The response of financial markets to the economic effects of SARS has been calm. But vulnerabilities still persist.
Financial markets in Hong Kong seemed to have behaved remarkably calmly in the second quarter, as SARS raged, hurting rather badly many sectors of the economy. The Hang Seng Index in fact finished 11% higher at the end of the quarter than at the beginning. The exchange rate remained very stable. If anything, confidence in the Linked Exchange Rate system actually strengthened, with the one-year forward premium falling to 115 points at the end of June, from 140 points three months ago. This may have been the result of the issue, for the first time, of a formal statement on the monetary policy objective by the Financial Secretary towards the end of June, as part of the response of the Hong Kong Special Administrative Region Government to recommendations in the Financial Sector Stability Assessment of the IMF. But clearly SARS and its impact on the economy and the public finances did not raise any doubts about the credibility of the Linked Exchange Rate system. Mirroring this, the interest rate differential between the Hong Kong dollar and the US dollar remained negligible, particularly at the short end of the money market.
I hope this calmness reflects the increasing sophistication of our financial markets. I hope also that this calmness has been, at least partly, the result of our continuous efforts, on the one hand, to be transparent in all that we do and, on the other hand, to try and explain in the clearest of terms the rationale behind our policies. But the behaviour of financial markets is always very difficult to predict. They have the habit of over-reacting or over-shooting, particularly when market participants are seized, sometimes blindly, by the herd instinct. And they also have the habit of surprising everybody in their reaction to issues, exhibiting violent movements in response to events that appear to be totally unrelated to the markets, or unmoved by events that are normally considered to be market-sensitive. We all still know very little about market dynamics. But policy and operational transparency, on the part of the regulator as well as the market participants, undoubtedly enhances market efficiency and robustness.
As we move into the third quarter, the financial markets will be exposed to the SARS-influenced economic numbers of the second quarter. I have very little doubt that the numbers will look bad - for unemployment, GDP growth, consumption expenditure, exports, investments, the public finances, and possibly (although I am not too sure about this) the balance of payments position. I hope calm will continue to prevail in the financial markets as they digest those numbers and rationally attribute the deterioration to whatever relevant factors, including SARS, and act rationally, if action is called for. Prices do go up and down and some volatility is to be expected, and indeed is normal, particularly in our traditionally volatile markets. In any case, it is possible that the numbers may be considered as interesting history and dismissed, given that financial markets, if they are functioning properly, are, at any point of time, more affected by prospects than by history. And the dynamism of Hong Kong, on all fronts, is such that new events and new developments having market impact occur frequently, resulting in market volatility. What is important is that volatility does not impair the robustness of the market structure, such as we saw in the financial turmoil of 1998.
As market regulators we should not, obviously, be complacent, but it does seem that the robustness of the market structure is now significantly better than before, although the same cannot be said about the ability of market participants in absorbing sharply adverse shocks. There is no doubt that the difficult economic circumstances of the past few years, characterised in particular by substantial deflation, have impaired the financial strength of many. With the possible exception of those having invested north of the border, Hong Kong generally, whether in the form of companies or households, is now weaker and arguably more vulnerable to market volatility, that is, if they are still in the market. But the financial market structure is generally stronger now, with sound risk management practices of the best international standards in place. There is, for example, a mechanism to detect and restrain market concentration, and there is much greater and effective exchange of market information among the regulators, on a bilateral basis and through the Council of Financial Regulators.
With continued calm in the financial markets, the current low interest environment should provide the needed window for companies and households to repair their balance sheets and prepare themselves for the economic recovery that will eventually come.
Joseph Yam
10 July 2003
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