Renewed market volatility

A strengthened currency board system makes market manipulation more difficult. But the risks of market distortion have not gone away.

Given the market volatility in the past weeks, I would like to remind all concerned, in particular small investors, that the characteristics of international finance have not really changed with the coming and going of the Asian financial turmoil. The explosion of international finance has certainly helped to increase the efficiency of international financial intermediation and the allocation of global capital. But that same efficiency can be highly destabilising, particularly for emerging markets. Economies with improper macroeconomic policies can be punished brutally. Even those that serve as role models of macroeconomic management can be tossed around by the tidal waves of international finance.

There has been much international discussion about reforming the international financial architecture. But so far there is still a dearth of concrete proposals for reform that is capable of harnessing international capital. Banks have been alerted to the need to be prudent in their extension of credit to highly leveraged institutions. That has limited somewhat the ability of the latter to mobilise large amounts of capital and therefore the potentially damaging effects of their activities in emerging markets. But competition for credit business is keen worldwide, and there is some risk that the lessons of 1998 will be quickly forgotten. I was told once that there are two types of participants in financial markets, those with short memories and those with no memory at all.

Emerging markets are, therefore, still left very much to fend for themselves. But even with all the good intentions in the world, it takes time to arrive at a consensus on what to do and even more time for the agreed reform measures to strengthen markets to be implemented. We in Hong Kong have been at the forefront of reforms in this area, but the reform process is a continuous one, and certainly at this point in time there is still a lot to do. Meanwhile, therefore, even with the economy showing all positive signs of strong recovery, our vulnerability to the rapid and voluminous flows of international capital persists. And that means inevitably substantial market volatility. This is notwithstanding the much more stable monetary environment that we in the HKMA have been able to maintain through currency board arrangements that command a high degree of confidence from the community. It may be more difficult now to engineer sharp hikes in interest rates in order to benefit from a short position in our securities and futures markets. But the risk of excessive market concentration remains. And for as long as this is possible, the risk of the market being distorted by the large players to their benefit cannot be ignored.

There is a further dimension. We have seen how the views of market analysts can sometimes be as volatile as the market itself. Although they may have good reasons for changing their minds, one wonders whether this can be good for their reputation, and whether this may to some extent exacerbate market volatility.

Small investors, beware. The sea is still quite rough out there.

Joseph Yam
13 January 2000

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