Mr Yam discusses financial stability, region and international co-operation
Speech by the Chief Executive of the Hong Kong Monetary Authority, Mr Joseph Yam, at the 32nd
Asian Development Bank annual meeting, in Manila, the Philippines, on 2 May 1999.
Introduction
I am delighted and honoured to have the opportunity to speak to this distinguished international
audience. The theme of the forum is regional monetary and financial co-operation. From the point of
view of time, venue, sponsors, and participants, it would, I think, be very hard to come up with a more
appropriate topic than this. In terms of timing, our region is currently, we hope, moving through the
final stages of a period of financial and economic dislocation that has taught us a number of lessons.
The most important of these lessons, in my view, and one consistent with the aims of this forum, is
that we need to intensify international and regional co-operation to reduce the risk of such crises
occurring again. The venue for this forum, Manila, is one of the oldest international financial centres
in Asia: it has also been the starting point for a number of important modern regional initiatives.
Manila has given its name to the recently established Manila Framework, within which central banks
and finance ministries in the region meet to promote regional co-operation on financial matters. The
beginnings of systematic economic co-operation can also be traced to Manila, with the establishment
here, in 1966, of the Asian Development Bank (ADB).
The ADB, one of the sponsors of this forum, has played a vital role in nurturing growth and technical
advances in Asian economies, and this role has in recent years both deepened, in the assistance it has
been offering, and broadened in the geographical scope it has been covering. The ADB' s joint
sponsorship of this forum is one of many examples of the good work it is doing to address regional
concerns. The co-sponsor of the forum, the Institute of International Finance (IIF), has, in two timely
and important reports issued in March this year, argued strongly for private-sector, as well as
publicsector, initiatives to address global financial crises. The co-sponsors have brought together a diverse
and experienced forum of participants from private-sector and public-sector organisations, all of
which have a large stake in ensuring that our regional and global financial systems work properly.
The Hong Kong Experience
As a regional and international financial centre, Hong Kong's livelihood depends, perhaps to a greater
extent than other economies, on the proper functioning of the international financial system. Our stake
in this, arguably, is larger than other economies. This perhaps explains why we seem to have been
quite forthcoming, in both our views and our actions, on issues affecting international monetary and
financial stability. This unusual stance has caused some controversy, particularly when we intervened
last summer in the stock and futures markets to deter market manipulation and correct market failure.
Interestingly, the controversy over this issue, which has now happily subsided following the success
of the operation, was then more intense outside of this region than within, and was especially strong
in the developed markets. I would attribute this difference in sentiment to the relative lack of
appreciation, outside of this region rather than within, of the predicament that smaller, open markets
face in the increasingly liberalised international financial system.
Hong Kong supplies a particularly striking example of this vulnerability. Our markets are very free
and open. They are big and liquid enough to attract substantial international capital. But they are also
small, by comparison to the developed markets and the amount of international capital flowing around
the globe, seeking opportunities for profit. They are small to the extent that the prices of those
markets are capable of being pushed around by big players, particularly those in a position to
influence market sentiment. Being a very externally oriented economy, we pursue an exchange rate
policy that promotes a stable external value for our currency to provide for predictability for all those
who engage in economic activity relating to the predominant external sector. In pursuing this policy,
we have gone as far as to adopt currency board arrangements that operate with a high degree of
transparency while eschewing the exercise of discretionary monetary management. This eclectic
combination of characteristics and policies, which is quite a common feature of economies in this
region, offered great temptation to market manipulation.
Such manipulation is often well timed and co-ordinated with the advance or reversal of capital flows,
since essentially the same market players, acting in the multiple roles of advisors, agents and
principals, are involved. One inevitable consequence of this is market panic and overshooting, to the
extent of risking a meltdown in the monetary and financial systems concerned. The authorities,
obviously, have a responsibility to act to prevent this from happening. Some have been in a better
position to do so than others, using market means, particularly those with deep pockets. Some have
been forced into closing their markets, albeit temporarily. Others have been quietly happy that they
had been a little more conservative in their move towards financial liberalisation. In Hong Kong,
where our commitment to maintaining open markets is strong, in addition to our unconventional
market operation, we had to introduce measures that have effectively built us a big cushion. The
purpose of this cushion is to help us to absorb the spasmodic international financial shock waves of
mammoth dimensions that can now be generated by the international financial system. Some others,
regrettably, have had to suffer the debilitating consequences of financial meltdown, and to face the
often unjust accusation that these were entirely of their own making.
Domestic responses by economies in this region cannot on their own address the root of the crisis or
lessen the chances of another international financial shock wave. One thing that we have learned from
this episode of financial turmoil is that, no matter how well maintained the domestic financial
environment may be, problems remain in our increasingly liberalised international financial system
that cannot be resolved by individual jurisdictions alone. There is a need for regional and
international co-operation. Hong Kong has not, of course, been alone in this view. There is now
international consensus that something needs to be done, if not on what exactly should be done, in
reforming the international financial architecture.
Financial Crisis: Local, Regional or International
The financial crisis is basically an international one, and I think it is now generally accepted as such.
But, when the financial crisis erupted nearly two years ago in Thailand, and even when it was already
spreading rapidly throughout the region, the explanations put forward by the experts then were largely
local ones: macro-economic imbalances in the crisis-hit countries, cronyism, poor regulation, policy
errors, and so on. Consistent with these explanations, the assumption was that the International
Monetary Fund (IMF) and the multilateral development banks would fix it country by country, as they
had done before in other localised crises elsewhere in the world. We therefore saw a series of policy
adjustment programmes and financing packages targeting specific economies. These international
financial institutions deserve much credit - far more than they have received - for mobilising,
sometimes in a matter of days, financing packages totalling US$400 billion.
But in a new and rapidly changing international financial system, the instruments that the
international financial institutions have at their disposal seem to be increasingly inadequate. They
soon found out that they can no longer use traditional strategies to deal with novel and unprecedented
problems thrown up by constantly changing technologies and ever more sophisticated market
practices. The striking thing about these problems is that they erupt without much warning and to the
surprise of even the most knowledgeable in this field. They are also not specific to individual
economies: market liberalisation and globalisation have made them common problems for all
economies that wish to play a part in the international financial system. Indeed, with a few economies
in Asia going through the same process of financial liberalisation and encountering the same
problems, the crisis was characterised as one specific to Asia, hence the reference to the Asian
financial turmoil.
But explanations of the financial crisis soon moved from regional to international. Events in Russia
and Latin America, the Long Term Capital Management (LTCM) episode, and the subsequent
deleveraging of hedge funds soon made it clear that our regional crisis was more than just a problem of
a few individual economies not keeping their houses in order. The root of the crisis is in the great
increase in the speed, quantity and unpredictability of international capital flows. And many of these
capital flows are mobilised or indirectly influenced by highly leveraged institutions operating behind
a veil of secrecy interlaced with esoteric mathematical models that do not allow the systemic as well
as the rather simpler counter-party risks to be identified, let alone properly managed. As recent events
in this region and throughout the world have shown, this phenomenon has reached a level where it is
capable of disrupting even the largest markets and completely destabilising smaller markets. It will
therefore be useful for us to discuss these issues in greater detail before focusing on what needs to be
done.
International Capital Flows
For a long time it has been taken for granted that capital flows are exactly analogous to trade flows:
that, wherever they occur, and in whatever form, they invariably benefit long-term economic
development, and that therefore the looser the rein they are given, the greater the benefit. This
presumption, however, has been questioned recently in light of the experience of some emerging
market economies. Professor Bhagwati, for example, in his article last year on " The Capital Myth"
, has argued that the assumption that free capital is as virtuous as free trade is wrong and that the
claims of enormous benefits from free capital mobility are not persuasive.
There are undoubtedly many benefits that go with free mobility of international capital. Traditionally,
capital flows take the form of commercial bank lending, foreign direct investment, or equity portfolio
investment. Over the past few decades, these flows have facilitated the efficient cross border
utilisation of capital and have provided liquidity in financial markets. By adding an international
dimension to financial intermediation, the mobility of international capital has clearly been helpful in
promoting growth and development in both the capital exporting and the importing economies. The
mobility of capital has more recently been boosted by advances in telecommunications and
information technology, allowing capital to move into or out of an economy in huge amount and
within a very short space of time. The virtue of capital mobility therefore carries the risk of capital
volatility. The volatility is destabilising in both directions. Too rapid a build-up of capital inflows
places severe upward pressure on domestic asset prices, fuels inflation, and exacerbates
macroeconomic imbalances. Conversely, sudden and massive reversals of these flows place intense
downward pressure on the exchange rate, and therefore upward pressure on interest rates, causing
asset bubbles to burst and splatter. When rapid build-up is followed suddenly by massive withdrawal,
we see the kind of crisis that swept across this region in 1997 and 1998.
The volatility of international capital flows is also attributable in part to the phenomenal growth of
derivatives and the global over-the-counter (OTC) market in the past decade. A survey by the Bank
for International Settlements (BIS) in June 1998 estimated the size of the global OTC derivatives
market at an aggregate notional value of US$70 trillion. Despite the trauma of the global financial
crisis last year, there have been no signs of an overall slowdown. According to the US Federal
Reserve Board, the notional value of derivatives contracts outstanding at US commercial banks, the
leading players in global derivatives markets, grew by more than 30% last year: this is the most rapid
annual growth since 1994.
The sheer volume of derivatives trading does not say much about their associated risks. These new
financial instruments have undeniably helped investors to unbundle their risks. They have promoted
investments and generated substantial benefits to the developing countries receiving such investments.
However, the availability of derivative instruments has also increased the opportunities for
speculation that resulted in significant losses with the downturn in markets during the financial crisis.
The use of swaps, futures, forwards, and other derivative instruments have enabled investors to take
on far greater exposure relative to their capital, and to greatly increase the potential for loss.
Market Stability and Highly Leveraged Institutions
Let me make it clear that the losses or gains by large financial market participants should not be a
concern to regulatory authorities. Nor should the positions taken by individual market participants
normally be of any concern. Speculators or investors, in essence, buy low/sell high or sell high/buy
low, thereby providing liquidity to markets. However, there are two situations in which the very large
positions taken by highly leveraged institutions are of particular concern to regulators.
The first situation is when the highly leveraged institutions taking very large positions are
overwhelmed by market forces. As the case of LTCM has illustrated, highly leveraged positions can
pose serious risks to systemic stability even in the large and established markets of the developed
economies. As the highly leveraged institutions are, for circumstances they have not factored into
their mathematical models, forced to unwind their very large positions, particularly against the
background of highly volatile and illiquid market conditions, the credit losses of institutions providing
the highly leveraged institutions with funding can be huge. The rapid de-leveraging of large positions
by highly leveraged institutions is also highly contagious in that it in turn exacerbates volatility and
reduces liquidity not only in the markets concerned, but also in other markets. The rapid de-leveraging
of the short yen positions by the hedge funds in October last year is a good example of the volatility
that can result. The yen strengthened by 11% to 111 over a couple of days. Such volatility affects the
positions of yet other highly leveraged institutions and their counter-parties providing them with
credit. The potential for market dislocation and the systemic risks this posed were so serious that, as
you all know, last September the Federal Reserve Bank found it necessary to broker an unusual
package by a consortium of banks to rescue LTCM.
The second situation is when the smaller markets are overwhelmed by the forces of the highly
leveraged institutions. Not only does this raise serious concerns on the risk to systemic stability, it
also undermines the integrity and efficiency of the markets. By virtue of their sheer size and
aggressive trading strategies, the highly leveraged institutions, through their agencies, who usually
also provide them with the credit, and possibly also ride along with them, often use their market
power to influence the prices in smaller markets. Almost always an attack on a currency in Asia starts
late on a Friday afternoon when the domestic markets in Asia are thin and when the international
currency markets in London and New York open for business. Almost always a succession of big sell
orders is placed for execution in a short period of time. And almost always the banks, when asked, say
that they are executing those orders on behalf of their customers, whose identity and purpose cannot
be disclosed because client secrecy is sacrosanct. And all this is supported with an immaculately
timed commentary of gloom and doom. Some are more objective than others, but regrettably the
impression one gets, particularly as a regulator, is that they are aimed at generating undue pessimism
and panic, and consequent sharp and widespread movements across the currency and other related
financial markets in favour of those behind the attacks.
Most of the activities of the highly leveraged institutions are carried out through the OTC markets,
which are very opaque. Unlike organised exchanges, OTC markets are subject to little, if any,
transparency or regulatory requirements, raising the risk of price ramping, collusion and other
misconduct.
International Financial Architecture: International Co-operation for Reform
So what can be done about all this? Following the outbreak of the financial crisis, various
international forums and multilateral financial institutions have devoted a great deal of effort to
improving the stability and functioning of financial markets. Working group after working group has
been formed to look into specific issues. There were the three G-22 working groups, the working
group under the Basle Committee on Banking Supervision, the two transparency and disclosure
working groups under the Committee on Global Financial Systems, and now the three working groups
of the G-7 Financial Stability Forum to be formed. And I should not forget the very useful work done
by the IIF, and by other forums in this region. Many helpful reports have been prepared, including the
two reports by the IIF released in March this year on risk management and on transparency in
emerging markets finance, all of them produced in a highly co-operative atmosphere. I welcome in
particular the Institute's readiness to work with relevant public sector bodies on appropriate
disclosure for private financial institutions active in the international capital markets. I am sure this
international co-operative spirit, not only among international financial institutions, national finance
ministries and central banks, but also with the private sector, will in the end produce helpful
blueprints for action. But this process can take too long. There is always the risk that when the dust
has settled the initiative and enthusiasm, dare I say, on the part of those less affected by the crisis,
may be stifled. There is also the risk that the plight of those who have been seriously affected by the
crisis is not given the attention it deserves, simply because they do not have an adequately
representative voice on the issues at hand at these international forums.
There is no lack of ideas, but they need to be translated into actions sooner rather than later. Let me
take this opportunity to outline three broad approaches mooted at different forums and supported by
us. The first approach involves enhancing the transparency of markets. Timely and reliable
information relevant to decision making by market participants as well as by the regulatory authorities
is crucial to the effective functioning of a market. It is thus important that there should be an adequate
public disclosure framework to provide information that is necessary for counter-parties, creditors and
investors to assess risks properly. Not only should increased transparency be promoted in markets
trading products in an established exchange. It is also perhaps time to consider whether some suitable
form of transparency requirements should be imposed in OTC markets. This is not an easy task, but I
believe that with earnest international co-operation, we can achieve meaningful results. Although a
delicate balancing act is required, I am confident that this is possible without imposing heavy
reporting burdens or infringing too much on proprietary information of individual institutions. In this
connection, the proposal by Germany for an international credit register is attractive. The register
could collect information on the exposures of international financial intermediaries to single
counterparties that have the potential to create systemic risk.
For the public sector, the tasks include developing still higher standards for macroeconomic and
financial data in emerging market economies, and promoting transparency in the reporting of their
holdings of foreign reserves. Greater transparency in the operations of international financial
institutions, such as the IMF, is also being pursued.
The second approach involves designing an appropriate form of oversight of highly leveraged
institutions. The Basle Committee's report on Banks' Interaction with Highly Leveraged Institutions
recommends indirect regulation in which banks should adopt more prudent policies on the
assessment, measurement and management of their exposure to highly leveraged institutions. Other
tools of indirect regulation could include the imposition of capital charges on lending to such
institutions, raising margin and collateral requirements, and so on. While such indirect regulation,
through creditors, should clearly be supported, we need to satisfy ourselves that it is an adequate
safeguard against the highly leveraged institutions causing the type of systemic problems in smaller
markets when their activities overwhelm these markets.
The third approach involves international co-operation to tackle regulatory arbitrage. As industrial
and emerging countries continue to strengthen their own regulatory standards, financial market
participants may relocate their operations to offshore financial centres to take advantage of relatively
lax regulatory standards. It is thus important for offshore financial centres to strengthen their
supervisory systems and standards. To encourage these centres to comply with international
standards, various measures could be considered. For example, higher risk weights could be applied
to counter-party transactions for banks doing business with a financial entity operating out of an
offshore jurisdiction that does not comply with Basle Core Principles.
Conclusion
Taken together, the three approaches could result in quite an extensive overhaul of the international
financial architecture and a great deal of co-ordination on the international front. This is no easy
undertaking, and the nature of the problem means that the process of reform needs to be both
comprehensive in market coverage and inclusive in the involvement of interested parties.
Crossborder speculative attacks target the vulnerabilities and weaknesses of particular economies and thrive
by exploiting the gaps and inconsistencies between jurisdictions. It is therefore essential that
emerging markets, and not just the big industrialised economies, are involved in the reform process.
Emerging markets have been most affected by the volatilities of the last couple of years, and their
experience is crucial for the formulation of workable policies: they have a different perspective of
events and different needs from those of the larger, industrialised economies.
Although reform of the financial architecture has to be done on an international basis, there is much
that can also be done through regional co-operation both to help advance the reform process and to
promote parallel and complementary initiatives. Regional forums, of the kind that we are engaged in
today, are way of gathering views and developing consensus so that collectively we can carry more
weight, and speak with a more unified voice, in the international forums. They also help to ensure, for
example, that the standards and best practices formulated in an international context are workable in
the context of Asia.
Regional co-operation can help give a spur to closer international co-operation by ensuring that our
recent experience and our special needs as open, emerging markets are taken into account in the larger
process of reforming the international financial architecture. We are a diverse region, and the crisis of
the past couple of years has affected us all in different ways. But the fact that it has affected all of us
underlines the need for us to work together as a region in our efforts to prevent future crises.