Managing market expectations is a challenging task, but it can be achieved by providing objective analysis and explanation.
In many years of involvement in financial markets, I have noticed one phenomenon: financial markets often react sharply to surprises. This has become more so with the advancement of information technology, which allows the programming of instantaneous shifts in market positioning when certain trigger levels are reached. Sharp market reactions are often associated with large gains or losses incurred by market participants. And these may magnify the market movements, given the possibility of leverage either through the underlying market with the use of bank credit or through the use of derivatives. In the worst case, the unusual market volatility may undermine the viability of market participants or financial institutions with exposure to them, leading to systemic problems. This is not helped by the common phenomenon that the general knowledge of the market dynamics of all concerned inevitably falls behind market innovation - financial skills are sometimes much better rewarded in risk taking than in risk management.
There is the attractive argument that the market will always work itself out and find equilibrium by itself, so that there is no need for the regulator, if one exists, to interfere. As I have pointed out before, only the largest and most liquid markets, with numerous players on both the demand and supply sides properly served by financial intermediaries and with perfect information disclosure enjoy that luxury. These perfect conditions for a perfect market are hard to come by and so, whether we like it or not, there is often a need for regulation of financial markets and supervision of financial institutions to safeguard the public interest in effective financial intermediation, and the stability and integrity of the financial system.
But even where financial markets are large and as near perfect as possible, regulators are acutely conscious of the need, where possible, to avoid surprising them. This is not to say that they would always refrain from doing something, for example, increasing interest rates, unexpectedly. Indeed, there are occasions when a surprise message has to be conveyed and a lasting impression made on the market. But more often than not, when preparing for and in support of a policy change, regulators will try to prepare the market by providing an abundance of analysis with a clear emphasis on gradualism, as in the case of the, so far, 13 successive interest rate hikes of 0.25% in the Fed funds target rate in the United States.
Although we do not have the luxury of determining the level of our own interest rates in Hong Kong, given the monetary policy objective of exchange rate stability, we still provide an abundance of analysis concerning interest rate movements in Hong Kong. The message we have been conveying is that the trend in our interest rates should follow closely that of US interest rates, but in the short term there can be significant deviations owing to factors specific to Hong Kong. Depending on the nature of these Hong Kong-specific factors, the deviations can be quite large and may persist for a while, as in the case of the 18-month period prior to the introduction of the three refinements to the Linked Exchange Rate system in May this year. As readers are aware, expectations of an appreciation of the renminbi exchange rate and speculation that the Hong Kong dollar exchange rate might appreciate along with it had caused our interest rates to be significantly lower than those of the US dollar, despite successive increases in the latter.
When the hopefully temporary deviations are removed, either by the market on its own or by deliberate actions on our part, the return of our interest rates to normal, that is, back to convergence with US interest rate levels, may be a sudden and disruptive one. It may also overshoot, meaning the Hong Kong dollar interest rates may become higher than US dollar interest rates, and this phenomenon is likely to be manifested in deposit and lending rates, rather than in the interbank rates. Overshooting in financial markets is a common phenomenon, but it is also something that can be avoided or at least mitigated by providing the market with relevant analysis and explanations. This is what we have been trying to do, and the banks concerned have also been forthcoming with their views in relation to the recent increases in interest rates. Our concern has been that the removal of the short-term deviation and the possible subsequent overshooting with added confusion caused by the different best lending rates in the market, might give the impression of an uncontrollable leapfrogging process that might shock the market. Indeed, we believe that the extent of the overshooting, if any, should be very limited because a premium of Hong Kong dollar interest rates over US dollar rates would generate inflows that could be large enough to trigger the strong-side Convertibility Undertaking, thereby increasing the Aggregate Balance and depressing interbank interest rates.
Joseph Yam
15 December 2005
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