The prospects of a solid economic recovery in the US are being threatened by volatile markets.
It is encouraging to see in the Federal Reserve's Monetary Policy Report to the US Congress earlier this month an upward revision of the forecast for real GDP growth in the US in 2002 of 3.5% to 3.75%. Alan Greenspan referred to this, unusually, as "the central tendency of Federal Reserve policymakers' forecast", which, to this keen Federal Reserve observer, suggests significant divergence of views. If so, this is understandable. The US economy continues to be influenced by rather unusual factors - the sharp downward adjustment in equity prices, a lack of investment spending and the threat of terrorism - and it displays very mixed signals. That is why doubts have been expressed about the sustainability of the current economic recovery. Yet economic growth for next year is further projected by the Federal Reserve, probably also reflecting the central tendency of unusually diverse views, to be solid again, with real output rising 3.5% to 4%. The US unemployment rate is also projected to come down, to between around 5.25% and 5.5% by the end of next year. Meanwhile, US inflation is expected to remain subdued, at 1.5% to 1.75% for consumer prices, meaning that US interest rates are unlikely to be raised, at least in the short term.
These numbers are comforting for Hong Kong. With the largest economy in the world and a major export market for Hong Kong continuing to grow at impressive rates, our economy should benefit. This would, we hope, help accelerate the economic recovery here. The weaker US dollar should also help, although, as I have indicated before, the sensitivity of the Hong Kong economy as a whole, in terms of GDP growth, to changes in the effective exchange rate, is probably quite low. But exports to Europe and to other markets with currencies that have appreciated against the US dollar should do better than they would otherwise have done, and hopefully this would mean some improvement in the worrying unemployment situation. Prices of imports, also from these markets, would, however, go up accordingly. This would, ironically, be manifested in an apparent easing of deflation in Hong Kong, measuring deflation in terms of the rate of change in consumer prices. But, realistically speaking, it would take some time for any improvement in economic performance and higher import prices to be translated into higher wages in view of high unemployment.
Meanwhile, there is still significant risk that the forecast sustained economic recovery in the US may be derailed. There is no way of predicting how the "infectious greed" that gripped "much of (the US) business community", now revealed in misleading accounting practices, if not in falsification and fraud, will affect investor confidence. It is unlikely that damage is irreparable. Indeed, speedy accounting reform measures are being promulgated in the US, with strong legislative support. But financial markets do overshoot, and they do so by increasing degrees, as shown in financial market volatility in recent years. Let us hope that the overshooting, if it occurs, is not serious enough, or allowed to become so serious, to lead to any major change in consumer behaviour, through sharply reduced wealth in the form of holdings of stocks. The exchange rate, too, can overshoot. As investment manager of a significant fund, I read the unusual reference by Alan Greenspan in his testimony last week to "a technical issue and a flag of caution" regarding market forecasts in the foreign exchange value of the US dollar as a move to pre-empt such overshooting. Let us see how the many players in the foreign exchange market - a market that is many, many times larger than the demand arising from trade and investment - behave in the next weeks and possibly months to come. To them, the exchange rate between the dollar and the euro is probably the biggest foreign exchange play of the year, if not the decade. The large balance of payments deficit of the US is likely to add potency to this play. What is quite clear is that they will not leave it alone. It hardly need be said that, as investment manager, the HKMA intends to do nothing that would exacerbate the current severe volatility in world markets.
Latin America must be another worrying factor for the US, although surprisingly not a lot is said on this in recent reports by analysts. There appeared to be a welcome lack of contagion as Argentina's problems worsen. But now crises are brewing in a few neighbouring countries. This indeed may be a mere coincidence and not contagion, given that the problems being experienced in one or two cases can be attributable to other distinct events. But what is happening in Latin America also bears watching closely.
Joseph Yam
25 July 2002
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