The year 1997 has been one of the most eventful and significant chapters in the financial history not only for Hong Kong but for the whole Asia Pacific region. The most serious currency turmoil dominated the last quarter of the year while the magnitude and speed of the contagion caught every one by surprise. Hong Kong was fortunate and with good reasons to be the least and the last to be affected.

"The most serious currency turmoil ...... Hong Kong was fortunate and with good reasons to be the least and the last to be affected."

Smooth transition with greater autonomy

The first half of 1997 witnessed a smooth transition of the territory with the resumption of sovereignty by China on 1 July. On the monetary front, the hitch-free handover was to a great extent due to the persistent reforms of the monetary system undertaken over the last 10 years. Under the "one country, two systems" principle, the monetary autonomy enjoyed by the Hong Kong Special Administrative Region (HKSAR) Government is considerably greater after the handover. The close consultation between the past administration of Hong Kong and the UK Secretary of State on matters related to monetary and financial areas is no longer required after 1 July as the central government in Beijing has left such matters entirely with the HKSAR Government. This is a clear demonstration of the high degree of autonomy as promised under the Basic Law and the Sino-British Joint Declaration.

"Monetary stability was maintained despite the fiercest speculative attack in recent history."

The objectives of the Hong Kong Monetary Authority (HKMA) are three-fold: deliverance of monetary stability in the form of exchange rate stability; the maintenance of financial stability through sound banking supervision, and the promotion of the financial infrastructure, such as an effective and robust payment system. I am pleased to report that in 1997, the HKMA was able to deliver on all three objectives.

Strong confidence sets the background for asset inflation

During 1997, the economy in the months leading to the handover was brisk and the market sentiment was bullish - perhaps exceedingly so. Reflecting the robustness of the Hong Kong dollar, the foreign exchange and money markets reacted calmly to the passing away of the Chinese leader, Deng Xiaoping, in February. On the other hand, strong confidence and the smooth transition set the background for the sharp surges in equity and property prices which hit historical highs in July - reaching levels hardly sustainable even without the Asian regional turmoil. Asian currency turmoil and short-lived attack on the Hong Kong dollar The day following the smooth handover, the floating of the Thai Baht sparked off an unprecedented wave of currency devaluations in the region. Market sentiment in the region worsened by the week. The turmoil reached its peak in early October when the New Taiwan dollar - considered by many as one of the few remaining stalwarts of stability - succumbed and fell by 7%. Within days, the speculation which had so far left Hong Kong virtually untouched swept over our shores. The speculative selling of the local currency in the third week of October resulted in banks collectively selling more Hong Kong dollars to the HKMA than they could settle. As a result, the acute shortage of the Hong Kong dollar drove interbank interest rates to 280% briefly on 23 October. However, the sharp interest rate hike quickly stemmed capital outflow and fended off speculators. Overnight interest rates stabilized at single digits within two days. Monetary stability was maintained despite the fiercest speculative attack in recent history.

It is unfortunate that there was a common lack of appreciation then and even now within and outside the market that the currency system in Hong Kong is the strongest form of fixed exchange rate system, quite unlike any in Asia. Our currency board system which requires the strictest discipline leaves the authorities with no room to manoeuvre the supply of money or the interest rates as both should automatically adjust in accordance with capital inflows and outflows. The fact that the Hong Kong dollar has weathered the regional financial turmoil and fended off episodes of speculation and had remained the staunchest currency in the region shows that the currency board system has worked well as it has done so in the past 14 years since it was first put in place in 1983. And over those years, numerous reforms were introduced to strengthen the monetary system while the official reserves of the territory more than doubled from US$45.6 bn to US$92.8 bn between 1983 and 1997. Although the currency board system requires only 100% backing of the monetary base (money in circulation plus balances held by banks with the HKMA), it is more than 700% backed in our case. In Hong Kong, budget surplus is the norm and this explains the healthy accumulation of reserves. The HKMA has also undertaken prudent management strategies in the investment of the reserves which are vested in two separate portfolios - the Exchange Fund and the Land Fund. Despite the extremely volatile market in 1997, the Exchange Fund performance was very satisfactory with 10% growth in accumulated surplus. The Land Fund which was transferred to the HKSAR Government on 1 July 1997 is now also managed by the HKMA. Unlike the Exchange Fund which is primarily invested in OECD bonds and equities, the Land Fund was exposed to Asian equity markets right from the start. However, the HKMA had taken early and major defensive steps to reduce regional exposure before the regional turmoil set in resulting in a small (0.8%) loss in the assets by the end of 1997.

"Despite the extremely volatile market in 1997, the Exchange Fund performance was very satisfactory."

The October episode was brief and overnight interest rates have fallen as quickly as they have risen. But market sentiment has since remained weak. Longer-term Hong Kong dollar rates have remained relatively high while banks have become cautious in their lending activities. Credit tightening and the sharp correction in the property and stock markets following the October crisis resulted in a slowdown of the local economy. The Financial Secretary has forecasted a 3.5% growth in GDP for 1998 compared with 5.2% in 1997. However, if one puts Hong Kong in the context of the entire region, we in fact emerged from the regional turmoil comparatively unscathed. Some regional economies have lost 50% or even 80% of the value of their currency in a matter of a few months leading to hyper inflation and either zero or negative economic growth in 1998. Even relatively strong economies such as Taiwan and Singapore have seen hikes in their interest rates and more than a 10% drop in the exchange rate of their currencies.

Sound fundamentals helped banks weather the turmoil

There are fundamental characteristics of Hong Kong that distinguished us from other economies in the region - again something not well understood and appreciated. Hong Kong has experienced and learnt from the lessons in the early 1980s about the importance of a strong banking system. The irrational exuberance that has been the feature of asset markets in the Asian region was also present in Hong Kong in the months leading to the regional crisis. But prudent risk management, best market practices and vigorous supervision on our part have enabled banks in Hong Kong to absorb the sharp asset price deflation and the generally difficult environment in the last quarter of the year. Limited exposure to the Asian region explained why banks were able to stand up well against the currency turmoil. For 1998, higher provisions are expected but the local banks should still be able to report reasonable profits. Overall, the banking sector should remain well-capitalized and liquid. The HKMA will continue to monitor closely the banking sector in particular property-related lending. We will adopt a forward-looking approach and ensure that the projected growth in property lending complies with reasonable projections. Ultimately, the emphasis will be sound fundamentals, such as strong capital adequacy; high liquidity; prudent loan classification and provisioning, as well as sound risk management.

"For 1998, higher provisions are expected but the local banks should still be able to report reasonable profits."

Preparing the banking sector for Year 2000 and beyond

To prepare us as the supervisory authority for the next millennium, one of the key tasks in 1998 is a strategic study on the banking sector. Developments such as increased globalization of markets, increased competition, innovations in financial products and the advent of new technology will have major implications for the sector and it is essential that we should be proactive in addressing these challenges. It was the wide-ranging banking reforms carried out since the mid-1980s which have made banks in Hong Kong the most resilient and healthy in the region and which have also left banks largely protected from the regional turmoil and the subsequent downturn in the local economy.

I should add that the banking sector and indeed the corporate sector in general in Hong Kong need to ensure that they survive into the next millennium by taking timely and effective action to deal with the Year 2000 problem. We shall be intensifying our monitoring effort in this area during the course of 1998.

The Real Time Gross Settlement (RTGS) payment system for banks which was put in place in December 1996 well proved its worth during the currency turmoil. Despite the huge volume of initial public offerings and large fund flows during the year, the RTGS system functioned without any hitches and received appreciation and acclaim from the banking and international financial communities. Significant efforts were made to upgrade the hardware and improve operating efficiency and backup procedures at Hong Kong Interbank Clearing Ltd, a joint-venture between the HKMA and the Hong Kong Association of Banks.

Hong Kong's role in regional and international financial co-operation

The regional turmoil has stabilized considerably since the beginning of 1998. This would not have been possible without the will of the troubled economies and the close international co-operation in which the HKMA has played an increasingly significant role over the years. The World Bank Group /IMF Annual Meetings held in Hong Kong in September 1997 provided a most timely opportunity for international financial experts and top government officials from around the world not only to witness the successful political transition of Hong Kong but also to ponder the future of global financial markets. Much debate was generated on issues such as liberalization versus tighter control of capital flows, or private sector capital versus public sector funds to aid needy economies. The HKMA has also taken part actively in 1997 in various regional and multi-national central banking forums to discuss strategies and approaches to tackle the Asian regional crisis. In 1997, the HKMA entered into bilateral repurchase (repo) agreements with the Bank of Korea and the Reserve Bank of New Zealand. These are the ninth and tenth repo agreements that the HKMA has signed with central banks and monetary authorities in the region. In addition, we have contributed US$1 bn towards an IMF-led loan facility to Thailand to assist the country in carrying out the necessary reforms. This showed our commitment to regional monetary stability since it is in Hong Kong's interests, as a leading financial centre, to see a strong and stable neighbouring environment.

"The World Bank Group/ IMF Annual Meetings provided a most timely opportunity for international financial experts and top government officials from around the world to witness the successful political transition of Hong Kong."

Trilogy of robust financial systems: monetary management, banking supervision and financial infrastructure

The financial turmoil in Asia has highlighted the importance of risk management and sound financial intermediation. The benefits of financial liberalization created an euphoria that regrettably encouraged neglect of the need to promote prudent management of financial risks and to build a robust financial system in order to cope with the associated volatility in financial flows. Since the Mexican crisis in early 1995, we have played a key part in promoting greater awareness of the issues that needed to be addressed building robust monetary management mechanisms, upgrading banking supervisory standards that are internationally accepted, and constructing sophisticated financial infrastructures. Such efforts will be maintained and continued in the years ahead.

Locally, the need for a sophisticated financial infrastructure and in particular for the development of a deep, liquid debt market are highlighted by the currency turmoil. The pain tolerance level of the Hong Kong economy will be much enhanced and the equities markets will be much less affected if Hong Kong has a well established debt market that can absorb some of the shock brought about by interest rate volatility which is inevitable under our currency board system. After two years of preparation and study, the HKMA kick-started the development of the secondary mortgage market by establishing the Hong Kong Mortgage Corporation (HKMC). This is a strategic piece of financial infrastructure which will channel long-term investments to the home buyers using the banking system and the HKMC as the intermediaries. Less than 12 months after formation, the HKMC launched a pilot scheme of fixed rate mortgages with two banks. Home buyers are given an additional choice in locking in the interest rate (and hence repayments) on their mortgages, thus protecting them against higher interest rates. The HKMC has profound significance as it will entail considerable benefits to Hong Kong in terms of promoting banking and monetary stability, debt market development and home ownership.

"Lessons learnt from 1997 were clear: we will have to remain highly vigilant and should be proactive and pre-emptive rather than reactive."

Outlook

After the drama in 1997, we cannot be over optimistic as to any drastic recovery in the region. The global financial markets may be difficult as uncertainty reigns in respect of the success of the euro. Also, although the US economy is still robust, the US equities market has perhaps been too bullish in discounting the adverse impact of the Asian contagion on the economy. This is also reflected in the continued strength of the US dollar.

Having experienced 1997, we are convinced that despite the years of work to strengthen our monetary system and banking supervisory framework, there is no room for complacency. Lessons learnt from 1997 were clear: we will have to remain highly vigilant and should be proactive and pre-emptive rather than reactive. We shall continue to listen to constructive ideas for strengthening our monetary management system under the currency board arrangement. We shall continue to improve the soundness of the banking sector; enhance the transparency of the financial system; and promote the development of a deep and liquid debt market. Michel Camdessus, Managing Director of the IMF, has praised the Hong Kong dollar as a pillar of stability for the Asian region, a sentiment very much shared, publicly and privately, by leading central bank governors and finance ministers. We at the HKMA will strive in the year ahead to aim at maintaining just that and we realize that this will be no small task in times of uncertainty and volatility.

Joseph YAM
Chief Executive