Mr Yam: Risks and challenges in coping with international capital flows
Opening address by Mr Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, at the
Sixth Manila Framework Group Meeting, held in Hong Kong on 20-21 March 2000.
* * *
Ladies and Gentlemen,
On behalf of the Hong Kong Monetary Authority, I would like to extend a very warm welcome to all
of you to this Sixth Meeting of the Manila Framework Group.1
As you will no doubt recall, the Manila Framework Group was founded in the deep throes of the Asian
financial crisis in November 1997 to develop a concerted approach to restoring financial stability in
the region. With the worst clearly behind us, and with signs of a strong economic recovery in the
region, the mission of this group has still not ended. This forum embodies a valuable spirit of
cooperation, with wide participation of emerging market economies in the dialogue. The value of this
forum lies in its quality dialogue on regional surveillance and on reform of the international financial
architecture.
There is no doubt that economic recovery in the region has gathered considerable momentum.
Economic growth for most economies has been better than expected, external balances have improved
remarkably, international funds have renewed interest in the region's asset markets, and yield spreads
of Asian sovereign bond issues over the US treasuries have narrowed notably. According to estimates
by the Institute of International Finance, net private capital flows into emerging markets in Asia
increased nearly six times from 1998 to US$39 bn in 1999, and are forecast to increase again by 50%
to US$59 bn in 2000. There is therefore a real danger that we might forget the severe pains inflicted by
the Asian financial crisis over the past two years. It is also easy to forget the lessons learnt and to
become complacent. However, if the recovery in the region is to be sustainable, we should remain
vigilant and beware of the risks lurking under these bubbling activities.
Risks and challenges in coping with international capital flows
Challenges of domestic structural reforms
In order to address such risks, we would need to tackle three challenges faced by Asia. The first
challenge is that the globalisation and liberalisation of markets require structurally sound and
resilient domestic systems. Prior to the crisis, the banking systems were often inadequately supervised
and were prone to incurring excessive maturity mismatch risks by borrowing short-term funds to
finance long-term investments. Moreover, the corporate sectors of many Asian economies were
over-stretching themselves by engaging in risky or unproductive investments. To make things worse,
both the banks and the corporates were taking excessive currency risks by borrowing in foreign
currencies to fund projects that could only generate income in domestic currencies. Poor risk
management on the part of banks, ineffective banking supervision, political interference, and a critical
lack of transparency prevented disciplinary mechanisms from functioning properly. The result is a
staggering bank restructuring cost of an estimated 25% of GDP for the crisis-hit economies in Asia.
Since the outbreak of the Asian financial crisis, economies all over the region have taken important
strategic steps to promote conditions that foster a full and speedy recovery. But recovery cannot be
sustained unless it is accompanied by thorough structural reforms. It is encouraging to see that notable
initiatives are taking place in Asia where extensive programmes are in progress to restructure and
recapitalise banks. There are also efforts to tackle the problems posed by over-stretched and highly
indebted corporations. But there is a risk that the problems that were so evident then will be swept
under the carpet in the face of rapid growth. It is crucial that the reform momentum should not be
allowed to falter, as it could undermine the fledgling recovery.
Challenges of monitoring and surveillance of capital flows
The second challenge I see is to understand better the risks posed by volatile capital flows and how to
capture data to facilitate our understanding of such flows.
For a long time it has been taken for
granted that capital flows are analogous to trade flows: that, wherever they occur, and in whatever
form, they invariably benefit long-term economic development, and that therefore the more liberal the
flows, the greater the benefit. But between the processes of trade liberalisation and financial
liberalisation there lies a great difference. In the case of trade liberalisation, there are well-established
statistical systems to capture data on international trade, and hence their impact on the real economy.
In addition, there has been parallel development of institutional framework and rules to deal with trade
measures like tariffs, quotas, subsidies and dumping, and also counter-measures, and there are
mechanisms for dispute settlement and arbitration. In contrast, the statistical framework for capital
flows is, relatively speaking, very modest. And we do not have any framework to deal with disruption
caused by volatile capital flows comparable to the World Trade Organisation's mechanisms for
handling disruption from trade in goods and services.
The volume of global merchandise trade, valued at US$5.4 trillion in the year of 1998, in fact pales
beside the scale of global international finance. The average daily turnover in the world's foreign
exchange market stood at US$1.5 trillion in 1998, or roughly 70 times that of merchandise trade. On
top of that, the OTC derivative contracts had a daily turnover of US$1.3 trillion in 1998, and the
notional amounts outstanding at end-June 1998 came to US$72 trillion. There is no doubt that the
growth of foreign exchange and OTC markets, together with advances in information technology, has
contributed to cross-border capital flows and enhanced risk management standards. It is, however,
legitimate to ask what lies behind these vast numbers. What does it mean for the underlying markets if
the financial derivatives trading continues to multiply? Do we understand exactly what these
US$72 trillion worth of derivative positions represent? Do we really understand the nature of the fund
flows generated from the financial derivative trading in the OTC markets?
The problem is that we do not have the answers to most of these questions. To start with, there is not
even an adequate statistical framework to capture capital flow data. The current data on balance of
payments, international investment position, or flow of funds accounts have two major short-comings:
(a) low frequency of quarterly data; and (b) limited breakdown of data by currency, sector, instrument,
etc. The BIS, IMF and OECD are examples of institutions which have made some attempts to collate
relevant statistics but they are far from complete or timely.
This is not just a statistical issue for the data compilers but a major policy issue for the authorities and
other users. The compilation of high-frequency and detailed data is going to be resource-intensive and
there is keen competition for statistical resources. It seems to me high time to take a fresh look at the
adequacy of data on capital flows and if necessary review the priorities currently assigned to collection
of real sector or other statistical data.
Challenges of coping with the destabilising impact of highly leveraged institutions
The third challenge I should like to touch upon is how to cope with the destabilising impact of highly
leveraged institutions (HLIs). The issue is how to improve the stability and functioning of the financial
markets for all market participants. As there have been extensive international discussions in this
regard, I shall briefly recapitulate the key developments and the challenge ahead.
The Asian financial crisis has shown that the highly competitive and globalised financial world has
created individual market participants that are huge enough to mobilise, often with the help of
leverage, financial resources larger than the GDP of smaller economies. They can build up dominating
positions in the markets of smaller economies and influence short-term market movements either
singly or through acting in concert. Combined with the lack of information on the OTC market, the
highly leveraged institutions can develop potentially excessive and destabilising market
concentrations, whether consciously or unconsciously.
Under these circumstances, there are two types of scenario where HLIs could pose concerns in their
interaction with financial markets. The first scenario is a situation in which HLIs taking excessively
large positions are overwhelmed by market forces. Rapid deleveraging of positions in markets
associated with the default of an HLI of the size of LTCM could have systemic impact even in large
and mature markets, thereby threatening the global financial system. It has been said that a repeat of
the like of an LTCM debacle is most unlikely to occur, given the downsizing of hedge funds. I
certainly hope that this is the case but I also notice that the recovery of investor sentiment has seen
more money from institutional investors as well as high net worth individuals flowing to the hedge
funds.
second
The scenario, commonly known as the "Elephants in the Pond" problem, is a situation
whereby the HLIs take very large and concentrated positions in smaller financial markets and adopt
aggressive trading practices that could be destabilising to such markets. It is very encouraging that the
"Elephants in the Pond" problem is by now recognised quite extensively as a real issue to be tackled.
What is being done and is it enough?
Different approaches have been floated to tackle the problems arising from the two scenarios I just
described. The prevailing approach is through improving counterparty risk management. This is done
indirectly by asking the banks and other financial institutions to be more prudent in granting credit
lines to the HLIs, and directly by encouraging the HLIs to enhance their own risk management
standards. This is eminently logical and sensible, since with more cautious bank lending and enhanced
risk management within the HLI sector, it should be very hard for the HLIs to build up excessive
leverage and concentration in the major financial markets.
This measure is being pursued with earnest in both the public and private sector. The Basel Committee
on Banking Supervision, and IOSCO have issued respective guidelines on sound practices for
interactions with HLIs for banks and securities firms. The latest discussion has focused on the kind of
supervisory incentives for the compliance of risk management standards. The Basel Committee on
Banking Supervision has put forward two proposals for the revision of the Capital Accord, which
would help address the concerns on HLIs. One is abolishing the maximum 50% risk weighting for
non-bank OTC derivatives exposures; and the other is encouraging counterparties to impose an initial
margin on repo transactions.
From the private sector, the Counterparty Risk Management Policy Group formed by twelve leading
international financial institutions produced a report in June 1999. Five major hedge funds also
produced an industry group report in February 2000 on improving counterparty risk management and
internal control.
While we agree that enhanced risk management of HLIs and their counterparties is a useful first line of
defence, two major concerns remain. First, the return of competitive pressure may lead to a relaxation
or even a breakdown in risk management standards again in the future. There is anecdotal evidence
that some large HLIs are becoming less willing to supply information to their counterparties as
memories of the LTCM saga are fading. It is thus important that regulators continue to promote the
introduction of suitable supervisory incentives that would encourage continued compliance with sound
risk management practices by the financial institutions.
Secondly, these proposals may not be sufficient to resolve the problem faced by smaller and open
markets. Even with reduced overall leverage, HLIs could still build large foreign exchange positions
relative to these markets. It might also be possible for HLIs to build up potentially destabilising
positions in smaller markets while remaining inside internal limits on leverage and/or liquidity risk.
Enhanced risk management cannot therefore be relied upon, in isolation, to alleviate the problem.
A second proposal to enhance market stability is to improve transparency and disclosure to make
markets work better. There have been two major international initiatives in this respect, one at the firm
level and one at the market level. At the firm level, there is the Multidisciplinary Working Group on
Enhanced Disclosure, chaired by Peter Fisher of the Federal Reserve Bank of New York, which has
developed a disclosure template for individual firms to voluntarily disclose their risk exposures. This
initiative is breaking new ground, as it is the first time that the private sector would be providing more
information about their risk exposures. However, the usefulness of such disclosure depends very much
on the level of breakdown in the risk disclosure.
Furthermore, the US President's Working Group on Financial Markets recommends (a) a reporting
framework for large hedge funds to disclose more meaningful and frequent market risk information to
the public, and (b) a requirement on public companies to disclose information about their material
financial exposures to HLIs. A challenge here is for other authorities to take similar steps to require
such standards of disclosure, as this would help to avoid the possibility of regulatory arbitrage.
At the market level, a working group set up by the G10, and led by Jean-Pierre Patat of the Banque de
France, studied the feasibility of collecting and disseminating aggregate positions data in the foreign
exchange market. I believe the initiative, if implemented, could have helped smaller and open markets
in better understanding their currency markets and the accumulation of highly concentrated positions.
However, in November 1999, the G10 Governors decided not to proceed further with work in this
area. In making this determination, the G10 found that there were a number of practical limitations to
the proposal, including the difficulty in obtaining compliance, the unfeasibility of producing the data
in a timely manner, and the substantial costs involved. The demise of this initiative left a vacuum in
the area of transparency on market concentration. This is unfortunate and the international community
should explore other alternatives to bridge the information gap.
I have mentioned two approaches, that of enhanced counterparty risk management and improved
transparency and disclosure, which will hopefully help to address the concerns on excessive leverage
and on opaqueness of HLIs. There remains the issue of aggressive trading practices, such as taking
extreme measures to manipulate prices and to precipitate herding or panic selling by other market
participants. Such practices undermine market stability. I therefore call upon the private sector market
participants to review matters and devise a code of conduct to improve the standard of market
behaviour and practices. For such a code to be effective, I believe it needs to be market specific and
applicable to all market participants in that market.
Conclusion
Ladies and gentlemen, it has often been said that history, especially financial crisis, tends to repeat
itself. In the last ten years alone, we have had the ERM crisis in 1992, the Mexican peso crisis in
1994/95 and the latest Asian crisis in 1997/98. Notwithstanding the disturbingly frequent occurrence
of seemingly similar financial crises, I am inclined to believe that even though no two crises are
exactly the same, if people do not learn from past mistakes, the market will continue to repeat its
punishment. The only difference between the major financial crises in recent years is that the
punishment is getting more and more severe, if not violent.
I have cited three major challenges to learn from the mistakes in the last financial crises. First,
domestic structural reforms. Secondly, monitoring and surveillance of capital flows. Thirdly, coping
with the destabilising impact of HLIs. They are by no means exhaustive. However, if we, individual
economies and the international financial community, can muster the determination to tackle these
challenges, we will go a long way in helping to reduce systemic risks, and improve the functioning of
the international financial system and the stability of the financial markets. While much domestic and
international efforts have been devoted to these issues, there is still much catching up to do. This is
precisely the reason why we gather here today - to take stock of progress, exchange views on the
unfinished reforms, and work for a more robust and safe domestic as well as international financial
system for all of us.