Financial market volatility in the world economy

inSight

20 Jul 2006

Financial market volatility in the world economy

Volatility continues to affect both global and regional financial markets, and its causes are complex.

We all should be quite pleased with how well Hong Kong has weathered financial market volatility so far this year. At the turn of the year, out of concern about the possibility of much greater financial market volatility resulting from strong forces pulling in different directions, I sounded a general alert on the need for all concerned, particularly those running leveraged positions in financial markets and those providing the finance, to manage their risks. Given that I have some responsibility for monetary and financial stability in Hong Kong, I think it is appropriate for me to issue these alerts when circumstances warrant, even though some might have found my comments disagreeable.

Some of the strong forces identified at the turn of the year are still there. Global current account imbalances continue to hang like a sword of Damocles over the foreign exchange and capital markets, only kept from falling by large and increasing interest rate differentials among the G-3 currencies, for example over 5% between the US dollar and the Japanese yen. Interest rate levels are, of course, dependent upon the monetary policies of individual jurisdictions, which differ to a considerable extent, reflecting different outlooks for inflation and economic growth. This results in uncertainties in the interest rate relativities among the G-3 currencies and in the prospects for the foreign exchange and capital markets. In the US, the low core inflation rate seems to be converging with the significantly higher headline inflation rate with the passage of time and with temporary factors (such as higher oil prices) becoming permanent. At the same time, successive increases in interest rates and higher energy prices are beginning to slow the economy and the housing market, creating a delicate situation for monetary policy. While the market awaits with keen interest the inevitable pause in the upward trend of interest rates in the US, it also expects considerable head room for interest rates in Europe and Japan. There are tremendous amounts of liquidity (however defined) in financial markets held by entities that behave unpredictably, operating in derivative markets of inadequate transparency. These entities are ultra-sensitive to small shifts in yields, which makes continued financial market volatility in the months to come seem probable.

I would like to remind those paying close attention to interest rates in Hong Kong of what I have said many times in the past few months: we are more likely to see a plateau (possibly with some ups and downs reflecting fine-tuning efforts and short-term market anomalies) than a peak. In any case, it is not really in the long-term interests of anybody to see US interest rates having to come down sharply, because the underlying circumstances, in terms of concerns over the economy or financial stability, leading to such a decision would clearly be quite unpleasant globally (remember LTCM).

Meanwhile, we have recently witnessed an adjustment in the equity markets of emerging economies, which inflicted some pain on investors but thankfully did not do any structural damage to those markets. This adjustment has been described as resulting from a reassessment of the risks of emerging markets by investors, against the background of the earlier compression of yield spreads as excessive liquidity flocked to these markets, and was therefore considered overdue. But with the emerging markets, particularly those in this region, continuing to be underpinned by robust economic fundamentals, the recent adjustment should hopefully be temporary.

Nearer to Hong Kong, there are the continuing macro adjustment and control measures on the Mainland and the upward trend of the renminbi exchange rate that will continue to influence short-term market sentiment. This may either dampen or exacerbate financial market volatility, but hopefully not enough to derail what must be quite clear, long-term trends of significant gains supported by sustainable and rapid economic growth, continuing reform and liberalisation on the Mainland, and the promising opportunities for Hong Kong as an international financial centre. Please make sure you are not thrown off track by short-term bumps in this interesting ride.

Joseph Yam

20 July 2006


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