The Year of the Ram brings heightened risks both to the world generally and to Hong Kong in particular.
Crisis prevention and management in financial markets require constant awareness of the risks that we are exposed to. If this awareness is common to all those involved in financial markets - the regulators, the market intermediaries and those who use the markets - and if they take corresponding actions to mitigate the risks, then chances are that the risks will not materialise and the crisis will not occur. There is a saying "what you see is what you get". Now this may appear to be totally unrelated to financial risk management. But let's try to look at the other side of the argument, as we should all do in whatever we are doing. If what you see is what you get, then what you cannot see is what gets you!
How then do we avoid being caught in a cleft in our involvement, in whatever capacity, in financial markets? The trick is to read, listen and think, and to try to get that extra mileage out of one's rational self. Do not panic and do not be greedy. Be decisive and be objective. And, if you can spare the time, study these Viewpoint articles. This regulator does not mind sharing with you his analysis of the risks and vulnerabilities facing the monetary and financial systems, precisely for the purpose of reducing the probability of those risks materialising.
So what are the risks that we face in the monetary and financial systems as we move into the Year of the Ram? Regrettably, I have to say that there are many. Readers will already be familiar with those arising from the external environment - even greater volatility in world financial markets and the exchange rates of major currencies, geopolitical tension and the prospects of war, continuing financial and political problems in Latin America, and weak economic conditions in major economies. All these external factors could undermine the export-led economic recovery we are experiencing in Hong Kong and financial market performance. Being highly externally oriented, the very mixed external environment will likely affect the Hong Kong economy more significantly than it will for other less externally oriented economies, with similar implications on financial market performance. But the external environment, in isolation, is unlikely to lead to systemic problems, since our monetary and banking systems remain basically robust.
What seems more worrying is the combination of deflation and budget deficit that are specific to Hong Kong, and their implications for monetary and financial stability. Both Mr CH Tung and Mr Antony Leung have repeatedly referred to them, as discussions on the budgetary strategy for the next few years proceed in earnest. Their frankness, and the calmness with which their comments were received in financial markets, has encouraged me to be a little more specific about the nature of one of the risks that we face, and this is the risk of erosion of confidence in the Linked Exchange Rate system. I hope that these comments will help ensure that the risk is more prudently managed by all concerned, to the fullest extent possible.
If this risk were to materialise because of a lack of community support for, or a lack of credibility in, the budget package, it may take the form of an interest rate shock. The reforms (the seven technical measures) to the monetary system in 1998 have made interest rates somewhat less sensitive to capital outflow. But when capital outflow is large, even relative to the cushion of over HK$100 billion of Exchange Fund paper acceptable at the Discount Window, interbank interest rates, particularly those for short-term money, may go up sharply. Hopefully this would be enough to stem the outflow and things would return to normal quickly. But it is possible that the outflow may be sustained, in which case interbank interest rates for longer-term money may also rise sharply. This will affect different banks differently, depending for example on the extent to which their funding costs are linked to interbank interest rates. Generally speaking, however, the ability of the banks to absorb higher interbank interest rates without adjusting their lending rates, including their mortgage rates, has been eroded somewhat in recent years by greater competition and lower profitability. Higher funding costs will result in higher lending rates, more readily now than before.
It is up to individual entities in the economy to manage the risk of an interest rate shock to the best of their ability, having regard to their individual circumstances, should it materialise. But it can be avoided if we have a credible budget package and community support for it.
Joseph Yam
13 February 2003
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