Open, medium-sized and sophisticated international financial centres are attractive to international fund flows, which are often volatile. The task of policy makers in these economies is challenging.
Whether or not an economy is vulnerable to financial instability depends on many factors, including, for example, how its financial system is structured and whether it is open to foreign capital. An economy where the financial system is characterised by the preponderance of a few state-owned banks, performing the captive role of collecting savings and allocating them by administrative authority to borrowers, is not particularly vulnerable to financial instability. Financial stability, however defined, can be maintained with considerable ease. Similarly, for an economy that has tight capital controls, maintaining financial stability is relatively easy, for the simple reason that financial markets are not exposed to the potent effects of volatile international capital flows, which at times take on a predatory character.
Traditionally, it is recognised that the most important factor contributing to financial stability is prudent macroeconomic policies. This I think is still the case, despite the globalisation of financial markets, made possible by a general trend of financial liberalisation and advances in information technology. For example, a large balance-of-payments deficit is inevitably associated with an expectation of a sharp depreciation in the exchange rate. Another factor is how prudently financial institutions are run. Banks with poor systems for identifying, measuring and managing risk are vulnerable to shocks. And there are many other traditional, textbook factors that one can think of as contributing to financial stability. But there are four that I would like particularly to draw attention to, in the light of observations made in international finance in recent years.
First is the openness of financial markets in a particular jurisdiction. Obviously, with globalisation the more open the financial markets, the greater is their attractiveness to international capital looking for opportunities for quick profit. International capital will favour financial markets, such as Hong Kong, with a freely convertible currency, free flow of capital (safeguarded by the Basic Law), and free operation of financial business and financial markets (again safeguarded by the Basic Law) compared with less open markets. International capital is typically much more volatile than domestic capital and its mobility is often the trigger for financial instability.
Second, interestingly, is the size of financial markets. There is, I think, a non-linear relationship between vulnerability to financial instability and the size of financial markets. The very small financial markets are not attractive to international capital because of the lack of liquidity and so there is little volatility generated by the inflow and outflow of international capital. At the other extreme, where financial markets are very large relative to international capital, sudden movements of the latter will only lead to ripples, which are not big enough to cause any financial-stability concerns. The most vulnerable financial markets, other things being equal, are the medium-sized ones, which have adequate liquidity to attract international capital but which are, unfortunately, small enough for short-term trends to be dictated by large operators looking for short-term gains. There is also the temptation to engage in manipulative behaviour, amplifying volatility and vulnerability to financial instability.
Third is whether the jurisdiction is an international financial centre, where the turnover in financial markets, measured for example as a percentage of GDP, is much higher than elsewhere and where the size of the domestic economy or financial transactions arising from domestic economic activities pales in significance by comparison. The task of maintaining financial stability in an international financial centre is much greater than in a largely domestic financial centre. The stakes are high and the players are influential. International investment bankers obviously and understandably also have a different perspective than domestic bankers. For example, seldom can you appeal to them to take account of the longer-term public interest in their behaviour: not that the regulator should do so too often, even in respect of domestic financial intermediaries.
Fourth is the degree of financial sophistication of the jurisdiction. Where financial intermediation channels are highly diversified, with a wide variety of financial instruments cutting across different sectors of the financial system and overlaid by complex derivatives, the financial dynamics can be very difficult to grasp. We are all familiar with the double play across the Hang Seng Index futures market and the foreign exchange market in 1997-98. And frankly I share the uneasiness many people feel about the potential impact of the derivative warrants market on the stock market – theoretically, derivatives have a stabilising effect but it is not always obvious: the tail often seems to be wagging the dog.
Hong Kong scores high in all the four factors. I suppose this is a way of saying that we have a much more difficult task than others in maintaining financial stability.
Joseph Yam
1 December 2005
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