The world economy and financial markets

inSight

09 Jul 2009

The world economy and financial markets

Investors should continue to be cautious.

Some readers may have noticed an interesting phenomenon that has attracted much attention here at the HKMA. This is the distinctly different performances in the first half of this year of the economies and equity markets in many jurisdictions. While the economies continue to contract, in some cases rather sharply, stock prices have surged.

The popular explanation for this phenomenon is, of course, that the worst of the financial crisis may be over, with the financial system stabilising; the global economy, while contracting, is also showing signs of stabilisation, helped by the substantial fiscal and monetary stimuli; and equity markets always recover ahead of the economy as they telescope future prospects into present prices, taking account of and balancing the views of market participants, on both the demand and supply sides.

I certainly hope that this explanation is borne out by the facts in the coming months. But I would like to point out that there is a high degree of uncertainty associated with it, and I have an uncomfortable feeling that the factors underlying that uncertainty have not been adequately reflected in the performance of financial markets. The global financial crisis is, of course, continuing. In the US, where it originated, the financial system is still not functioning normally. Credit availability is still quite limited because of concern among investors and lending institutions over credit risk, to the extent of raising doubts about whether the financial system is adequately supporting economic activity or unhelpfully reinforcing economic contraction. Although there has been improvement in the corporate bond market in the US, the securitisation market, which had been one of the main channels of financial intermediation before the outbreak of the financial crisis, is still not functioning, other than for those securities, such as mortgage-backed securities, covered by the government purchase programme. The banks may be able to raise additional capital after the stress tests, but they are using it largely to repay government money that carries stringent conditions, presumably to get the government as much - and as quickly - as possible off their backs, rather than to expand credit. Meanwhile, the US housing market is still on a downtrend and the mortgage delinquency rates rising, albeit at a moderating pace. Consumer behaviour is also undergoing profound changes, characterised by a very significant increase in the savings rate, with considerable short-term negative implications for economic prospects, although the increase should, in the longer term, contribute to correcting the global imbalance and therefore to more sustainable growth. What seems quite clear, at least to me, is that the process of economic stabilisation and recovery in the developed economies will be a slow one.

But I am acutely aware that, as a general rule, bureaucrats cannot be wiser than the market, particularly financial markets that are free and liquid, of a considerable size and not subject to undue influence by individuals or groups of market participants acting in their own private interests. Regrettably, the two very large financial crises that we have seen in recent years both involved market failures, as a result of globalisation and innovation among other specific international and domestic factors. Financial markets do fail and they will do so again, if only because of the familiar herd instinct of market participants and their sensitivity to information that affects markets. We should not therefore exclude the possibility that, as hitherto inadequately appreciated reality sinks in, there may be disappointment and volatility in financial markets that may cause harm to investors again, although I think the likelihood of systemic problems erupting again in the financial system is low.

Here in Hong Kong we typically see large swings and sharp contrasts, given the high degree of external orientation of the economy and the financial markets. We all know that the GDP numbers showed a year-on-year contraction of 7.8% in the first quarter of this year. What seems to be brushed aside by many analysts is that the corresponding annualised quarter-on-quarter (2009 Q1 on 2008 Q4) contraction is 16.1%. Of course, the nearly 30% increase in the Hang Seng Index in the first half of the year is more apparent to everyone. But then the performance of the Hong Kong stock market, as measured by the Index, reflects the collective outlook of companies included in the Index, many of which have a heavy Mainland content and the Mainland economy continues to grow, notwithstanding the financial crisis.

It wouldn't hurt for all of us, in whatever capacity, to think through these issues, as we continue to sail in uncharted waters.

Joseph Yam
9 July 2009

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