The latest economic data show that the global economy has begun to recover and financial systems have begun to stabilise: the worst may already be behind us. However, some clouds of uncertainty still remain on the horizon. In Hong Kong, a gradual recovery is underway. At present, the market consensus is that, as long as nothing serious occurs in the external environment, Hong Kong will see a 3.7% GDP growth next year. But, with interest rates exceptionally low and with abundant liquidity around the world, Hong Kong faces the potential risk next year that asset prices may go up sharply and become increasingly disconnected from economic fundamentals.
Some people think that the Linked Exchange Rate system is to blame because it makes it impossible for Hong Kong to use monetary tools (i.e. interest rates) to address inflation and upward pressure on asset prices brought about by continuous inflows of funds. But we should bear in mind that many other Asian economies are also experiencing similar problems arising from substantial fund inflows and rising asset prices. In theory, these economies could of course raise interest rates to contain inflation and increases in asset prices. But the fear is that once interest rates are raised the carry trade will become even more active, attracting even more fund inflows. Asian economies are therefore facing a dilemma.
So is Hong Kong itself now experiencing an asset bubble? This is not at all an easy question to answer. In the short run, prices in the financial and property markets are determined by a number of factors. When market sentiment is positive, plenty of reasons can easily be offered to explain increases in asset prices. While it is difficult to assess whether a market is overheated, we can be certain that the larger an asset bubble has become, the greater will be the damage when the bubble bursts. When an asset bubble bursts, no matter how hard the government and its economic and financial advisers try, the community as a whole will have to pay a heavy price. The last time Hong Kong lived through the bursting of an asset-price bubble was in 1997. Sharp corrections in the asset markets and the subsequent recession in the economy reinforced each other, producing a vicious cycle: the consumer market shrank, unemployment increased, household incomes declined, leading to a further downward spiral in the property market. Hong Kong then endured 68 months of deflation as the economy continued to perform badly until the latter part of 2003, when a full-scale recovery began to kick in. Elsewhere, Japan was deeply hurt by the mega asset bubble formed in the late 1980s and it has not yet fully recovered even twenty years later. When the IT bubble burst in March 2000, the US markets experienced sharp corrections and the economy plummeted. But the US government was able to dampen the shock at that time by drastically cutting interest rates. The IT bubble was then succeeded by a broad-based property bubble. The current global financial crisis was caused by a huge bubble resulting from an intertwining of the exuberance of the property market in the US and of the financial derivative markets.
We are all, from hard experience, very familiar with the devastation caused by the bursting of an asset bubble. I am certain that no one wishes to live through such an experience again. The only sure preventive is to take timely steps to stop a bubble from forming in the first place. What practical steps can we take in the present environment of very low interest rates and abundant liquidity? Hong Kong is a small and open economy. There are no restrictions on the inward or outward flow of funds. We must therefore strengthen risk management and raise our alertness. The current near-zero interest-rate environment is unusual and it cannot continue indefinitely. Individuals as well as corporates should understand the potential risks they face. They should not be blindly optimistic and borrow beyond their ability to repay. People who plan to take out a mortgage loan against a property, whether for their own use or for investment purposes, should avoid overstretching themselves. They should take into account the effect on their repayment ability when interest rates increase. For their part, banks should carefully manage credit and market risks arising from the increases in asset prices and take prudent measures to prepare themselves for possible changes in the market.
If we wish to prevent an asset-price bubble, a price has to be paid. For as long as the US and Europe continue to pursue the low-interest-rate and quantitative easing monetary policies (i.e. central banks expanding the monetary base), depositors should be prepared to see their deposits continue to earn virtually no interest. This is a very difficult situation for depositors, for zero interest-rates have the effect of punishing prudent savers and rewarding risk takers (including speculators).
With large inflows of funds flooding the interbank market, banks should be even more careful in managing the risks arising from lending money to their customers. Perhaps only bankers can truly appreciate the frustration in being flushed with huge amount of liquidity but unable to lend it out to customers.
To buy or not to buy a home is also a difficult decision for many middle-class families and newly-weds. On the one hand, they may fear that with property prices continuing to rise, it will become even more difficult to enter the market if they don't act now. On the other hand, there is the fear that property prices might fall if international fund flows reverse direction. Some people may not fully understand the risk involved, and purchase properties beyond their affordability, thereby facing financial difficulties when interest rates increase from the current extremely low levels.
To sum up, the Hong Kong economy will hopefully recover next year but there are uncertainties and potential risks. One major source of potential risk is in the continued inflow of funds into asset markets in Asia arising from the low-interest-rate environment and the quantitative easing monetary policies around the world. At the same time, since Hong Kong cannot change the monetary policies pursued by the US and Europe, we should be prepared for significant adjustments in the flow of funds and asset prices if there should be a change in the low interest rates in the US or in the expectation of a continued depreciation of the US dollar. The HKMA will, as always, continue to monitor closely developments to ensure that the banking system is well prepared to cope with the risks and challenges and, if necessary, introduce appropriate and timely prudential supervisory measures.
Norman T. L. Chan
Hong Kong Monetary Authority
19 November 2009