Latest financial market developments

inSight

02 Apr 2009

Latest financial market developments

Markets remain volatile despite some hopeful signs.

I am sure readers do not need any reminder from me of how severely global financial markets have been fluctuating since the last quarter of last year. In fact, financial-market conditions deteriorated further in the first two months of this year. Following a short reprieve in early January, possibly because of optimistic sentiment in anticipation of the new administration in the US, the global financial markets worsened as optimism receded and economic figures indicating sustained difficulties facing both the developed and developing economies began to appear. Global equities fell by around 15% in the first two months of 2009 before rebounding somewhat in the second half of March, and the major currencies weakened against the US dollar. Contrary to the conventional wisdom that the bond markets usually fare well when investors avoid the equity markets, bond yields, especially the long-term yields, rose substantially on concerns over large increases in supply, causing bond prices to decline considerably. In such an adverse investment environment, most investors around the world were affected.

The most significant adverse development in the first two months of the year was the firming of long-term interest rates in the US. This was manifested in the increase in the yields of longer-term US-Treasury securities. The yield of ten-year US Treasuries, for example, went up sharply from about 2.2% to around 3%, leading to a fall in the price of those securities of about 6.5% in just two months. This hit all large holders of foreign reserves with substantial exposure to US-Treasury securities. Although yields have declined again since the Federal Reserve’s announcement on 18 March that it would purchase more agency debt and US Treasury securities, further volatility cannot be ruled out.

Interestingly, such holdings have, in a way, become involuntary, in that there are virtually no plausible alternatives as a home for large amounts of foreign reserves. And even if it were possible to diversify, one would be assuming other risks, including credit risks if the alternative assets were still denominated in US dollars, and exchange risks if one opted for securities denominated in other foreign currencies. In fact, with the US dollar strengthening significantly in January and February, holdings in other currencies will have experienced significant exchange losses. As to why the exchange value of the US dollar against most other currencies has strengthened, this is something that, I am sure many would agree, is difficult to understand, particularly when there has been so much monetary expansion — call it credit easing or quantitative easing — and such a large fiscal stimulus. But I suppose everything is relative. Compared with the situation in other jurisdictions, I must say that the US administration seems to be a lot more active in addressing the problems at hand, perhaps giving the impression in that it will come out of this once-in-a-century crisis sooner than others.

We should also bear in mind that the beginning of the year has seen the announcement of extraordinarily poor 2008 performances by financial institutions: hopefully, this will not develop into a prolonged trend. Recently, we have also seen some signs of a financial-market rebound in response to the US government's announcement of quantitative easing and new measures to address the problems relating to legacy loans and securities of financial institutions. Nevertheless, market volatility is likely to continue before the full effects of these measures become clear.

As far as the Exchange Fund is concerned, despite the difficult investment environment, the Fund’s financial strength, and its ability to safeguard monetary and financial stability in Hong Kong, has not been impaired. Our past efforts to build up the Exchange Fund when times were good and to manage it conservatively have paid off. Although the financial crisis is far from over, the prospects for Hong Kong's financial system remaining robust and for the exchange rate remaining stable are good. And meanwhile, despite much tighter conditions in the public finances, the Exchange Fund continues to contribute substantially as a stable source of government revenue. We will, of course, continue to be vigilant in performing the important task of investment management of the Exchange Fund. It is a task that we take seriously, as our track record shows.

Joseph Yam
2 April 2009

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