Formulating a policy for financial stability is a challenge for both academics and policy makers.
I am sure everybody agrees that the maintaining financial stability is a desirable policy objective. Although this is not specifically written in the Basic Law, there are references to the stability of the currency, which is obviously an important element of financial stability, and to the need to maintain the status of Hong Kong as an international financial centre, which is not possible without financial stability. The relevant laws of Hong Kong are more specific. The Exchange Fund Ordinance provides for the use of the Exchange Fund "to maintain the stability and the integrity of the monetary and financial systems of Hong Kong". The Banking Ordinance is built around the clear objective of promoting the general stability and effective working of the banking system.
But there is no clear definition of financial satiability in the laws of Hong Kong or in the laws of other jurisdictions or in academic literature on finance. How then can the policy makers develop a comprehensive strategy for achieving this desirable objective? This subject has been receiving increasing attention in the international financial community and attempts are being made, both on the academic front and among those with policy responsibility, to model financial stability, and integrate the model with the more traditional macroeconomic analysis, in both the domestic and international dimensions. While I await with keen interest the emergence of an authoritative analytical framework of general application, the current thinking of international experts seems, interestingly, to be along the line of defining financial stability as the absence of financial instability or financial crises.
Indeed, it is relatively easy to define financial instability. In my opinion, when the financial system fails to function properly, in terms of mobilising savings to finance economic activities – the all - important process of financial intermediation that promotes economic growth and development – then there is financial instability. When a shock to the financial system suddenly makes money unavailable, even for credit - worthy fund raisers no matter how high a price they are prepared to pay for the money, then financial stability is not being achieved. Alternatively, when, because of a breakdown of confidence for one reason or another, those with surplus money are simply not willing to trust the financial system with it, by placing it with banks or investing in financial instruments, then financial stability is not being achieved.
But I think this approach is still not quite comprehensive enough for a financial stability policy framework to be developed. The framework would have to include the situation where volatility in financial markets is so high as to threaten the viability or seriously undermine the interest of a significant group of market participants or intermediaries. But this is probably a controversial area where views may differ widely. On the one hand, there is the robust position that a market is a market, and the market price should be allowed to go up or down until the market clears and the equilibrium price is found. On the other hand, there is the argument that market imperfections arising from market concentration, information disclosure and so on mean that, in practice, there is no perfect, textbook market; and the market price can overshoot to the point where a financial meltdown threatens before the equilibrium price is found.
Whether we are defining financial stability or financial instability, I think there is a need for greater intellectual input into the subject. Even if internationally accepted clear definitions are still quite remote, a clearer conceptual framework will allow all concerned to better appreciate the nature of the task at hand, and help those responsible for financial stability to construct a comprehensive strategy to achieve that very desirable objective, which is really the pre-requisite for economic prosperity. I am sure there is scope for different emphasis in different jurisdictions, in the light of domestic circumstances and differences in vulnerability to financial instability, but there should be common concepts of general application across jurisdictions. Co-operation on an international level, involving the international financial institutions and financial forums, is therefore essential.
Next week I shall discuss what I think are the factors that determine the degree of vulnerability to financial instability in particular jurisdictions.
Joseph Yam
24 November 2005
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