Mr Latter gives an overview of the current monetary policy stance of Hong Kong
Address by Mr Tony Latter, a Deputy Chief Executive of the Hong Kong Monetary Authority,
at the CLSA Investors' Forum in Hong Kong on 17 May 1999.
I should like to say a few words about the present stance of monetary policy in Hong Kong
and its relation to the broader state of the economy.
Hong Kong has a fixed exchange rate against the US dollar. The pros and cons continue to be
a focus of debate in some quarters, but I don't intend to dig over that ground yet again today.
Suffice it to say that over the past fifteen years Hong Kong has enjoyed, on balance,
remarkable prosperity. I happen to think that the visible and trusted monetary discipline of the
exchange rate link has been a decisive contributory factor to that prosperity.
Of course, one cannot deny that there is some association between the strength of the
exchange rate and the level of interest rates on the one hand, and the current recession on the
other, but I would caution against adopting too short-term a horizon when drawing
conclusions, and I would also suggest that some of the adjustment which we have experienced
- for example in property prices - was both necessary and somewhat overdue. Perhaps I should
also add that the Hong Kong dollar's stability after the depreciations of other regional
currencies in 1997 probably helped to avert what might have been a spiral of further
depreciations, which could have caused greater damage in the region and might even have had
more painful eventual consequences for Hong Kong itself than we have in fact suffered.
Slide 21 shows the path of the real effective exchange rate since mid-1997. This is the
tradeweighted exchange rate adjusted for differences in movements of consumer price indices. It is
one of several possible measures - none of them ideal - of external competitiveness. A
movement up the page denotes a loss of competitiveness. The steep loss around the time of
the Asian crisis in late-1997 has been partly recovered. The setback in the earlier part of this
year arose mainly from the strength of the US dollar.
But let's look at this question in a longer-term perspective. Slide 3 shows that in the 131⁄2
years from the introduction of the linked exchange rate up to mid-1997 the real rate
appreciated on average by 4% a year; in the period since then the real appreciation has
averaged 41⁄2% a year.
On this basis one might say that we are scarcely off track at all, from what appears to have
been a secular trend of real appreciation of the currency. But others might argue that the
structural changes of the eighties and nineties which were consistent with an appreciating real
rate because of much more rapid productivity gains in the tradable than in the non-tradable
sectors, cannot be repeated, so that the assumption of a continuing secular uptrend is invalid.
On that view, the net appreciation over the past couple of years may be deemed to have
dragged us away from our preferred path.
It is hard to judge where the proper balance of these views lies. I recall how, 15-20 years ago,
the doom merchants were prophesying the end of Hong Kong's long run of growth because
we were rapidly losing competitiveness in much of manufacturing. Presumably they did not
foresee the remarkable extent to which the service sector would develop as an alternative
wealth-generating lynchpin of the economy. Now, the next generation of doom merchants is
prophesying imminent disaster as competitiveness in certain parts of the service sector appears
to have been eroded. Will they be wrong again? Have they failed to appreciate the true
workings of the market economy and comparative advantage? Do they not realise how
difficult it is to foretell exactly how an economy will evolve, even though the evolution is
taking place right under our noses? Indeed, as we sit here worrying about it, there are people
out there who are busy exploiting niches and opportunities which will mould the future
structure of the economy. We can try to facilitate that process, or even to guide particular
aspects which we reasonably expect to be important (eg the cyberport), but there will always
be surprises.
In any analysis of competitiveness there is inevitably scope for argument about the
appropriateness of the statistics one is using. I believe that in the current Hong Kong
conjuncture the popular measures such as the real exchange rate may have been lagging
somewhat behind the recovery of competitiveness that may have actually occurred. Business
decisions are influenced more by marginal prices and expectations of future prices, than by
prevailing average prices; yet the measure of rentals which enters the CPI is typically based on
an average of outstanding contracts and not the price at which new contracts are being struck
which have over the past year or so fallen much more steeply. Thus, when thinking of
business decisions, even assuming that residential rentals are a satisfactory proxy for rental
costs affecting business, some adjustment for the marginal/average discrepancy may be
needed at times when that discrepancy is significant - as it certainly is when one is at or near
turning points in the rental cycle. Please be assured that I am not criticising the construction of
the CPI, which is, so far as I am able to judge, absolutely appropriate in terms of arriving at an
overall cost-of-living index, but I do suggest that some qualifications may be needed if it is to
be used in other analysis, such as that of business decisions which we are discussing here.
Let me turn now to interest rates. Real rates have been high, at least as measured on the
backward-looking basis in slide 4 (ie nominal rates less recorded inflation over the preceding
twelve months). This is the arithmetic result of nominal rates which are very much dictated by
US rates and recent deflation of prices in Hong Kong. US rates are being held up in part by
the extremely buoyant US economy, and you will see from slide 6 that the Hong Kong
economy is out of phase with the US, on the downside, to a greater extent than at any time
since our exchange rate link was established. The only comparable divergence was in the
1980s, and that was on the upside, when we experienced - in complete contrast to today
uncomfortably rapid inflation and negative real interest rates.
But tight monetary policy is being balanced by a more relaxed fiscal stance (slide 7), as
defined by the size of the budget balance relative to GDP. This is a reversal of the more
common position in Hong Kong of relatively loose monetary and tight fiscal policy. The chart
confirms that historically, as one might expect, there has generally been an offsetting balance
of these two policy components.
I think, nevertheless, that there is a tendency to exaggerate the tightness of monetary policy at
the present time. This happens because of too simplistic an approach to measuring real
interest rates and assessing their influence. I can best illustrate this by reference to the
illustration in slide 8. As at April last year, 12-month HIBOR was 8.0%. Looking back over
the preceding 12 months (ie April 1997 to April 1998), inflation had been 4.7%, so at that
time (April 1998) the commonplace measure of the real interest rate would have yielded 3.3%.
A more sophisticated method would have been to take the forecast for inflation over the
coming year (April 1998 to April 1999), which was then 4.2% (I have based this on an
interpolation from the annual figures from the consensus of private sector forecasters at that
time), yielding a somewhat lower real rate of 3.8%. But that forecast of inflation turned out to
be wildly wrong; the actual outturn for the 12 months April 1998 to April 1999 was minus
2.6%, which means that the real rate actually realised, and thus experienced by someone
borrowing or lending for twelve months at HIBOR, was, on the CPI basis, 10.6%. On top of
that, the marginal/average adjustment for rentals to which I referred earlier would have tended
to raise the realised real rate even further, because the prices influencing business decisions
probably fell by more than the CPI. In sum, what started as a headline real rate of 3.3% ended
up as a rate well in excess of 101⁄2%. Businesses would have been affected by the factors
responsible for the difference between these figures, but would not have been able to
anticipate all of them.
If we move on to April this year, the position is rather different. The backward-looking real
rate, which tends to be the one which most people take as their guide when clamouring about
oppressive monetary policy, is indeed high at 8.9% - again taking 12-month HIBOR as the
base. But because expectations are that prices are now going to move up rather than down, the
forward-looking measure, based on consensus forecasts (from the private sector) of what the
published CPI will show, yields much less, 5.6%. In addition, the marginal/average
adjustment may now have turned the corner, since business decision-takers may be facing
prices that will rise by more than the recorded CPI, in which case real interest rates will now
be perceived as lower than 5.6%. Perceptions may still be of a figure which is above the 3-4%
range, which is often regarded as a global norm; but perceptions vary, and there may be some
who visualise a lower figure. We are of course not yet in a position to observe the actual
outcome; there may, as last year, be surprises in store. My examples have been based on
12month HIBOR; there may, of course, be benchmarks higher or lower than this reference point
which are more relevant to individual decisions.
I hope that I have succeeded in demonstrating that the measurement of real interest rates is
rather more complex than may appear at first sight, and is dependent also on the context.
If you were to look at only the popular measure of the real rate - the nominal rate deflated by
a measure of past inflation - then the recovery in asset prices in Hong Kong over recent
months would seem inexplicable, because real rates would have appeared so high. The
recovery in asset prices would, however, be consistent with a reduction in perceived real rates
- which is in fact what I am suggesting has occurred, on a fairly significant scale, as
expectations of inflation have probably become positive while headline recorded inflation
remains negative. For those who see some downside in all of this from the implication in the
consensus forecasts that general inflation is now expected to resume, it is worth noting that
the forecast magnitude is only very modest.
I would not pretend that every piece of evidence unequivocally supports my thesis today. For
instance, the continuing lethargy of bank lending to business in Hong Kong might suggest that
high real interest rates remain a deterrent to borrowing and investment. However, I suspect
that, while that may well have been the case a little while ago, we are now in a period where
decisions are being more influenced by confidence factors relating to the broader economic
situation than by interest rates per se, although interest rates do of course remain important.
I have pointed to elements of the present economic conjuncture - namely, competitiveness
and interest rates - where the position may not be so bleak as painted by some. But I do not
deny that we face tough challenges and I note that the consensus for the immediate outlook is
for no more than an unspectacular recovery. I have no brief today to try to talk up our
economic prospects. My wish is rather to contribute analytically to the discussion of those
prospects. The only certainty is that the future is always uncertain.