In line with market expectations, the US Federal Open Market Committee announced this morning (Hong Kong time) that it would pursue another round of quantitative easing policy (widely referred to as QE2). The Fed will purchase US$ 600 billion of long-term Treasury securities in the next eight months and will regularly review the pace of its securities purchase and the overall size of its asset purchase. The Fed aims to promote economic growth in the US, which has shown signs of slowing momentum, in the hope that this will help improve labour market conditions and influence inflation expectations.
As I mentioned in my briefing to the Legislative Council Panel on Financial Affairs on Monday, it is still too early to judge how effective QE2 would be as a policy prescription. However, its side effects on Asia and other emerging markets would be apparent. The decisive and extraordinary actions taken by the US and European economies following the eruption of the global financial crisis did successfully stabilise the global financial system and prevent a meltdown. However, the near-zero interest-rate and quantitative easing policies do not seem to have achieved the desired results. The US economy began losing momentum since the middle of the year. The huge amount of liquidity injected into the banking system has failed to drive stronger growth of the real economy, while credit conditions are still tight for corporations and the unemployment rate remains high. At the same time, excessive liquidity flowed into the emerging markets where the economic outlook is more favourable, creating pressure on the exchange rates, consumer price inflation and asset prices in those economies.
Since 1983, the Hong Kong dollar has been linked to the US dollar under the Linked Exchange Rate System (LERS). Following the outbreak of the global financial crisis, central banks around the world introduced large-scale quantitative easing measures. As capital continued to flow in, interest rates in Hong Kong declined to near zero, and currently new mortgage loans are generally priced at less than 1%. This phenomenon is unprecedented. While both property transaction volume and prices have increased sharply over the past year, the introduction of QE2 heightens the risk of the formation of an asset price bubble in Hong Kong.
There are views that the risk of asset price bubble in Hong Kong is mainly caused by the LERS, and that the Hong Kong dollar should not peg to the US dollar any more. Some further suggested that the Hong Kong dollar should be linked with the renminbi. At the Panel meeting on Monday, I pointed out that such views are misguided. At present, there is abundant excess liquidity in the global environment and hot money is flowing around the world in search for yield. All emerging market economies, regardless of whether they adopt floating exchange rate systems or fixed exchange rate systems like Hong Kong, are facing similar upward pressure on property prices and inflation. The attached tables show that the risk of inflation and rising property prices is not a situation unique to Hong Kong. We and other economies in the region are in the same boat.
In theory, under a floating exchange rate system, capital and hot money inflows would exert upward pressure on the exchange rate of the currency; and when inflation rate and property prices are surging, the central bank may raise interest rates in response. But in reality they are not panacea. In an open economy without foreign exchange and capital controls, appreciation of the currency will only attract even more capital inflows to profit from exchange rate speculation. Similarly, raising interest rates will lure even more hot money to profit from carry trades. Of course, some of such hot money will also enter the equity and property markets. Currency appreciation and interest rate hikes are therefore not necessarily effective in alleviating the pressure on the asset markets in the short run. In fact, they may attract even more hot money into the economy.
As I wrote in another inSight article on 1 February, while there had been huge capital inflows to the Hong Kong dollar, and some of the money did go into the stock and property markets, the LERS has not provided incentives for these funds to profit from currency appreciation or interest rate arbitrage. One can imagine that if the Hong Kong dollar were de-linked, the exchange rate would shoot up sharply and the asset price bubble would become even bigger as capitals continued to flood in; when the bubble finally burst, capital outflows would set in, causing the exchange rate to plummet. Before the introduction of the LERS in 1983, we had seen sharp volatility caused by overly-optimistic sentiment in good times and overly-pessimistic sentiment in bad times, allowing speculative big market players to take advantages of the market swings. We should all be alert to this.
We do not agree with the suggestion of linking the Hong Kong dollar to the renminbi now. The renminbi can be an anchor currency only when it meets a number of important fundamental conditions. First, there should be a high degree of synchronisation between the economic cycles in Hong Kong and the Mainland. At present, Hong Kong's economic cycle is more affected by flows of trade between the Mainland and the advanced economies, rather than domestic demand on the Mainland. As a major international financial centre, Hong Kong's economic cycle is to a large extent influenced by the global economic and financial market conditions. Secondly, the renminbi must be freely convertible, the capital account control on the Mainland removed, and all currencies allowed to flow freely. Thirdly, the financial and asset markets on the Mainland should be wide, deep and liquid enough to allow the Exchange Fund of Hong Kong to hold substantial amounts of renminbi assets to support the Hong Kong dollar, preserve capital, grow in value and meet contingent needs.
I would like to reiterate that the LERS has served Hong Kong well since 1983. It is the pillar for the monetary and financial stability in Hong Kong. We have no plan to change it.
To address the risk of asset price bubble in Hong Kong, I think we need targeted measures. The HKSAR Government has implemented a number of measures to stabilise land supply, normalise selling practices and contain speculative transactions in the property market. The HKMA also introduced measures in October 2009 and August this year to strengthen the banks' risk management on residential mortgage lending. We will continue to monitor market developments and stand ready to introduce further measures to strengthen the risk management of banks and ensure the stability of the banking sector.
We are now facing an unusual international macro-financial environment. But it will not last forever. Adjustment will come and there could then be shockwaves when it happens. We cannot predict when the adjustment will happen or completely avert the associated shock. Yet what we can do, and will do, is to manage the risks and strengthen our defence as best as we can to minimise the impact when the adjustment comes. The HKSAR Government and the HKMA will of course do our best but we must not work alone: everybody should also join us to stay alert, manage their risks and get fully prepared.
Norman T. L. Chan
Hong Kong Monetary Authority
4 November 2010
Table 1: Consumer Price Inflation (year-on-year change)
|Latest (Sept 2010)
Table 2: Property prices in Asia Pacific areas (year-on-year changes in September 2010)
|Increase in property prices