Joseph Yam: Building stability in unstable times
Speech by Mr Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, at the Hong Kong
Institute of Bankers Lunch Talk, Hong Kong, 24 October 2001.
* * *
Thank you for inviting me to speak today. It is a pleasure to see such an excellent attendance - a sure
sign of the vitality of the Institute and the relevance of its work to the banking community. It is less of a
pleasure to be speaking at a time when the international situation is a grave and unstable one, when
our own economy is under immense strain, and when conditions are likely to get worse before they get
better.
What is the role of our financial community in times like this? And, more specifically, what should the
regulator be doing to ensure that monetary and financial systems are conducive to stability and are an
aid to recovery? The answers, I believe, are to safeguard the strength of our banking system, to
ensure that our financial infrastructure remains sound, even under stress, and to maintain steady
policies that are conducive to stable, robust and efficient markets. I shall, in this talk, give some
examples of how, thanks to the hard work that has been put in over the years, Hong Kong is well
equipped to deliver on these aims. The examples may provide reassurance. But I have to confess that
they will not be exciting to those who advocate quick fixes - and in particular to the small minority who
believe that something more spectacular, such as depegging or repegging the Hong Kong dollar, is
the panacea for all our problems. In the last part of this talk I shall devote some time to this question,
which has received some attention in the past few weeks, with the aim of explaining why, in my view,
tinkering with the Link is not a solution.
Unstable times
Let me first, however, offer some comments on the environment that we now find ourselves in.
Internationally, prior to the tragic events of September 11th, there were already signs that a global
slowdown was either imminent or already in progress, although it was not clear quite how long or how
severe the slowdown would be. September 11th, and its aftermath, has not made the answers to
these questions any clearer, but it has left no doubt that the deterioration will be sharper, or that the
subsequent recovery will take longer.
A number of factors in connection with September 11th are at play. Some have immediate effects that
are to a certain extent quantifiable: the physical damage caused by the atrocity; the cost - in additional
security and insurance, lost revenue, lost jobs - to the airline and tourist industries; the blow to markets
worldwide. Others present considerable uncertainty: for example, the extent and duration of the
collapse in business and consumer confidence, and the question of how far monetary and fiscal
stimulus will contain the collapse; and the scope and economic effects of the war against terrorism,
which, we have been told, will be long and unlike any other war.
The effects on our regional economy are likely to be severe. We are heavily dependent on exports to
the USA, at a time when these are declining and likely to continue to decline for some time to come.
Capital inflows into the region are falling because of increased risk aversion. Within the region, many
countries face persistent internal problems, in some cases - such as Indonesia - both economic and
political. The big engine of the region - Japan - continues to falter, with declining exports, rising
unemployment, a weak banking sector, and an economy officially teetering on the brink of yet another
recession. The latest news from Singapore - in many senses our sister-city in the region - is not good
at all.
The bright spot in the region continues to be China, which has sustained real GDP growth of 7.6% and
export growth of 7% for the first three quarters. It seems inevitable that exports, and in turn GDP, will
be affected by the decline in consumer spending in the US, which accounts for around 20% of China's
export market: the latest figures already suggest this. The impetus to growth will therefore increasingly
need to shift to domestic demand, which is already enormous, and which has been growing quickly in
recent years. For the medium and longer terms, dynamic and far-reaching economic transformations
will be set in motion by China's accession later this year to the World Trade Organisation. As a result
of accession, China's trade flows are projected to double between now and 2005. There will be
profound changes in the financial landscape, including an increased presence of financial institutions.
All this is, as I have pointed out before, good news for Hong Kong. It will, we estimate, increase our
annual GDP by around half to one per cent, just through the resulting increase in re-export trade. It
should additionally provide a great boost to our professional, mediatory and service industries. Those
who despair about Hong Kong's future viability should perhaps reflect on the opportunities that our
position as China's international city will bring post-WTO accession.
Yet it is understandable that the focus of attention should currently be on immediate problems rather
than on future benefits. The rapid deterioration of the external environment now threatens to prolong
the cyclical downturn in Hong Kong, engulfing the vigorous, but all too brief, resurgence last year.
Growth this year is likely to be in negative territory again, and price deflation is expected to persist.
Such a prolonged downturn is unprecedented in Hong Kong's recent economic history.
Repeated US interest rate cuts have allowed a timely easing of monetary conditions in Hong Kong.
But, up to a point, further cuts in interest rates are akin to pushing with a string. Given the gloomy
mood that now prevails, it may therefore take some time for monetary easing to have an impact on
economic activity. Of particular concern now is the unemployment rate. Having declined from a peak
of 6.3% at the darkest time of the Asian financial crisis to 4.4% in late 2000, it has been slowly rising,
and is likely to edge up further. Part of this is the result of the global slowdown. But unemployment is
also complicated, and aggravated, by the structural transformation of our economy, as our
manufacturing sector continues to contract and as skill mismatches make it difficult for the growth
industries - such as financial services and, until recently, IT - to take up the slack.
Behind all the figures are stories of individual pain and hardship - of lost jobs, negative equity,
bankruptcies - and a general sense of insecurity and pessimism in the community. These are the
conditions for very unfavourable, and potentially destabilising, interactions between the real economy
and the financial sector. The Hang Seng Index has dropped by more than 30% since the beginning of
the year. Sluggish lending is hurting banks' profits. The delinquency ratio for credit card receivables is
on the rise. That for home mortgages has nevertheless been falling, thanks to substantially lower
mortgage interest rates, but higher unemployment may reverse the trend.
At times such as this, it is necessary to look very carefully to see how our financial system is coping
with the stresses and strains of prolonged economic difficulty, particularly since that difficulty is likely to
continue for some time. In the light of September 11th, it is also important to reflect on how resilient
our system is in the face of a sudden emergency. How strong is the financial and banking
infrastructure we have built in Hong Kong over the years, and what further building is necessary to
make it still stronger?
Building stability
The attacks in Lower Manhattan on September 11th were, among many things, an attempt to bring the
world's largest financial centre to its knees. Given the scale and the location of the attacks, it is
remarkable how quickly operations resumed in New York and, consequently, how little disruption
occurred to financial markets across the world. In particular, the all-important payment systems were
able to remain in operation without failure or gridlock. This is a tribute to the crisis-readiness of the
organisations involved - whether private or public - and an example of that quality of determination in
the New York spirit, which has impressed, and moved, all of us.
Because the US financial infrastructure was robust enough to cope, there was no contagion in Hong
Kong or elsewhere. But the possibility of a systemic problem of global dimensions involving the world's
most important currency was a serious concern at the time. And the events in New York quite naturally
prompted us to look at our own contingency plans, especially for crucial operations, such as our
payment and settlement systems. These plans had already been greatly expanded and rigorously
tested in advance of the Y2K transition. They cannot specifically address every possible disaster
whether at home or elsewhere - but we are pretty confident that they are robust and flexible enough to
enable us to maintain our core operations in all but the most unmanageable situations.
More broadly, the events on 11 September have also prompted us to reflect on the nature and
structure of global clearing systems. Last year, as you know, Hong Kong launched its own US dollar
clearing system, to provide real-time settlement for the full range of US dollar transactions in the Asian
time zone. The aim is to cut down Herstatt risk - that is the foreign exchange settlement risk relating to
the delivery of different currencies in different time zones - and to provide a fast, efficient and cheap
service for our own region. September 11th brought home to us the risk of serious disruptions to the
global settlement system and underlined the importance of our US dollar clearing system as a risk
management service. Clearly, greater use of the local system for real-time settlement of Hong Kong
dollar versus US dollar transactions would bring real benefits in terms of reduction and diversification
of risk. Banks in Hong Kong will no doubt be looking seriously at their existing settlement
arrangements for such transactions, and at the greater use they can make of local services to achieve
finality of settlement for the currencies simultaneously in our time zone.
For our own part, the HKMA will continue to develop and reinforce our local financial infrastructure and
to link it more efficiently with global systems. We have, for example, started on the development of a
two-way linkage with Euroclear, one of the world's largest central securities depositories. The two-way
linkage, which will be highly automated for heavy usage, will enable investors in the Asian region to
gain trading access to securities lodged with Euroclear.
The infrastructure providing for payment and settlement form the essential roads and bridges that
connect banks and other institutions with each other. What of the banks themselves? In Hong Kong,
they have seen declining profits at a time of increasing competition. Yet the banking sector remains
remarkably strong, with an average capital adequacy ratio of 18%. With good reason, the general
public, and the international financial community, have a very high degree of confidence in Hong
Kong's banks. They have maintained, and in many cases increased, their strength during a prolonged
period of financial crisis, at a time of far-reaching change to the banking industry worldwide and
important regulatory reforms at home.
A large part of this programme of reform has aimed at enabling our banking system to build further on
its strengths and to channel them more efficiently. An important theme in the reform programme is the
removal of barriers to competition with the aim of driving efficiency and energy in the banking sector.
One of the outcomes has been the considerable progress made recently towards the consolidation of
banks into institutions of a size and scope that can make them more capable of deploying their
strengths in an increasingly globalised environment.
The complementary theme in the reform programme is improving and expanding safety measures, not
with the aim of sustaining weak institutions, but in order to prevent systemic contagion should a bank
run into difficulties and to provide a greater measure of protection to the small depositor. In 1999 we
clarified our role as lender of last resort, a measure of some importance in times of economic or
financial uncertainty. We have made progress in implementing our risk-based supervisory approach,
which is intended to produce a more focused and accurate assessment of the areas of greatest risk to
individual institutions - and to take pre-emptive actions. Our plans for a deposit insurance scheme
which will provide a safety net for small depositors in the event of a bank failure - are progressing well.
Consultations on the technical details are continuing, and we expect to be able to introduce the
necessary legislation in late 2002.
The aim of all these measures - and the first duty of any banking regulator - is to maintain and improve
the stability and strength of the system as a whole. During these times of difficulty, there is a further
impetus to seek, where possible, to alleviate some of the burdens carried by the community, if only for
the purpose of safeguarding the asset quality of the banks. A balance needs to be drawn between
efficiency, profitability and prudent risk management - which are the essential ingredients of banking
stability - and concessions to the individual customer, however desirable these may seem. But banks
in Hong Kong have shown that, by balancing the two in an imaginative and sensitive manner, these
aims are not incompatible. Banks have, for example, generally been careful so far to ensure, in their
setting of fees and charges, that vulnerable groups are not excluded from basic banking services.
They have - far more perhaps than has been acknowledged - been both forbearing and constructive in
their treatment of mortgage-holders facing difficulties; in particular, they have responded positively to
our recent measures to enable them to be more flexible in offering relief to homeowners in negative
equity. I have no doubt that they will act equally positively on the proposed $1.9 billion loan guarantee
scheme for small and medium enterprises recently announced by the Government.
Such schemes, like the various other relief measures announced in the annual policy address a
couple of weeks ago, will provide some palliative, and perhaps some stimulus, during hard times.
Ultimately, however, sustained recovery will come only when the external situation improves. In the
meantime, we should take what measures we can to control the damage, maintain stability and
strength in our financial and banking systems, and position ourselves as best we can to get the best
advantage out of recovery.
The link
One question, raised by a few commentators, is whether Hong Kong would be benefited if we were to
change, or even abolish, the Linked Exchange Rate system. Some have simply recommended a
thorough, but not urgent, review of the system. Some have suggested a repegging - at a lower value
or an abandonment of the peg when times are less unstable or when the economy is booming again.
Others have called for action now. Still others, though not very convincingly, and not very
constructively either, have criticised the Government for not introducing changes in the 1990s. The
reasoning behind most of these commentaries claims that the Link hinders Hong Kong's
competitiveness, and therefore our recovery; that the Link removes from us control over our monetary
policy; and that the Link is fuelling deflation.
Before I respond to these claims, let me make three points very clear. The first is that I have no
objection to an open and informed public debate on the merits and disadvantages of the Link - and on
possible alternative exchange rate systems. It is absolutely right that a policy that forms the keystone
of our financial system should be open to scrutiny. The strong public and market confidence in our
currency can only be sustained if the reasons for adopting the monetary policy we choose are properly
understood, and if the limitations, and the merits and demerits of possible alternatives, are examined
through informed and reasoned debate. We encourage this process in the various publications we put
out, in our educational programmes, and through the presentations and discussions that my
colleagues and I take part in with people from all walks of life.
Secondly, the benefits and disadvantages of the Link - its effects on the economy, the experience of
similar systems elsewhere, the possible alternatives - are, and always have been, subject to
continuous and critical review. This process has been considerably strengthened in recent years with
the creation of a dedicated research department within the HKMA, the establishment of the Currency
Board Sub-Committee, and the opening of the Hong Kong Institute of Monetary Research. A very
large part of the output of these institutions is made public, so that the range and depth of the research
they carry out is available to anyone who is interested.
Thirdly, we are under no illusions about the limitations imposed by the Link. We agree that it rules out
the possibility of using the exchange rate to help us adjust more quickly to sudden shocks. We agree
that it ties Hong Kong to US monetary policy at times when the economic cycles of the Hong Kong and
the US may not necessarily be moving in sync. We agree that it is a cause of asset price inflation in
the nineties and deflation more recently. We agree, in short, that it is not a perfect system. But then,
no exchange rate system is perfect. And the question to be asked, I would suggest, is not "Where is
the exchange rate system that will remove these limitations?" It is "Are these limitations so severe, so
constricting, so damaging as to outweigh the advantages that the Link brings to Hong Kong, or to
outweigh the risks and uncertainties that would inevitably arise if we were to change or abandon the
Link?" I think that the answer has to be no.
Let us take the question of competitiveness first. The claim is made that, without exchange rate
flexibility, our products, and Hong Kong generally, have become uncompetitive when compared with
economies in the region that have devalued their currencies. Even ignoring the fallacy of competitive
devaluation, this claim assumes that the nominal exchange rate on its own is a reliable measure of an
economy's competitiveness. Of course, it is not so for any economy, and is still less so for Hong Kong,
which is going through structural transformation. The nominal exchange rate is relevant, but more
relevant is the real effective exchange rate (REER), which also takes into account the inflation rate
and the trade patterns. The REER for the Hong Kong dollar has depreciated by around 13% since the
crisis period in 1998. During the same period, the REERs for other Asian currencies have appreciated
by various degrees, reflecting both a rebound in nominal exchange rates as well as higher domestic
inflation.
Hong Kong's competitiveness can also be measured by our economic achievement in terms of real
GDP growth over the past few years. Here again the figures show that Hong Kong, with an annual
average of around 3% growth in GDP between 1997 and 2000, has not performed badly compared
with other economies in the region. And remember, these other economies have had their currencies
devalued substantially. The sharp deceleration in growth this year is due mainly to the slowdown in the
major industrial economies outside the region, not because of our competitive position, and certainly
not because of the strength of our currency. All of us within the region are affected to one degree or
another, and some, such as Singapore, Taiwan and Korea, have been badly affected because of their
strong dependence on exports of electronics and computer parts. Hong Kong has done rather less
badly so far, though we are still slowing down.
The second claim is that, with the Link we place the control of our monetary policy in the Federal
Reserve and thus lose monetary policy as an instrument for stimulating (or restraining) the economy.
In particular, we have, during the life of the Link so far, had the experience of low interest rates
imported from the US when a tighter policy might have been more suited to our macroeconomic
needs; and, more recently, in the aftermath of the Asian financial crisis, the opposite problem. But
these misalignments are one of the trade-offs that we have to accept from time to time in return for
exchange rate stability.
At present, and more often than not, the US and Hong Kong economies are more or less in sync, and
the interest rates we import are perhaps more appropriate for our needs than they have been at any
time over the past decade. That in itself does not alter the point about loss of control of monetary
policy, though it makes it less relevant and less forceful at a time like this. But the complaints about
shackling our interest rates to those of the US beg the larger question of whether, if we free ourselves
of that burden, we would really be able to run a truly independent monetary policy. How far, for
example, would we be inhibited from reducing interest rates at times when that would be appropriate
because of inflationary concerns generated by exchange rate depreciation? And how far, in any case,
would we be able to avoid importing US monetary policy even in the absence of the Link? The
experience elsewhere in the region does not give ground for much optimism.
The third question is how far the Link is fuelling deflation, and how far this is detrimental to our
economy. Internal price deflation is indeed a part - and a necessary part - of the process of adjustment
imposed on the economy under the Link when there is a fall off in external demand. It is also,
incidentally, a feature of our longer-term economic integration with the Mainland of China. It is the
counterpart of currency depreciation under a floating regime, except that the adjustments that it forces
to take place tend to involve less overshooting, less instability, and more lasting restructuring. Price
deflation brings pain to those who see the value of their assets shrink dramatically, and, as we know,
there are many in Hong Kong who are, sadly, in this position. But there are many more who have seen
their purchasing power increase, as prices for the whole range of goods and services steadily decline.
And the effect, equivalent to that of devaluation, on adding to the attraction of Hong Kong as a
regional centre, and as a destination for tourists, can only be positive. The concern comes when price
deflation, as part of the adjustment process under the Link, turns into the kind of spiralling deflation
that inhibits investment and fuels recession. At present, and despite nearly three years of steady price
deflation, this does not appear to be happening. Indeed, the experience last year of robust growth and
moderate price decline underlines the point that price deflation and economic expansion are quite
compatible under a linked exchange rate system.
I have tried to place these complaints about the Link in a larger perspective. That is not to deny that
the complaints have some validity. The Link does have shortcomings. It does impose restrictions. We
should all have the courage to speak of and accept them, while not overlooking the advantages of the
system. And there are two clear and simple advantages of overriding importance for Hong Kong. A
stable exchange rate provides a predictable and conducive business environment for an economy that
imports practically everything that it consumes, processes or re-exports. And, for a financial centre
with strong international capital flows but no capital controls, linking our currency to a strong
international currency provides stability and strength. Although not perfect, the Link has served Hong
Kong well, and there is no better and less risky alternative. There is no intention or plan to change or
abandon it.
Given the renewed interest in the subject, and for the sceptics who remain, let me go the extra mile
here for their benefit. Let me tackle the question of what would happen if Hong Kong were to depeg.
Within the HKMA we think of this a great deal. This is not because we expect or intend it to happen. It
is because any responsible central banking institution must have an idea of what conditions might be
like under an alternative system - if only to clarify its understanding of, and justify its adherence to, the
present system. And any organisation must have contingency plans to deal with the unexpected and
the unintended. We do not, of course, make public our contingency plans, though we do, as I have
mentioned earlier, make public a great deal of research carried out within the HKMA or under our
auspices on issues surrounding the Link.
What, then, might happen if Hong Kong were to depeg? The answers would, of course, depend on
what monetary policy was adopted in its place. It would also depend on domestic, and particularly
external, conditions at the time. The outcome could, I think, even with the most benign conditions and
the best-judged strategy, be summarised in two words, "uncertainty" and "instability". Uncertainty,
because the Hong Kong dollar would become a magnet to speculators eager to test the limits and the
weaknesses of the new regime, with all the instability that would bring. Uncertainty in the effects on
business and on daily life, if, as a result of that instability or of a general fall in confidence, the value of
the Hong Kong dollar depreciated dramatically and, in consequence, the price of our imports
increased sharply. Uncertainty and instability, because if imported inflation was high, and if monetary
policy were to be targeted towards stable domestic prices (which is the general alternative to an
exchange-rate-based regime), it may not be possible to keep interest rates low.
If, heaven forbid, depegging were to be carried out in the conditions that we have now, then we might
add a third word to "uncertainty" and "instability": "catastrophe", since nearly everyone seems to
recognise that the worst possible time to change a fundamental monetary policy of this kind is when
the economy is weak and when the outlook is full of risk.
Those of you who are old enough will recall the circumstances that led to the creation of the Link in
October 1983. At that time, we were facing a crisis in confidence in the future of Hong Kong, concerns
about the soundness of a number of banks, and speculative attacks on the Hong Kong dollar. The
crisis followed almost a decade of a floating exchange rate system, during which inflation rose to well
over 10%, and sometimes hit 20%, and the value of the Hong Kong dollar declined from around five to
the US dollar to a low of 9.6 on 23 September 1983. In the uncertainty that prevailed during that crisis,
people rushed to the supermarket to stock up on rice, instant noodles, cooking oil, soya sauce,
detergent and toilet paper, not knowing how much these basic commodities might cost in a week or a
month's time. Some shops were reluctant to accept Hong Kong dollars. No one, I think, who lived
through those times would wish to live through similar events again.
Conclusion
The creation of the Link eighteen years ago helped restore stability at an unstable time. History does
not repeat itself. Times change. But let us at least remember the experience of those years when we
talk about the usefulness or otherwise of the Link to Hong Kong during what are, arguably, even more
unstable times. At this time of great global uncertainty and local distress, our efforts should be directed
towards building stability, not destroying or undermining it. I have given some account in this talk of
how, in its banking system and financial infrastructure, and in its currency, Hong Kong enjoys a
position of great strength. It is from this position of strength, and not through any sudden and
destabilising gimmickry, that we will best be able to weather the difficulties that now face us, and to
embrace the opportunities to come.