Address by the Chief
Mr. Yam comments on the financial turmoil in Asia
Executive of the Hong Kong Monetary Institute, Mr. Joseph Yam, JP, at the Euromoney Asia Pacific
Issuers and Investors Forum on 2/12/97.
1. Ladies and gentlemen, I am honoured to have been invited this year to deliver the
opening address for Euromoney's Asia Pacific Issuers and Investors Forum.
2. The year 1997 has been an unusual year for Asia, particularly for Hong Kong.
Amidst financial turmoil of the worst kind in the history of Asia, Hong Kong went through political
transition to become a Special Administrative Region of the People's Republic of China. This was
achieved in the smoothest manner one could imagine. And as the currencies of Asia tumbled one
after another in a process of competitive devaluation, involving sharp depletions of foreign reserves
and requiring financial assistance from the International Monetary Fund and others, and sending
shock waves to financial markets throughout the region and beyond, our currency, the Hong Kong
dollar, remained very stable and our already very substantial foreign reserves increased. Although our
asset markets have been affected by the contagion, some consolidation was in any case overdue; and
in the event, for the year to date, the downward adjustment has been significantly less severe than
those of many others in the region.
3. Hong Kong has thus held up extremely well under the circumstances. This has
perhaps surprised many, just as they have been surprised that the financial turmoil of the region could
so suddenly erupt with such severity and contagion.
4. Indeed, not long ago, stories about the Asian miracle abounded. Asia had been the
fastest growing region in the world and the economic numbers had been generally sound. Asian
economies had low inflation rates and exchange rates had been stable, at least until recently. Current
account for the region as a whole had been broadly in balance, although understandably the situation
for individual economies varied. The fiscal account excluding Japan had been in surplus. Asia also
had exceptionally high savings rates of over 30% of GDP and investment rates were equally high.
Official sector savings of the Asian economies, in terms of their foreign currency reserves, were very
substantial, accounting for about 40% of the world's foreign exchange reserves. Now five of the top
six foreign reserves holders in the world are in Asia. The work force in Asia was young, educated
and flexible. The political situation was stable. Policies were outward-looking with a commitment to
open markets and free trade.
5. So what went wrong in Asia? What turned the Asian miracle into what is now
referred to, quite unkindly in my opinion, as the Asian myth or the Asian mirage? A few months into
this fall out, there have been many explanations offered. The most talked about was the rapid growth
and volatility of international capital flows.
6. According to IMF statistics, net capital inflow to emerging markets was less than
US$ 50 billion a year at the beginning of the decade. By 1996, however, this had increased to
US$ 235 billion. Asia has received roughly half of this capital inflow. In some Asian economies, net
capital inflows have averaged 5% to 8% of GDP over a long period. Contributing to this surge of
international capital flows was financial liberalization undertaken by economies which had the
foresight to do so, with a view to encouraging financial intermediation, domestically as well as
internationally, so that the high savings could be channelled into productive investments, thus
promoting economic growth. Meanwhile, there has been continued willingness on the part of the
developed economies to export capital, under the influence of sustained economic growth, low
inflation and low interest rates. Increasing amount of mutual funds and pension funds of these
economies looked for higher returns in the emerging markets. In the case of Japan, sustained large
current account surpluses, coupled with the earlier appreciation of the yen, have forced many
Japanese firms to relocate their production to the rest of Asia. Thus capital inflows into the Asian
region have been large.
7. With financial liberalization and the globalization of financial markets, a substantial
part of the capital inflow into Asia has been in the form of foreign portfolio investments directed
principally at financial instruments in the form of equity and bonds, and, where available, derivatives
thereof. These international funds are generally highly alert to shifts in the expectation of risk, return
and liquidity. They can therefore be highly volatile, with the tendency of reversing direction
whenever there is the slightest hint of trouble, in respect of the macroeconomic policies, in particular
financial policies pursued by governments, the robustness of the financial markets in which they
operate, the soundness of the financial intermediaries with which they deal, etc.
8. Those economies which are dependent upon such capital inflows are clearly
vulnerable to their reversal. Ideally therefore they ought to pay a lot of attention to pursuing sound
macroeconomic policies and be transparent about them. This has perhaps proven to be politically
difficult to achieve in some cases. They also need to ensure that they are in a position to deal with the
volatility that characterizes the flow of international capital. And this means having:
first, an effective monetary management mechanism that is capable of
delivering currency stability;
second, a regulatory and supervisory framework that safeguards the
integrity of financial markets and the financial intermediaries in accordance with
internationally accepted standards; and
third, a robust financial infrastructure that enables financial transactions to be
conducted efficiently and with a minimum of risk of failure.
9. This is a tall order, even for a relatively closed financial system that operates under
more benign circumstances, not to mention for a newly liberalized financial system under stressful
conditions. It is therefore understandable that when the reversal of capital inflows came, it caused the
damaging financial turmoil that we have seen in a number of Asian economies.
10. Financial liberalization encourages greater financial intermediation, domestically
and internationally, and this obviously is beneficial to economic growth and development. But clearly
the risks arising from this worthy process must be identified and managed properly before the long
term beneficial effects could be realized. The risks are, nevertheless, not well appreciated, simple as
they may be, particularly with the benefit of hindsight.
11. There is, as always, credit risk. Yet it is such a common feature that undue
exuberance on the part of investors would push price to earning ratios well beyond fundamentals.
Bankers also fail to assess the impact of interest rate hikes on the value of collateral or on cash flows.
The result is therefore the usual over exposure of investors and lenders to asset losses. Then there is
maturity risk. To say that it is risky to finance illiquid non-tradables, such as property, with short term
capital inflows is, I suppose, teaching grandmothers to suck eggs, particularly in this company, but
this again has been a common feature underlying financial shocks, not just in Asia but also in other
parts of the world. The same with currency risk. Many borrowers, in both the private and public
sectors, were keen to borrow foreign currency funds to finance investments that do not generate
sufficient foreign exchange to repay the debt. Such debts were also unhedged. And so when exchange
rates move sharply, which they do, the currency mismatch results in large losses.
12. But I suppose we all learn from mistakes. We in Hong Kong did so the hard way
in the early 1980s when the situation was compounded by uncertainties about the political future of
Hong Kong. We had our currency crisis in 1983, after nine years of operating with a floating
exchange rate, against volatile capital flows, without any effective mechanism for monetary
management or currency anchor. Our banks had been overly exposed to credit, maturity and currency
risks, and a total of seven banks had to be rescued directly or indirectly through the use of public
funds. In short, we had been complacent.
13. But, thankfully, never have we been in any doubt about the need to maintain free
and open markets, and a liberal financial system. The correct response to financial turmoil is not to
resort to controls or to apportion blame, but to put one's own house in order, and ensure that one is in
a position to cope. This we did through a series of reform measures to strengthen our monetary and
financial systems implemented in the past ten years. This was, in part, also spurred by the desire to
minimize the risk of possible financial disturbance ahead of and through political transition, and to
provide the environment for Hong Kong's continuing development as an international financial
centre, as required under the Basic Law. Our experience tells us that financial reform takes time and
determination, and the ability to bite the bullet and bear the short-term pain. It is also very much a
continuous process, with financial innovation creating new circumstances and presenting new
challenges all the time.
14. I believe that we have successfully achieved this, which is the important reason
why we have stood out as an oasis of calm, at least relatively speaking, in the storm of financial
turmoil that is currently sweeping through the region and beyond. Some say that we are sticking out
like a sore thumb, referring particularly to our fixed exchange rate link with the US dollar. I can of
course respond to that by pointing to how well our linked exchange rate system, a currency board
system that functions on auto-pilot, has worked. I can point to the supervisory efforts which have put
our banking system on a very sound footing, and to our advanced financial infrastructure which has
helped tremendously to contain and manage risks of a systemic nature. But many of you are, I am
sure, already sick of my talking all the time, and may even dismiss what I say as trumpeting. I do not
blame you. I am well aware of the possibility that over ten years of direct involvement in monetary
reform in Hong Kong may have introduced a degree of bias in my views on the subject, which I have
tried consciously to avoid.
15. But I would urge you instead to look at the reports of our annual medical
check-ups conducted by the IMF since 1990 in the form of what are known as the Article IV
Consultations. The IMF team was in fact in Hong Kong for this year's Consultation in the second
half of October, when the short-lived but somewhat intense attack on our currency occurred. It was
the best time for any diagnosis of financial problems. But after observing us closely over the period
the team again gave us a clean bill of health. Let me give you a few relevant quotes from the
Concluding Statement of the Consultation, which has already been published. It said that:
"The authorities' commitment to a rules-based and non-interventionist approach
should enhance the economy's ability to withstand the recent regional and financial market turmoil."
"As in the past, the mission strongly endorses the authorities' continued commitment
to the linked exchange rate system."
"Appropriately, the authorities have taken forceful action during the past two weeks to
tighten significantly monetary conditions, and have successfully demonstrated their ability and
commitment to defend the link."
"It is important to recognize that allowing interest rates to rise in response to exchange
market pressures is an essential element of the currency board mechanism that lies at the heart of
Hong Kong's monetary arrangements."
"Recent events demonstrate that the system is working exactly as intended ..."
"Our discussions with market participants have indicated a widely-held consensus that
the prudential and regulatory oversight of the financial sector is strong, which has helped underpin
confidence in the system."
16. But what the internationally renowned doctor, in the form of the IMF, says may
not always be universally acceptable, particularly for those who may have been innocent parties
having to suffer the pain of market adjustment, inevitable as it may be. It is quite understandable
therefore that there will always be grievances and consequently calls for prescriptions for pain killers
and other preventive medicine. I welcome constructive suggestions very much and we are in the
process of meeting with those who are so kind as to offer their views and go through the vigorous
technical discussions that good ideas deserve.
17. So far I am glad that there is full support for our linked exchange rate system. No
one liked the prospect of Hong Kong being swept along in the process of competitive devaluation in
the region and sharper downward adjustment in asset prices. At the technical level, two schools of
thought could be identified at this stage. One expressed concern on the scope in which the Hong
Kong Monetary Authority exercised discretion in our rule-based monetary system. Associated with
this are also suggestions for improvement on how the system could be allowed to work more
effectively and automatically. The other felt that the HKMA should have been more forthcoming in
relieving the tightness in the money market and therefore the pain of those affected.
18. Interestingly, the two schools of thought are quite polarized. And, as always, the
correct course should be somewhere in between, involving a good mix of pragmatism in the light of
present day circumstances in financial markets, having regard also to the need for the HKMA to
function as the lender of last resort to the banking system, but without any departure from the strict
discipline of the currency board system requiring full US dollar backing for the Hong Kong dollar
monetary base. This, incidentally, has very much been the attitude of the HKMA. Discussions
continue, as part of the review initiated by the Financial Secretary, and I look forward to more of the
technical scrutiny of ideas which can be quite enjoyable and revealing.
19. Meanwhile, elsewhere in the region, the full doses of the medicine prescribed by
the IMF for a number of the Asian economies are being dutifully and courageously taken. If they
persevere, they stand a good chance of coming out of this financial turmoil quickly and the damaging
contagion that has spread across the world would be effectively contained. And for the longer term, I
am hopeful that the new framework for enhanced Asian regional cooperation to promote financial
stability, agreed upon at the Manila meeting of Asian finance and central bank deputies, and
subsequently endorsed by APEC economic leaders at the Vancouver meeting, would play an
effective role.
20. The framework, which recognizes the central role of the IMF in the international
monetary system, includes important initiatives:
first, there will be established a mechanism for regional surveillance to complement
global surveillance by the IMF;
second, there will be enhanced economic and technical cooperation particularly in
strengthening domestic financial systems and regulatory capacities;
third, there will be measures to strengthen the IMF's capacity to respond to financial
crisis; and
fourth, there will be a cooperative financial arrangement that would supplement IMF
resources on a case by case, contingent basis.
21. But it is perhaps in the nature of financial flows that they do more often than not
lead to overshooting in financial markets. The strong growth track record of Asia and indeed of other
emerging markets has, with the benefit of hindsight, brought about excess optimism in these markets,
producing a compression of yield spreads which underpriced the underlying credit, market and other
risks that are typical of emerging markets going through financial liberalization. Indeed, Alan
Greenspan said recently that "in retrospect, it is clear that more investment monies flowed into these
economies than could be profitably employed at modest risk". With the sharp correction seen in
financial markets in Asia, against the background that the economic fundamentals have largely
remained sound, whether in isolation or relative to other emerging markets beyond the region, it is
possible that there might now have been overshooting in the other direction.
22. I am sure, however, that the markets will eventually find their right levels,
reflecting new circumstances, for better or for worse. I am not convinced, in any case, that the
devaluation brought about by floating the exchange rate is necessarily the panacea for the ills of our
Asian neighbours. First year economics tells us that the four elasticities of demand and supply of
imports and exports may not interact to produce a clearly positive contribution to the balance of
payments position from devaluation. Furthermore, when stable exchange rates are replaced by
flexible, volatile and, in all likelihood, depreciating ones, the demand for hedging in the more volatile
environment and under liberalized arrangements may drive exchange rates to such debilitating levels
that many would regret the lack of resolve in pursuing sensible policies and in the defence of stable
exchange rates in the first place. There is no doubt that confidence in the stability of a few Asian
currencies has now been badly undermined and rebuilding it may take more than just time.
Nevertheless, as the very productive Asian economies find their feet again, they will soon be on their
way with renewed vigour.
23. For Hong Kong, as very much a service-oriented economy, any erosion of
competitiveness, as a result of our currency holding stable against the US dollar while others have
fallen, is likely to be mild. Our economy is not particularly sensitive to exchange rate changes. The
IMF forecast for Hong Kong's growth rate next year is 4.25%, only a shade below our trend growth
rate of 5%, representing a healthy consolidation in the circumstances.