Mr Yam focuses on international capital flows and free markets
Speech by the Chief Executive of the Hong Kong Monetary Authority, Mr Joseph Yam, JP, at
the Crédit Suisse First Boston Asian Investment Conference on 26 March 1999.
Introduction
1. I am delighted to have the opportunity to speak at this year's Asian Investment Conference
organised by Crédit Suisse First Boston. It is particularly gratifying to be able to speak to such
a large and diverse gathering in Hong Kong itself. Many of you, I know, are old friends of
Hong Kong, and to those among you who might be visiting this city for the first time I extend
a warm welcome. Your presence here happily relieves me of the need to set the scene or to
explain in detail how Hong Kong has been grappling with regional financial crisis and
economic slowdown. You will have been able to see and hear for yourselves that, despite the
difficulties of the last year or two, Hong Kong is still very much alive and well, and that it
remains one of the most open, most welcoming, and freest markets in the world. International
opinion continues to echo this conclusion, so these are not empty boasts: within the past
couple of weeks, for example, two reputable regional surveys have found the banking system
of Hong Kong to be the best and the soundest in Asia. We continue to develop our services
and infrastructure in a way that will help business make the most out of changing
opportunities and challenges. Recent initiatives include plans announced by the Financial
Secretary earlier this month for a cyberport that will be able to offer the most advanced
information technologies to a whole range of businesses and industries. Within the HKMA,
we have, in the last few months, seen the completion of a major strategic consultancy study
that will help to guide the broad development of our banking sector into the next century.
2. I single out these initiatives - and I could mention many others - for two main reasons.
First, one of their aims is to help Hong Kong get the best advantage out of three closely linked
and irresistible trends: the globalisation of markets, the liberalisation of trade and finance, and
the rapid advance of information technology. Secondly, while we need to grasp the
opportunities produced by globalisation, liberalisation and technological advance, we also
have to manage the risks that they bring with them in ways that strengthen, rather than
undermine, our economic fundamentals. Along with many other economies in this region, we
have, over the last year or two, been grappling with this challenge in a very practical way at a
time of crisis and uncertainty. The Asian financial crisis is the cumulative result of many
complex causes coming together at roughly the same time. But if we were to find a single
factor that has brought the crisis to a head and magnified its damaging effects, we should be
looking, not to 'crony capitalism' or 'Asian values', but to a more specific and more universal
phenomenon: the swift flow of large amounts of heavily leveraged capital into and out of the
region through an international financial system that is globalised, liberalised, technologically
advanced, but, from an international point of view, largely unmanaged and unregulated.
3. The freedom of capital flows is, of course, essential to effective financial intermediation in
the international dimension, which has played a vital role in promoting economic
development in this region. But, as the current crisis has shown, it also has the potential to
distort, disrupt or even destabilise domestic financial markets: this applies not just to ailing
economies, but also to sound ones. Being small and open, with predictable policy responses,
their markets are susceptible to manipulation. As you know, last summer Hong Kong was
exposed to this problem in an extreme form, and we took radical and controversial measures
to address it. We remain convinced not only that what we did preserved our financial system
from a serious threat to its stability at a time of stress and uncertainty, but also that our actions
were entirely consistent with our responsibilities as a government mandated by law to
safeguard the free operation of financial business and the free flow of capital within, into and
out of Hong Kong. I shall come to this episode later on. But first I should like to go a little
more deeply into the characteristics of international capital flows. I shall then discuss the
implications, practical and philosophical, that they have for free and open markets, which
collectively make up an increasingly seamless international financial system, but which
continue to rely largely on their own limited resources when they encounter the problems that
this system throws up.
International capital flows
4. Like wind currents and weather patterns, international capital flows carry with them a
mixture of benefits and risks. Let me try briefly to pin down what makes them so powerful
and so protean in their effects on the international financial landscape. I find it helpful, as a
mnemonic, to think of their main characteristics in terms of what I shall refer to as the six
'V's: Virtue, Volume, Variety, Velocity, Volatility, and Viciousness.
5. By Virtue, I mean simply that international capital flows, by promoting an efficient and
balanced use of financial resources, bring enormous benefits throughout the world. Over the
past few decades they have been of crucial importance in developing new economies and
revitalising old ones. When they work smoothly, international capital flows help to relieve
shortages of capital in previously segmented markets. They provide a competitive
environment that encourages innovation. And, by affording better returns to investors, they
help to put spare capital to the best possible use. We have seen the value of this in our own
region in the 1980s and early '90s, and, when discussing the problems created by capital
flows, we should never forget that they have specific and beneficial functions.
6. The second characteristic is the sheer Volume of capital movements around the world. In
April 1995 the global value of foreign exchange transactions taking place on an average day
was US$1.2 trillion. In April 1998 this figure increased to US$1.5 trillion, or, to put it in more
meaningful terms, to around 48 times the daily value of world trade. It is also worth stressing
that these are largely private capital flows. In 1997, for example, the amount of private capital
flowing into developing economies was estimated by the World Bank to be five times the size
of official flows.
7. Within these private flows there is considerable Variety and fluctuation in the nature and
organisation of capital. With financial liberalisation and the globalisation of financial markets,
portfolio capital flows are of increasing importance compared with the more traditional
foreign direct investment and commercial bank lending as a source of international capital
flows. An aspect of this Variety is the growing number of complex investment tools, and
different orders of derivatives therefrom, involving different degrees of leverage, available for
moving money around the world, or indeed enabling investments to be made in markets
without having actually to move money around.
8. The variety and volume of capital flows are made even more potent by the Velocity with
which capital moves around the world. The advance of telecommunications and information
technology now means that distance and national boundaries are no longer important
restraints. Two consequences follow from this. First, huge amounts of money can be moved
into an economy in a very short space of time, and can be moved out just as quickly. In 1996,
for example, capital was flowing into the emerging economies of Asia at the rate of about
US$100 billion. By the second half of 1997 it was flowing out of the region at about half that
speed. Secondly, with the negation of distance and boundaries, events in one particular market
can have immediate, dramatic, but often quite unpredicted effects on other markets on the
other side of the world. Last year, for example, the debt default in Russia affected
mortgagebacked securities as far away as the US and Brazil. Earlier this year, the devaluation of the
Brazilian real raised expectations - unfounded, as it turned out - that the ripples from that
crisis would destabilise the renminbi.
9. During periods of instability or uncertainty, the volume, variety and velocity of
international capital flows can, in an increasingly liberalised and globalised financial
environment, often add up to the fifth 'V': Volatility. Indeed, the behaviour patterns of capital
flows can magnify minor local uncertainties into extensive, prolonged and highly destabilising
crises. While other factors were also at play, it is clear that something of this kind took place
in the spate of local troubles that snowballed into what we now call the Asian crisis. Private
capital inflows, attracted by high short-term returns, fuelled Asia's economic boom. The Thai
baht crisis of July 1997, which many initially dismissed as a local blip, snowballed into a
regional crisis when a sudden reversal of these flows took place following a rapid and
wholesale reassessment of emerging market risk. In one way or another, the crisis has affected
nearly every emerging market and has slowed growth throughout the world. Stampedes of this
kind take little account of the economic fundamentals behind the markets: there were ongoing
problems in many Asian economies, but there was no macroeconomic reason why there
should have been such a sudden and wholesale withdrawal of funds at this particular time. To
quote the US Deputy Treasury Secretary, Lawrence Summers: 'Financial crises have elements
of a self-fulfilling prophecy, like bank runs. Everyone expects failure or everyone expects
everyone else to expect failure, leading to a rush to be the first one out and thus causing
failure.' The Asian financial crisis, in which untold and unnecessary damage has been caused
by such behaviour, is a classic illustration of this.
10. Widespread volatility resulting from financial panic and herd behaviour is one of the more
worrying aspects of international capital flows because small fires can spark off major
conflagrations. This volatility becomes Vicious when market participants with extensive
control or influence over capital flows line themselves up, manipulate the prevailing negative
and disturbed public mood, and exploit the discrepancies and vulnerabilities that inevitably
arise in a global financial system that is held together by localised jurisdictions. The most
vulnerable of these jurisdictions are often those which are held up as models of free-market
economics: the small or medium open markets with few or no controls on capital movements
and with transparent financial systems that operate according to simple and precise principles.
11. In Hong Kong last summer we found ourselves in exactly this situation. We were a choice
target because our options were limited. We are prohibited by law from imposing exchange
controls, and, even if we were not, it would be an act of lunacy for Hong Kong, with its highly
externally oriented economy, even to consider them. The cornerstone of our financial system
is the linked exchange rate between the Hong Kong dollar and the US dollar. This link is
maintained by a classic currency board system so transparent and predictable in its responses
to market conditions that it was, at least at that turbulent time, vulnerable in one of its central
features. Under the currency board's autopilot mechanism, any expansion in the monetary
base causes interest rates to fall, while a contraction causes them to rise. The crucial part of
the monetary base influencing this rise and fall is the aggregate balance that banks maintain in
their clearing accounts held with the currency board: it is extremely small, and, at the time,
made the monetary system susceptible to speculative attack.
12. In their attempts to destabilise the Hong Kong dollar in late 1997 and early 1998,
speculators found that, although breaking the link was impossible, driving up interest rates by
putting pressure on the Hong Kong dollar was not so difficult a matter. Late in the summer of
1998 they developed their strategy into a pre-concerted, heavily leveraged cross-market
assault, which sought to play off the currency board system against the stock and futures
markets: according to this strategy, extreme conditions created by a large-scale dumping of
Hong Kong dollars would cause the stock market to plummet to a level that would allow them
to make large profits from the futures contracts they had taken out.
13. We prevented them from reaping these profits - and in fact caused many of them to incur
a loss - by investing a small part of Hong Kong's official reserves in Hang Seng Index
constituent stocks and futures contracts in sufficient quantities to ensure that the strategy
failed. We followed this up with technical changes to the currency board system to make it
less susceptible to manipulation. The results of our market operation in August and our
technical measures in September have been stable interest rates and financial markets that
have been free of the manipulation that posed such a threat to stability and confidence over the
summer. For an economy that is still working its way through its worst recession in more than
a generation this is good news. Many critics, however, were shocked by what they saw as a
gross violation of free-market principles in a city that had been held up as one of the world's
great models of free-market economics. We did not, and do not, see it in this way. And, six
months or so after the event, now is perhaps an appropriate time to place the events of last
summer in some perspective.
Free markets
14. What, then, is a free market? It might be helpful to go back to basic economics to set out a
few simple principles. In bald terms, a free market is a market in which buyers and sellers are
free to trade on whatever terms they wish without government interference. The great writers
on free markets, from Adam Smith to Milton Friedman, argue that free markets and free
enterprise, rather than governments or monopolies, are the most efficient means of producing
and distributing wealth and, as a consequence, the soundest basis for a just and prosperous
society. In Adam Smith's conception, it is the 'invisible hand' of the free market that
organises the seemingly chaotic and self-interested activities of human beings into a
beneficent and productive social order. For Milton Friedman, 'the organisation of the bulk of
economic activity through private enterprise operating in a free market' is 'a necessary
condition for political freedom.'
15. In its daily operation, a free market serves three main purposes. It manages resource
allocation by supplying answers for buyers and sellers to the basic economic questions of
what, how, and for whom goods and services are to be produced. It provides price discovery
by channelling competition and adjusting prices to reflect changes in supply and demand for
different commodities. And specifically in terms of money, it arranges financial
intermediation by matching the needs of ultimate lenders - or those in possession of surplus
loanable funds - with those of ultimate borrowers - or those in need of liquid funds: interest
rates, which are determined by the supply and demand of liquidity in the loanable fund
market, play a crucial role in this process.
16. The philosophers are agreed that, in general, the less a government has to do with these
various functions, the more efficiently the market can do its job: centralised, directive
authorities, or 'big government', are anathema to true economic freedom; governments
should, at most, play a minimal, instrumental role in fostering the conditions in which each
individual has the freedom to make his or her own economic choices. But this does not mean
no government. In a free market, a government has a number of specific and limited functions
to address well-known areas where the unregulated functioning of markets can result in
outcomes that are undesirable from the perspective of society as a whole. In general, these
areas involve some form of what economists call 'externalities' - spillover effects of one
person's behaviour on others that are not incorporated in the market prices that people pay and
receive. Public goods are an example, where the benefits to society as a whole of, say, police
protection are not easily captured by unconstrained market forces. Protection against
monopoly practices is another - situations in which individual market participants can take
prices away from levels consistent with free competition. All countries are involved in
correcting instances of market failure in one form or another: indeed, from a philosophical
perspective, it would not be too strong to say that that is what governments are all about.
Many countries, of course, have become involved in the economy in ways that go well beyond
such cases of market failure. In general, the experience has been unsatisfactory, and there is a
worldwide trend towards limiting government involvement in the economy.
17. Here it may be helpful to turn from theory to practice, and to our experience in Hong
Kong as an economy long acknowledged to have one of the freest markets in the world. In
Hong Kong, government is probably as small as it can get in the modern world. Government
expenditure as a percentage of GDP, although now at a historical high, is only about 20%. Yet
the Government is involved in supporting the free market in a number of limited but key
areas. First, it provides infrastructure and facilitation to enable markets to thrive and progress:
these range from highly visible projects, such as the new airport and its associated facilities, to
the HKMA's own quiet successes over the last few years in developing an advanced and
robust interbank payment and settlement system or in stimulating the development of a local
debt market. The Hong Kong method is for such projects to be done, where possible, as
partnerships between government and private sector, with a heavy emphasis on private sector
involvement. Nevertheless, the role of government is essential in getting them off the ground
and in mobilising resources that cannot always be easily provided by the private sector.
18. Secondly, the Government provides regulation and protection. This ranges from the highly
visible, and currently much debated, rule of law, which is the ultimate guarantee of contracts
between individuals, to the day-to-day regulation of the markets themselves. Much of the
activity in this area is also left to the private sector: only a small proportion of contracts are
ever disputed in the public courts, and a large part of the regulation of the markets and the
professions is self-regulation. Once again, however, government involvement is of key
importance. The Government is there in the background as the last resort when conflicts arise,
and, in consultation with market practitioners, it takes the initiative to reform regulatory
systems when new conditions require it: the far-reaching reforms proposed for Hong Kong's
securities and futures markets in the recent budget are a good example of this.
19. Finally, the Government is prepared to intervene in isolated, clearly identified cases where
markets appear to be malfunctioning. In this respect, the Hong Kong Monetary Authority has
a special role to play within the financial sphere. One of its primary tasks is to promote the
stability and integrity of Hong Kong's financial system, and one of its tools - in addition to
the linked exchange rate, banking regulation, and the financial infrastructure - is the
Exchange Fund, our official reserves. The Exchange Fund, among other things, is available to
be drawn on to maintain the stability and the integrity of the monetary and financial systems
of Hong Kong. This is done rarely and sparingly, but it is necessary to have this provision for
reasons that should be readily apparent. In addition to being a free market, Hong Kong is also
an open market. This gives it one of its main strengths as an economy, for our links with
overseas markets are a vital part of our success as a financial and commercial centre. But it
also renders Hong Kong exposed, and therefore vulnerable, to economic and other forces that
are entirely beyond its control. We would not have it any other way, because the advantages of
openness far outweigh the disadvantages. But the risks involved in this exposure were brought
home to us by the Asian financial crisis.
20. For Hong Kong, the consequences of that crisis have been first a sharp recession, and
secondly the series of attacks on our currency which I have already described. At the height of
these attacks, during the summer of 1998, there was clear evidence that the free market in
Hong Kong was in danger of failing to fulfil its functions. Specifically, the currency, securities
and futures markets were being distorted to the point where efficient resource allocation had
given way to manipulative speculation; where prices in the markets were no longer being
determined by changes in underlying supply and demand; and where interest rates, instead of
reflecting the supply and demand of liquidity, were being hijacked for the purpose of
engineering dramatic changes in the markets. Strong evidence suggests that at the time a very
small group of players were responsible for a preponderant proportion of the short futures
contracts open at that time. We also estimate that currency borrowings to the tune of HK$30
billion, arranged in advance to avoid the expected interest rate volatility they were hoping to
generate in Hong Kong, had been made by a similarly small group of players to be quickly
dumped at a time when the markets were most vulnerable. In short, we were far from the
model of 'atomistic competition' among small individual actors envisaged by thinkers such as
Adam Smith. The invisible hand of the market had been replaced by a very visible club being
wielded by a concentrated group of speculators.
21. In many other jurisdictions, this cornering of the markets would have been subject to
investigation under anti-trust legislation: the Salomon Brothers scandal in the US in the early
1990s, which many of you will recall, is a parallel that springs to mind. In Hong Kong we
have no such laws: it is probably time that we thought out the cases for and against having
them. We should also look at safeguards against market concentration. As things stood in
August last year, we were watching (in a loosely worked metaphor that might appeal to those
of you who will be attending the Rugby Sevens this weekend) a playing field that had become
so badly slanted that ordinary players could barely stand up, and a game that was about to be
cornered by a highly oversized and unsportsmanlike team with steroid-enhanced muscles
playing by its own rules. As a referee with limited powers, but with responsibility for
preserving the basic integrity of the game, we intervened using the quickest, most efficient
and fairest methods that we had at our disposal. Stability on the playing field was restored,
and Hong Kong remains an open market, and, we believe, like the Rugby Sevens, attractive to
participants from all over the world who are keen to play a fair game.
22. We have been taking another look at the rules of the market to ensure that its free
workings receive the best safeguards possible. The reforms include the currency board
measures, now in place, and the proposed reorganisation of the securities and futures markets
that I have already mentioned. It has to be stressed, however, that there is a limit to what can
be done locally in an international financial system that still lacks international forms of
regulation. There is consensus that some international action is now needed to build a global
financial architecture that can cope with volatile fund flows more effectively than can
individual jurisdictions on their own. Various international agencies and forums have been
grappling over the last six months with this issue, and Hong Kong, with its direct experience
of speculative attacks, has been pushing as hard as it can for an internationally backed and
non-intrusive system of disclosure and indirect regulation of cross-border fund flows. While
some progress has been made in working out what the problems that need to be addressed
consist of, we are still a long way from seeing results, and with the absence of major
speculative attacks in the last few months, we are in danger of being lulled into a false sense
of security.
Conclusion
23. To summarise, the problem to be tackled is essentially this: capital flows are moving
through a financial system that is now to a large extent global and borderless. Market
liberalisation and advances in information technology mean that the system will continue to
develop in this direction. Yet the machinery that regulates this system is still largely operated
by individual governments. There is much that governments can do, and are doing, on their
own to help ensure that markets can channel the benefits that capital flows bring while
minimising the risks. But managing these risks - which lie mainly in volatilities exacerbated
by high volume and high velocity, and occasionally by deliberate viciousness - may ultimately
be beyond the capacities of individual jurisdictions. Crisis management and rescue packages
are expensive and disruptive methods of clearing away the damage and picking up the pieces.
The only effective long-term solution lies in prevention through collective action to reform the
international financial architecture and ensure that free markets continue to be able to function
as they should. Given what we have been through in Hong Kong and in this region in the last
twenty months, we are eager that the momentum on this issue should not be lost, and that it
should not require the disruptions and dislocations of another major financial crisis for the
importance of preventive action to be driven home.