Financial markets across the world have seen increased short-term volatility in recent weeks. Market participants should be aware of the need to manage the risks associated with this volatility, even though underlying trends may be robust.
There has been considerable volatility in the past few weeks in financial markets worldwide, as the focus has sharpened on the confluence of risks arising from a number of developments. These include the transition of monetary policies to more neutral settings, the macroeconomic adjustment in the Mainland of China, high prices of oil and other commodities, persistent global imbalances, and high levels of household indebtedness in some countries. The equity market in Hong Kong has had its usual share of such volatility, by almost 10% up and down within a matter of about three weeks. Considering the robustness of the underlying global economic trends, the extent of the volatility seen is a little surprising.
The financial markets in Hong Kong, and specifically the equity market, do enjoy a degree of liquidity that is probably higher than many similar markets in the region, to the extent that they have become the favourite market to get into and out of quickly. Indeed, volatility is an inevitable feature of financial markets with liquidity, particularly those of an international financial centre. This is particularly so in view of the special orientation of our markets, in terms of the extensiveness in the coverage of Mainland interests, both as fund raisers and as investors, and the rapidly increasing global interest of investment funds in China.
On the other hand, one can argue that volatility is also a reflection of some lack of efficiency in the market in performing the important role of price discovery. An efficient market should be capable of continuously taking in new information that affects market outlook and of moving quickly and smoothly to the new equilibrium price level. But of course the market merely reflects the sentiment of market participants, and market participants are human, and are not always totally rational. Thus the market often exhibits human characteristics, feeling nervous, jittery or even panicky occasionally, producing short-term, possibly sharp volatility, even in the most sophisticated financial markets. And this can at times be exacerbated considerably by market participants engaging in short-term speculative plays, although these plays could also dampen volatility and stabilise markets. Furthermore, market intermediaries have a natural affinity for volatility and it is entirely understandable that their market actions, whether for their customers or their own proprietary positions, may be influenced by such a desire, even if only subconsciously.
Thus we - the regulators, the intermediaries, the investors and those providing credit - all have to learn to live with financial market volatility and make sure that our respective interests are well protected. The regulators, of course, have the public interest of maintaining financial stability, in the systemic sense rather than the stability of the prices of financial products, foremost in their minds, so that the important function of financial intermediation is not disrupted. But short-term financial market volatility may have a bearing on systemic stability, when, for example, volatility is so great as to undermine the financial viability of those involved, particularly those of systemic importance. It is therefore essential that market participants understand clearly the extent of their vulnerability to the sharp, short-term volatility in the market that they operate and do what they can to minimise it. I believe that, with the experience gained from the financial turmoil of 1997-98, there is general awareness of this need and appropriate risk management mechanisms are in place. So, notwithstanding the roller coaster in equity prices we saw in recent weeks, the monetary and financial systems of Hong Kong appear robust.
The only area that we need to be alert to is the operation of hedge funds, or whatever other name we call them. There continues to be a serious lack of transparency in what they do, how they do it and how leveraged they are. And there probably are funds of these hedge funds that may also be highly leveraged and as opaque. It is possible that the sharp volatility we saw recently was, to a significant extent, a reflection of forced, mass liquidation of positions by a group of these funds, triggered by sudden market movement in a particular direction, which could itself be the result of new market positions taken by another group in the same direction. There is no clear information on these funds or on their activities, and therefore no mechanism for close monitoring. But I hope that those who deal with them, in particular the lending institutions providing the leveraged funding, continue to exercise the counter-party discipline that we have been promoting since our last encounter with the so-called macro hedge funds.
Joseph Yam
17 June 2004
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