and inefficient urban planning
and approval procedures that delay market responses to the rising demand for housing.
Over-rapid liberalization of supply constraints were also one reason for the emergence of excess
supply.
• Fourth, the high global liquidity that appeared has improved access to funds, which resulted in
excessive exuberance on asset price inflation.
The Impact on Hong Kong
26. Amidst the recent attacks to the regional currency markets, no economy in Asia
has been totally immune, not least Hong Kong, despite the strong fundamentals.
27. If we identify the real issues in Asia as one of structural competitiveness in the
global economy, caused by shifts in global resources and rising productivity outside the region, then
structural adjustment must come through changes in either the internal price or the external price.
With a fixed exchange rate regime and therefore a fixed external price, such as in Hong Kong, the
adjustment comes through changes in the internal prices, especially the asset markets. In those
economies with floating exchange rates, there may be adjustment in both the internal and external
prices. This is exactly what is happening right now. Using the US dollar still as the benchmark
currency, it is very interesting to see that since the beginning of the year, the Hang Seng Index has
declined by 26% as of last Friday, Singapore Strait Times Index by 32%, the Nikkei 225 by 28% and
the other ASEAN indices by between 50-60%. Thus, markets adjust irrespective of the exchange rate
regime and the unit of account.
28. Is there any easy way of avoiding the pain of adjustment in Asia due to rising
global competition? The answer is clearly no. As a general rule, the faster we adjust, the less the pain.
There have been different approaches to this issue. There are some who think that a floating exchange
rate regime would cushion the pain, but many forget that Hong Kong has tried the floating exchange
rate regime before, in 1974-83. During that period, growth was more volatile and inflation much
higher than what we are experiencing now. As an open economy with trade accounting for 285% of
GDP, any inflation would be immediately imported under exchange rate volatility. The recent
experience in Asia actually shows that contrary to the theory, floating exchange rates requires even
higher interest rates, because of the higher risks associated with exchange rate volatility.
29. Here I would like to correct the common image that the Hong Kong's exchange
rate regime is a peg. The Hong Kong dollar is a fixed exchange rate, not a peg which can be adjusted
from time to time. The linked exchange rate system in Hong Kong operates as a currency board
system whereby the issue of Hong Kong dollar notes is fully backed by the US dollar at the fixed rate
of US$1 to HK$7.80. Such a note-issuing mechanism ensures that currency issued is fully backed by
foreign exchange. With the sustained budget surplus and accumulated surplus on the Exchange Fund
and Land Fund assets, the actual amount of foreign reserves in Hong Kong amounted to US$88.1
billion at the end of September, the third largest in the world. This is more than seven times Hong
Kong dollar cash in circulation or over three times HK$ M1.
30. The currency board system has an automatic adjustment mechanism to maintain
exchange rate stability. When there are outflows of funds from the Hong Kong dollar, the Hong
Kong Monetary Authority (HKMA) will sell US dollars to banks for Hong Kong dollar. On
settlement day, the HKMA will debit the clearing accounts of the banks for the necessary amounts of
Hong Kong dollars in return for the US dollar that will be credited to the New York accounts of the
same banks. Since banks may have sold more Hong Kong dollars than they have in their clearing
accounts with the HKMA, they can only obtain Hong Kong dollars by borrowing from other banks,
by bidding up the interbank rates, or selling back the US dollars to the HKMA, that is, by reversing
their short position. In fact, the banks do not hold excess Hong Kong dollars because they are
generally long in foreign currency. The latest data at the end of July shows that the Hong Kong
banking system is short roughly HK$33 billion or US$4 billion.
31. In addition to the robust currency board mechanism, the linked exchange rate
system is underpinned by some of the strongest fundamentals in Asia, if not the world:
• Growth is strong, at 5.5%.
Fiscal position has been consistently strong, with an average fiscal surplus averaging 2% of GDP
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for the past decade. Fiscal surplus in 1997 so far is 4.4% of GDP and is expected to exceed 5% of
GDP.
The government has no external debt.
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• Exchange Fund and Land Fund together have more than US$100 billion in assets.
• Corporate debt ratios are amongst the lowest in Asia.
• The external account is broadly in balance.
32. The free markets and strong fundamentals mean that the nature of the shock is
absorbable. Hong Kong does have a strong competitive edge, since we are a service economy with
83% in the services sector. As a major investor and integrator of production in the region, with
manufacturing concerns in China and Southeast Asia, Hong Kong companies could adjust production
to areas which have the greatest export competitiveness. In addition, the mainland Chinese economy
is still growing at 8-9% per annum, with low inflation, a balanced external account and strong
commitment to reforms in the enterprise and financial sectors. All these auger well for Hong Kong as
the main gateway to the Chinese market.
33. The current higher interest rates reflect somewhat a slightly higher risk premium
in Asia due to the currency turmoil. We do admit that the higher interest rates affected the stock
market and property market. But we should also remember that high interest rates are necessary to
cool the overheating in the asset markets that prevailed until recently. Given the excess demand
situation in Hong Kong as the economy grew by 6.4% in the second quarter, a correction was
expected. A moderation in property prices will help bring houses to more affordable levels to
homebuyers.
34. Higher interest rates will also bring down inflation, by encouraging savings. Once
inflation and the asset markets correct under the free market regime, Hong Kong will become much
more competitive. In real effective exchange rate terms, the competitive effect of neighbouring
depreciation will be offset somewhat by a rise in domestic inflation. Higher interest rates will also
bring the external account more in line with the fundamentals and improve the trade balance. Hong
Kong, as a free market economy, is adjusting exactly according to the textbook.
35. Moreover, our banking sector is very robust and strongly capitalized to withstand
any shocks. Operating profits of the local banks grew by about 18% in the first half of 1997 and the
bad debt charged fell in the first half of 1997 as the level of classified loans was 2.08%, down from
2.91% a year earlier. The capital adequacy ratios of local banks as a whole exceeds 17%. The average
loan-to-value ratio is 70%, with the actual measured loan-to-value ratio being 53.3%, according to
our survey at end September 1994. Therefore, HKMA's efforts to build a strong banking sector,
including the distribution of maturity risks through the mortgage corporation and the creation of an
efficient RTGS payment system are all necessary efforts to prevent an external shock from affecting
the banking system. In particular, the RTGS system allows the HKMA to monitor closely banks'
settlement transactions on a real time basis. Banks would also have to fund their settlements and
provide ample liquidity on a more prudent basis. All these are in line with our objective of making
the markets more efficient to enable the free market to clear aggregate supply and demand at an
equilibrium price quickly.
36. But we should always remember that there is no free lunch. The fixed exchange
rate regime implies a flexible economy to adjust to the exchange rate. Hong Kong has high flexibility,
attributable to a high savings rate, entrepreneurial spirit and high labour productivity. A fixed
exchange rate is a discipline on both the private and public sectors: the economy adjusts to the
exchange rate, not the other way around. We do not pretend to say that a fixed exchange rate is the
perfect system, because even the IMF admits that there is no perfect system. But it is the best system
for Hong Kong. The linked exchange rate system is here to stay.
Conclusion
37. As one of the contributors to the World Bank study on the Asian Miracle, I have
never considered the Asian growth story as a miracle. Paul Krugman called it perspiration, not
inspiration. Yes, it was the result of hard work, high savings, stable governments and good
aspirations. But no one can deny that Asian corporations rank amongst some of the most productive
and efficient in the world. Perhaps we were victims of our own success. Global capital inflows were
the most sincere form of flattery, and those of us who succumbed to the easy money have now
wakened to new challenges and risks.
38. Asia is now in a new growth league, with greater global competition. The
adjustments will not be easy, especially building stronger and more robust financial systems to handle
the new risks of globalization. There is a new realism in Asia, that however painful the adjustment,
we have to make the necessary changes. As competition intensifies at all levels, there can be no
reversal to the globalization, and we simply have to recognize that we live in one globe and we share
the same growing pains. I am confident that Asia's basic strength of flexibility, realism and pragmatic
policies will see the region through, with a little bit of help from the IMF. In the words of Mr. Michel
Camdessus, IMF Managing Director, what has happened is a blessing in disguise. Asia will emerge
stronger and more resilient, and it will continue to be a pillar of growth in the new global economy.