This third and final article in a series on deflation examines the appropriateness of macroeconomic policy responses in an economy such as Hong Kong's.
In this third article on deflation I shall focus on the appropriateness of macroeconomic policy responses to deflation. By macroeconomic policy I mean the twin areas of fiscal and monetary policies.
Hong Kong is a highly external oriented economy. The value of its visible trade is equivalent to 280 per cent of GDP. This means that we cannot be in control of our economic destiny. It is in our best long-term interest to make sure that we are flexible enough to respond quickly to changes in the external environment.
On the fiscal side, this dictates, very simply, that we should have a small government that commands minimal economic resources, leaving as much as possible to the private sector to ensure maximum ability to adjust. It is difficult for us, through Government expenditure, to spend our way out of a recession or out of deflation. The import leakage is just too large for this policy stance to be effective. So, we seek to limit the relative size of the public sector by making sure that the growth rate of Government expenditure is commensurate with the growth rate of GDP and strive to maintain balanced budgets. These principles are considered so important that they have been spelt out in Article 107 of the Basic Law.
The high degree of external orientation of the economy also means that monetary policy should aim at achieving a stable external value of the currency. The predictability of the exchange rate creates a stable environment for the many who do business with the rest of the world. A floating exchange rate is just too unpredictable, particularly with financial markets becoming increasingly global, and often exhibiting a life of their own that is quite out of line with the basic economic fundamentals.
There are, nevertheless, arguments and pressures for a macroeconomic policy response to deflation. A responsible Government should consider all options to tackle a problem, particularly when the problem has been debilitating to the community. Indeed, the Government has been running expansionary budgets for a few years now. But I would like to suggest that, in the macroeconomic policy context, we should, having identified the causes of deflation, try and analyse also its nature, in terms of distinguishing between its cyclical and structural aspects. In making such a distinction, I suppose I am suggesting that these different forms of deflation justify a different degree of macroeconomic policy response, although I am not aware of any economic theory in support of this position.
My view, very simply, is this: to the extent that deflation is a cyclical phenomenon, we should try and sit it out and not attempt to depart from long established macroeconomic policies that have served Hong Kong well in the past. It is, of course, possible that the amplitude of the economic cycle is so large as to lead to possible systemic problems on the financial front. But I am quite sure that we are not currently seeing any problem that is of a systemic dimension in the financial system.
To the extent that deflation is a structural phenomenon, I believe all of us should maintain an open mind on the use of a macroeconomic policy response. And it is necessary for us to ascertain the severity of structural deflation, as against cyclical deflation, although it is not easy to apply these labels with precision to the six causes of deflation I have identified. For example, the deflationary influence of technological revolution may be partly structural but there is also a pronounced cyclical impact on the world economy. Deflation arising from economic integration with the Mainland is more clearly structural, and equilibrium, other than that for the property sector, seems not yet in sight. The deflationary effect of the bursting of the property bubble seems to be cyclical, but there is the structural aspect concerning the lifting of the quantitative restriction on the sale of land in July 1997. But our research - and the research of other organisations - suggests that, so far, deflation in Hong Kong is more cyclical than structural in nature. Published on our website are many detailed research memoranda. One of them is entitled "price convergence between Hong Kong and the Mainland". It contains the finding that the Mainland factor appears to have accounted for less than a quarter of the total decline in the Consumer Price Index over the past four years.
And so we come to the delicate question on the appropriateness of a monetary policy response to deflation in Hong Kong. I hope this series of articles has put the matter in its proper context. Already we are seeing signs of the cyclical nature of deflation correcting itself. The unemployment rate is coming down. The number of bankruptcy cases looks like peaking. Exports are recovering. We can probably sit this one out. And a microeconomic policy response aiming at stabilising the property market has been announced. So I hope I can say this without being misunderstood: there is no doubt that the Link has been a structural factor in deflation in Hong Kong. In fact, that is precisely the point of the adjustment mechanism under the Link. But the adjustment mechanism is the vehicle for deflation, not the cause of deflation. It is the counterpart of currency depreciation under a floating regime, with the exception that it tends to involve less instability, less overshooting, but also, understandably, less instant adjustment to changing economic conditions.
I can see the attractiveness of the argument that currency depreciation would provide a quick inflationary boost to the economy, stimulating investment, pushing up property values, wiping out negative equity, resolving the budget deficit, and all of Hong Kong's other problems. This might hypothetically be the case, but the question is how much time it would take for the destabilising impact of floating the exchange rate to die down before any economic gains could be realised. And would these gains be short lived, if depreciation and inflation overshoot to the extent of requiring a substantial rise in interest rates to maintain currency stability, however the Financial Secretary chooses to define an alternative monetary policy objective? What might come after the initial boost is a matter for speculation: no doubt, with careful management, equilibrium and stability would eventually be achieved. And the monetary mechanism we have carefully built over the years is amenable to the achievement of any one of the popular monetary policy objectives. But the risk of a rough ride is genuine and should not be taken lightly.
Joseph Yam
28 November 2002
Related Viewpoint Articles:
Deflation (1): Causes, 14 November 2002
Deflation (2): Microeconomic Responses, 21 November 2002
Click here for previous articles in this column.
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