Managing interest rate shocks

inSight

08 Jan 2004

Managing interest rate shocks

Economies with currency board systems are vulnerable to interest rate shocks. There are ways of handling this risk.

At a recent international conference on fixed exchange rates and capital flows held here in Hong Kong, I was given the opportunity to express my views on the subject. The following is the gist of my observations, which may be of interest to readers.

Every economy is subject to shocks every now and then. These shocks could be of a political or economic nature. They could originate domestically or externally. In an open economy, they could occur in the current account or the capital account of the balance of payments. To varying degrees, these shocks could generate substantial capital outflows (or, indeed, inflows).

In an economy operating with a currency board system, where non-discretionary, non-sterilised foreign exchange intervention at a fixed exchange rate is automatically triggered by capital outflow, there will be a shrinking of the monetary base and a tightening of inter-bank liquidity. In other words, to the extent that the shocks involve sudden capital outflow, they will be transformed into interest rate shocks.

Interest rate shocks can be painful and destabilising. Asset prices - particularly financial asset prices - may fall sharply under the influence of high interest rates, eroding the collateral value of bank loans. At the same time, the credit and liquidity squeeze may lead to corporate failures. As the quality of the loan books of banks deteriorates, depositors' confidence in the banks may be affected to the extent of causing bank runs and even a financial meltdown. The banks may fail in their role as an important- if not crucial- intermediary of funds, causing serious disruption to the normal functioning of the economy. The pain may be politically so unacceptable as to lead to the abandonment of the fixed exchange rate, only to show, in all probability, that the alternative of possibly uncontrolled exchange rate depreciation is even more painful.

Those operating or contemplating the adoption of a currency board system, therefore, need to be acutely conscious of these risks and to focus their minds on how these risks could be managed if they wish the economy to benefit from a stable exchange rate offered by a currency board system. Strategically, they should, to the extent possible, pursue proactive policies that have the effect of (a) lowering the probability of capital outflows; (b) lowering the sensitivity of interest rates to capital outflows; and (c) enhancing the pain tolerance threshold of the economy.

In an economy without exchange controls, capital flows are largely influenced by perceptions about the appropriateness of macroeconomic policies, in particular, those on the public finances, and the level of indebtedness of the economy, in both the public and private sectors. Hong Kong is running a budget deficit equivalent to 6 per cent of GDP. We have also had deflation of 3 per cent and unemployment over 8 per cent. But the fact that we have no public debt and substantial fiscal reserves has provided considerable comfort. In fact, the whole of Hong Kong has net external assets (claims on non-residents less liabilities to non-residents) equivalent to 210 per cent of GDP. This is by far the highest ratio in the world. The economic recovery and the substantial balance of payments surplus provide further support, to the extent that the probability of capital outflow seems now remote.

With no reserve requirement and a very efficient real time interbank payment system, there is no need for licensed banks to maintain substantial balances in their clearing accounts. Consequently, the Aggregate Balance in the clearing accounts of licensed banks, that crucial element of the monetary base is very small compared with the volume of capital flows. As a result, interest rates are ultra-sensitive to capital flows. This was the situation in Hong Kong before various technical measures were introduced in 1998 to reduce that sensitivity. The inclusion of the pool of Exchange Fund paper as part of the Monetary Base, involving the commitment of more foreign reserves backing the Monetary Base, has been helpful in reducing the probability of interest shocks.

The pain tolerance threshold of the Hong Kong economy is traditionally high given the high savings rate. Furthermore, over the years, as banking supervisor we have worked closely with the banking sector to develop a culture of prudent risk identification, assessment and management that has contributed greatly to enhancing its robustness.

 

Joseph Yam

8 January 2004

 

ANSWERS TO THE CHRISTMAS QUIZ 2003

 

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