The Conundrum

inSight

23 Jun 2005

The Conundrum

The persistent decline in long-term bond yields in an increasing interest rate environment cannot go on for ever. Markets should be prepared for possible volatility when the adjustment takes place.

Readers may have noticed the frequent references lately by some in the financial community to what Alan Greenspan recently called the "conundrum" - the decline in interest rates of long-term bonds at a time of rising short-term interest rates. This phenomenon is not specific to the United States. Given the firm link between the Hong Kong dollar and the US dollar, it is also to be observed in Hong Kong. Indeed, the yield differential between our three-month and ten-year Exchange Fund papers is now less than one percentage point. This is even smaller than the yield differential between corresponding US Treasuries.

I do not have an answer to this conundrum, as we see it from Hong Kong's perspective. But I see it as a US phenomenon that we import through our exchange rate link. And if Alan Greenspan is puzzled by it, I have no better answer to offer than the general explanation put forth by others: that there is an excess of savings in a large part of the world economy that is chasing after, and driving down, the yield. Of greater interest I think to all concerned is where this will lead to and the implications, if any, for monetary and financial stability, particularly in Hong Kong. It is, of course, difficult to envisage those economies that have savings carrying on for ever increasing investment in financial liabilities of a country that does not save. Similarly, it is difficult to imagine the current account deficit of the United States, already of an unprecedented scale, growing and sustaining itself for very much longer.

So we have to assume that the correction will come sooner or later, and hope that it will be an orderly one and be prepared for it. This is quite challenging. To manage risks arising from possibly sharp adjustments in global finance, we have to know what form the adjustments are likely to take place and how they would affect our monetary and financial systems. I fear that it is not just a matter of a sharp correction in exchange rates ?this would be relatively easy to manage and our financial intermediaries, for example banks, do not have large open foreign exchange positions - but also a resolution of the conundrum that may involve falls in the value of financial assets. To make matters more complicated for us, there is the declared intention of the Mainland in introducing greater flexibility in the mechanism of the exchange rate of the renminbi. Although the timing is uncertain, this is likely to be translated into action, and that action, in whatever form and whether or not it involves an appreciation, is likely to be the event of the decade in terms of its significance. And the significance, for economies outside the Mainland, is likely to be greater for Hong Kong than for others.

The two events will hopefully be independent of each other, but it is possible, given the sentiment shared by a not insignificant part of the international financial community that an exchange rate correction is long overdue and is just waiting for a trigger, that one may come on the heels of the other. However, as these events have been talked about so long, when they do occur they may turn out to be rather benign in terms of their impact on monetary and financial stability globally. Or it could be the perfect storm in the making. Whatever it is, there is enough to make those responsible for monetary and financial stability, and I hope financial intermediaries as well, rather uneasy. So, while the economy is recovering robustly and everything seems to be moving in the right direction, it is time for all concerned, particularly those incurring significant exchange rate, interest rate and market risks, to ask questions, do stress tests, make the necessary adjustments and be vigilant. I think it is time to be careful and not to be brave.

It is very much in that spirit that we introduced the refinements to the operations of the Linked Exchange Rate system. I believe that they will put us in a better position to cope with whatever that comes our way. Meanwhile, the need for a co-operative, global solution to this global problem is increasingly clear, although the co-operative effort has not been adequately forthcoming.

 

Joseph Yam

23 June 2005

 

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