Global financial markets have been performing impressively, but there are risks ahead. Investors should remain alert.
There are currently a lot of uncertainties confronting our economy and our financial markets. Those that stand out are the economic and financial outlook for Mainland China and the US, our two largest markets.
In the US, the sub-prime crisis persists. The use of the word "crisis" is not my choice. This was the word frequently used in international meetings on financial stability that I attended in the past two months. A sharp spike in the delinquency rate of sub-prime mortgages in the US has led to great tension in the money markets of Europe and the US, and a general credit tightening. Much time is now being devoted in the developed markets to containing the damage and returning things to normal, achieving a clear understanding of the causes of the crisis, identifying the weaknesses that need to be addressed and putting together longer-term remedies. Meanwhile, tight credit conditions are threatening to slow down the US economy and lead to further downward pressure on property prices. With a low household savings rate and high loan-to-value ratios of residential mortgages, the mortgage delinquency rates of not just the sub-prime market but also the much larger, more normal, market may go up. The possibility of a recession in the US cannot be ruled out. A recession in the largest economy in the world would obviously have adverse implications for everybody. And the scope for introducing appropriate monetary responses is constrained by the prospects of higher inflation, as oil prices surge and productivity gains arising from advances in information technology begin to recede.
In Mainland China, although the economy continues to grow at a fast pace, the macro monetary conditions are causing considerable concerns. The current-account balance-of-payments surplus continues to be large, putting upward pressure on the renminbi exchange rate and sustaining large capital inflows. Large accumulation of foreign reserves continues, requiring "sterilisation" by the People’s Bank of China to prevent the monetary base from growing to such an extent as to encourage excessive credit creation and inflation. This requires increasing the reserve-requirement ratio for the banks to historically high levels and very substantial issues of central-bank paper to absorb the excess liquidity in the banking system. Both actions put pressure on the profitability of the banks, since the banks’ required reserves held with the PBoC earn interest of 1.89% a year and the yield of the one-year central-bank paper is only around 3.5%. To protect the banks’ profitability, the net interest margin (the difference between interest charged for loans and paid on deposits) will need to be maintained or widened, and this has adverse implications for the efficiency of financial intermediation through the banking system. Meanwhile, inflation has been climbing to uncomfortable levels, requiring interest rates to be raised to contain it, but at the same time attracting more capital inflows. With plans to encourage the orderly outflow of capital by allowing residents to invest outside the Mainland not yet implemented, and domestic savings continuing to accumulate, the imbalance in the supply of and demand for financial instruments other than bank deposits persists, leading to prices being much higher than would otherwise be the case, and causing concerns about the possibility of a stock-market bubble. It is not clear how this scenario might develop. The inevitable market adjustment, if sharp and destabilising, would have serious implications for monetary and financial stability, not just for the Mainland but also for others, including of course Hong Kong.
In both jurisdictions, developments in the next few months will be crucial. In the US, there is hope that normal money-market conditions will return shortly, limiting the adverse impacts on the economy and the housing market there. On the Mainland, there is hope for more concerted and effective macro-economic adjustment measures, now that the Party Congress is over. But there are structural issues in the financial system that will need to be addressed to make it conducive to promoting sustainable economic expansion. Against this complex background, we in Hong Kong have to be cautious about our short-term economic prospects, despite the different and bullish signals that our financial markets are sending us. Perhaps there are factors that I have failed to see. Irrational exuberance or not, investors should act with caution.
Joseph Yam
25 October 2007
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