Carry trades and other risks to monetary and financial stability

inSight

02 Aug 2007

Carry trades and other risks to monetary and financial stability

A number of risks continue to affect global monetary and financial stability.

Last week I talked about the potential risks to monetary and financial stability posed by carry trades, as a subject causing me, as Monetary Authority, some anxiety. An obvious danger is that the exchange rate risk involved might be wrongly assessed, leading those engaging in the trade to assume too much of this risk. When they are eventually forced by the market to unwind quickly the voluminous trades that have been built up, their solvency may be threatened to the extent of causing financial instability at a systemic level. There is also the possibility of the enormous capital inflow generated by carry trades creating asset-price bubbles with debilitating economic, financial and social consequences when they burst, as they invariably do.

Carry trades are only one of a number of issues currently on our radar screen. There are at least four others that I am anxious about. The second concerns the increasingly unclear picture of the distribution of risks in the financial system. Financial innovation has enabled risks assumed by participants in the financial system, particularly the financial intermediaries, to be off-loaded. Credit risks of normal bank lending, particularly the homogeneous ones such as mortgages, can be off-loaded through securitisation, almost as quickly as they are originated. But the extent to which they have actually been off-loaded (as opposed to the assets just disappearing from the balance sheets of the banks in an accounting sense) is not clear, given the possibility that the banks may, directly or indirectly, knowingly or unknowingly, be providing funding to those assuming the risks. What is clear, however, is that the ease of off-loading risks, together with keen competition for the business, has led to some erosion of credit standards in, for example, the sub-prime mortgage market in the US. It may be that the risks have been spread to those in a better position to assume them, thus making the financial system more stable. Some have argued that long-term investors without leverage have more staying power and are therefore more able than others to absorb sharp adjustments in financial markets. Others, however, have pointed to the fact that the management of the investment funds (or savings) of this group of people has been institutionalised and is therefore subject to strict credit standards requiring the institutions (such as pension funds) to automatically sell financial assets that have become sub-standard, so that the stabilising effect is not there. Whatever the case, it is now less clear than before where the risks really lie, who is assuming them, whether they are being prudently managed and what happens if, for one reason or another, some of those risks deteriorate by an extent larger than those assuming them expected.

The third issue concerns an area of greater relevance to Hong Kong than other jurisdictions: macro adjustment and control on the Mainland. Different people have different perspectives on the macro-economic conditions on the Mainland and the risks to monetary and financial stability that they entail. Many, however, look at the subject making use of the familiar, established analytical framework normally applied to a capitalist, free-market economy. But we are dealing with a socialist market economy and there are no textbook cases to which we can refer to help us understand the functioning of such an economy, although a market is of course a market, where supply and demand are supposed to interact to discover a price for the goods or services being traded, in an environment of varying degrees of bureaucratic interference. It is precisely because of our ignorance that we will frequently find ourselves (and our capitalist free markets) surprised by developments on the Mainland and the associated policy responses. Indeed, the doubtful effectiveness of market instruments for macro adjustment and control in the circumstances of the Mainland means that there is a continuing readiness to resort to administrative measures. Effective as they may be, the administrative measures are also blunt instruments and prone to creating distortions, possibly exacerbating the underlying problems, and the costs and the market effects of eventually resolving them.

I shall be brief on the other two issues since they and the resulting risks to global financial stability have been well discussed. They both relate to the United States. One concerns the US housing market, particularly in the area of housing finance. Not all housing markets are the same and so our own experience in Hong Kong is never a good example for others, other than, I suppose, as an indication of how bad it can get. The other issue concerns the continuing external imbalance that everyone considers unsustainable and continues to hope that the eventual adjustment will be an orderly one. I fear that the unjustified focus on exchange rates as the answer to the problem and the manifestation of differences of opinion on the subject in a resurgence of protectionism are both problematic for global finance.

Joseph Yam
2 August 2007

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