Speech by the Financial Secretary

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Following is a speech (English only) by the Financial Secretary, Mr Donald Tsang, at a presentation at the Kennedy School of Government at Harvard University today (Wednesday, HK Time):

"Globalization, capital flows and free markets: Lessons from Hong Kong"

Professor Leonard, Distinguished Guests, Ladies and Gentlemen,

Introduction

I am extremely honored to be back in Boston to meet old friends, to seek out some new ones and to refresh intellectual vigor amidst the hallowed halls of my old alma mater.

As Finance Minister of one of the world's most free and open economies, this past year has indeed been trying. The existentialist philosopher Woody Allen perhaps sums up how I feel some days. He once said: "More than any other time in history, mankind faces a crossroad. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly."

I am more optimistic than Woody Allen, but we must not underestimate the gravity of the current economic crisis today. For the first time, the world must work together to put floundering economies back on track. The global village is indeed a reality, but many of us still do not fully understand the consequences of living in such close quarters. Last week, at the Bank/Fund Annual Meetings in Washington DC, finance ministers and central bankers agreed we were facing the world's greatest economic, political and social challenge of the past 50 years. We are all in the same boat. We need to row in the same direction if we are to achieve sustainable and soundly-based economic growth in the future.

On July 1 last year, Hong Kong made its peaceful return to China. The next day, the Thai Baht devalued. Since then, the Asian crisis has become a crisis of globalization. What caused it? What are the solutions? Is this the end of the free market?

These are not academic questions. Rather, they are matters of life and death for small and open economies like Hong Kong. No-one believes in free markets more than I do. But I have to admit that this past year has shown there is more to a free market than we had previously - and dogmatically - believed and promoted. So let me reflect on what we have learnt. If you bear with me, I wish to first speculate on the cause of the 1997 global financial crisis, and why it was so contagious. I shall then discuss the implications for the free market as we have known it and for the systems created by Bretton Woods. Finally, I wish to bring you back to present day Hong Kong.

Possible causes of the crisis

A distinguishing feature of the global financial crisis is its complexity. No one could have foreseen it would happen with such speed or ferocity. With the perfect vision of hindsight, there were many warning signals that the Asian Miracle could not continue unchecked .

First, the Asian crisis was similar to the ERM crisis in 1992 and the Mexican crisis in 1994. However, the distinguishing features in Asia were excessive private sector borrowing and a high degree of contagion. In 1992, high liquidity from the developed markets sought high yields in a European 'convergence play'; the Asian version of the 'carry trade'. These speculative flows borrowed funds in a cheaper market to invest in another currency with a higher yield. Large hedge funds first gained fame by bringing down Sterling in 1992. However, they could not shake the French Franc because of strong co-operation between the core European central banks. Yet, Europe was devastated. In 1994, the notion that the US would act as lender of last resort led to excessive capital flows into Mexico. Contagion spread once the market realized that no one, not even the IMF, was willing, or able, to act in that role globally. The saving grace in both incidents is that they did not overspill into other regions. The contagion was less lethal then, but the illness was the same - overwhelming capital flows.

Second, many would agree that Asia made many mistakes during the boom period. These included crony capitalism, weak financial systems, corporate over-borrowing, bad policies with implicit government guarantees, and poor bank supervision. With strong growth, fuelled by high capital inflows, Asia developed a big bubble - and that bubble burst.

Third, the wide acceptance of the free market model after the fall of the Berlin wall in 1989 brought 300 million new workers and consumers from former centrally-planned economies into the global market. This brought excess production capacity, new sources of cheap labor and untapped natural resources. Asian exporters suddenly found themselves thrown into greater competition and unsustainable levels of current account deficits and total debt.

Fourth, as US Fed Chairman Alan Greenspan said: "Major advances in technology have engendered a highly efficient and increasingly sophisticated international financial system [which] has the capability to rapidly transmit the consequences of errors of judgement in private investors and public policies to all corners of the world at historically unprecedented speed." Paul Volcker summed it up even better. He said: "Success breeds confidence; greed overcomes prudence; fear becomes contagious and a financial crisis becomes an economic crisis."

Fifth, corporate borrowers took advantage of derivative products that generated high yields with huge leverage and unknown risks. Credit bubbles grew both above the line and below the line. In Greenspan language, "standards of due diligence on the part of both lenders and borrowers turned somewhat lax in the face of all the largess generated by abundant capital flows".

The credit bubble became very large by any standard. Total, global financial assets in mid-1997 amounted to roughly US$56 trillion, of which bond market and stock market capitalization each accounted for US$23 trillion. The other US$10 trillion represented Bank of International Settlements reporting banks' international assets. This became nearly twice world GDP, compared with only 1.25 times in 1990. Daily foreign exchange trading, at US$1.2 trillion, is 50 times larger than the movement of physical trade.

Finally, all this created massive borrowed wealth. In the four years to 1998, the US stock market added US$4 trillion in wealth, or nearly 50% of her GDP, even as private savings declined. But, excessive gearing in the US market can also cut wealth dramatically elsewhere. Asian stock market capitalization has rapidly declined by US$1.7 trillion since July 1997 - that is nearly 35% of East Asian GDP. We must now beware that an over-correction of capital flows in 1997 and early 1998 may trigger off another U-turn in capital flows, hopefully, this time towards a more sustainable balance.

Why was the Asian 'flu so contagious?

Global integration in trade, banking and finance made the 1997 Asian 'flu more contagious. For example, Korean financial institutions were major offshore borrowers as well as investors in high-yielding Russian and Brazilian debt paper. Thus, when the standard IMF prescription of a floating exchange rate, plus tight monetary and fiscal policy was applied to Asian economies, the corporate sector, with excessive short-term foreign debt, promptly collapsed. This in turn led to bank failures, domestic and foreign capital flight and full-blown deflation.

The deflation then cut intra-Asian imports, causing competitive devaluation on other Asian economies. Moreover, a mistimed Japanese consumption tax increase, and efforts to meet the 8% Basle capital adequacy ratio by Japanese banks, sent the Japanese economy into a tailspin in 1997. This weakened the Yen, worsened the banking crisis and accelerated the domestic and international credit crunch. Since July 1997, Japanese and other foreign banks have withdrawn an estimated US$200 billion in offshore bank credit from Hong Kong and Singapore, exacerbating the liquidity crunch in Asia and elsewhere. As Asia cut back on commodity imports, oil producers started to cough and splutter. The 'flu spread from Russia to Venezuela, plunging these economies into crisis. South Africa and some Scandinavian markets also made nervous moves. A global financial crisis is thus in the making.

Initially, everyone thought calling in the IMF would calm the markets. But the IMF program for Indonesia proved to be an excessively bitter pill. Then the Russians defaulted, despite another large IMF program. This series of events, together with a delay in providing new capital to the IMF, punctured the assumption that the IMF had enough resources and capacity to deal with a global crisis. All this has enormous implications for the conventional belief in the free market and the Bretton Woods financial architecture.

What of the free market model?

What went wrong? The free market model basically states that good economic performance requires liberalized trade, macro-economic stability and getting the prices right. Once government gets out of the way, private markets allocate resources efficiently and generate robust growth. Logically, financial and trade liberalization is the right strategy for emerging markets which should open their trade and capital accounts in order to share in global prosperity and economic growth.

The power of this model, in which I believe, created unprecedented global prosperity. Hong Kong is the living example of how the free market works. But, the free market model is not as simplistic as that perceived by gung-ho, 29-year old market traders. For example, the problems in Russia demonstrate how markets must have strong regulatory and supervisory institutions to prevent market exploitation by a handful of conglomerates that wield enormous political and economic power.

In other words, free markets not only need sound macro-economic policies, but also an understanding of how the microstructure of markets work.

Free markets work well with a free flow of information, a level playing field in terms of competition, sound regulatory and legal framework, and very clear rules of market entry and exit. But these conditions do not always hold in many markets around the world. They certainly do not hold well in regards to capital flows across international boundaries. Indeed, an open market can only remain free and level if its breadth and depth are significantly bigger than the volume of capital flowing through it. A market that is small in relation to capital flow is invariably unstable once the flow increases its speed or reverses its direction. Its free and level structure cannot help much. It is like a sudden torrential flow from a loosened icefield thundering through a narrow stretch of river, tearing down the river banks and flooding all communities in the neighborhood.

The distinguishing feature of the current global crisis is the dominant role of private sector funds, the flows of which appear too large for authorities to monitor or manage. The volatility of capital flows has something to do with the leverage power of some hedge funds, which gives them enormous resources relative to the size of smaller emerging markets.

The United States is the strongest advocate of free markets, and at the same time has the most vigilant anti-trust laws. There are stringent laws against market manipulation and predatory practice to prevent incidents such as the Hunt Brothers silver debacle of 1980. Elaborate rules and regulations exist to prevent short-selling activities that could destabilize the well functioning of bond, commodities and equity markets, partly learnt from the crash of 1987. Beyond the US, the situation is vastly different.

As Professor Charles Goodhart noted: "Finance is rapidly becoming global; but laws and regulations are national." Because of tax and regulatory arbitrage, funds are moving increasingly to offshore centers to escape the tax and regulatory net. This legal anomaly means offshore funds can - and do - behave very differently from those onshore funds subject to stringent disclosure and regulatory requirements.

The hedge fund industry, for example, has rapidly grown from a handful in the early 1990s to more than 4000, with assets of US$400 billion. Their capacity to leverage up to nearly 20 times their capital makes them lethally potent. For example, Long Term Capital Management (LTCM), with US$4.8 billion in capital and debt of US$100 billion, has an exposure larger than the external debt of Korea, the 11th largest economy in the world. The LTCM failure has posed systemic risk that could bring down the large money center banks.

Since these investment funds operate in a non-transparent manner - they are only accountable to their limited shareholders - they have been able to take advantage of their power to leverage and to move quickly and secretly to take large positions in smaller markets. The 1993 IMF International Capital Markets report stated that some funds treat "an attack on a fixed exchange rate...as an assault on the central bank's accumulated international reserve stock". Since the incentives to win are tremendous, and with no regulatory restraint, some predatory hedge fund managers consider anything is fair game as long as they win. Human and social dimensions, as well as wider geo-political considerations, play no part in their game. Thus, predatory activities such as acting in concert and collusion to fix markets; naked short-selling; and spreading rumors to panic smaller investors, are not, and cannot be regulated, because the domestic regulatory framework, even if it exists at full strength, cannot prevent such illegal behavior as long as it radiates from offshore markets. Indeed, there is no information on such behavior because these funds are not required to disclose their positions and their flows.

There is a widely-held view that hedge funds are best regulated by their lenders. However, as the LTCM experience shows, the shareholders and supporters of these funds include banks that have granted considerable credit to the funds. Indeed, we known also that some investment houses handling the large and lucrative transactions of these funds also have proprietary positions that add to the bandwagon effect of speculative behavior. The temptations are high to gain from insider information and collusive behavior.

On the other hand, the costs of self-fulfilling speculation against emerging markets have proven enormous for the developed markets too. Large derivative positions undertaken by hedge funds such as LTCM are now getting "too large to fail". In other words, the balance of risks has shifted towards having some reporting or regulatory net over the behavior of large institutional investors, including private funds.

I am not advocating capital control or a regulatory system as tight or elaborate as those for the banking system. Let us first concentrate on monitoring. What I would like to see is greater transparency in terms of the funds' financial position, especially exposures (both above and below the line) in different markets, and the degree of their leverage. This is necessary because the cumulative exposures of these funds, either by herd instinct or by acting in concert, can be extremely large in smaller emerging markets. When these markets become thin and volatile, sudden shifts in exposures can be extremely disruptive to the real economy. Greater transparency would discourage potential manipulative and predatory behavior, since regulators and other investors would be able to monitor the build-up of positions.

Revisiting Bretton Woods

Let me now turn to the need to renovate the Bretton Woods legacy. Unfortunately, the recent Annual Meeting was not able to reach a consensus on the way forward. Each region seems to have very different views as to the urgency and depth of the problems and the solutions in response. I would like to make a few points.

First, there is no free lunch in globalization, because the first premise of free markets is that there is no free lunch. We cannot, as Jeffrey Sachs puts it, have free markets on the cheap. Globalization offers tremendous benefits, with the advantages of free trade and capital flows. But globalization also has costs, in terms of building a global framework of transparency, strong financial systems and a uniform set of rules for competition, for entry and exit etc, that are fair for all. Without such a framework and infrastructure, the costs can be huge - contagion, capital flight and putting nearly 40% of the world into recession. It will take time to devise this framework, and the costs of repairing the present damage will not be small either.

Second, a key lesson from Asia is that many national balance sheets have been devastated by high real interest rates and exchange rate devaluation as a result of excessive short-term domestic or foreign debts. Consequently, a real question is whether there is adequate international burden sharing in assisting the devastated economies to recover without worsening moral hazard.

Third, globalization requires co-operation and consensus, not just self-interest and preaching. One of the problems that led to unilateral action by various economies, such as exchange controls, is the perception that global problems are not shared equally. Because funding to the IMF is delayed, there is a belief, right or wrong, that the IMF offers painful medicine to program countries without adequate funding. The whole purpose of the IMF, under its original Bretton Woods mandate, was to internationalize the burden of adjustment. However, G-3 economies cannot, for their own internal reasons, co-ordinate their monetary policies. Nor can they contribute towards IMF funding quickly enough. The burden of adjustment thus falls immediately on the smaller economies. As Chairman Greenspan aptly remarked: "We must act now". But this was followed by "Okay, Buster, you're on your own."

As an international financial center, Hong Kong was the first to ratify the New Arrangements to Borrow, which still cannot be activated because the large nations have difficulty persuading their legislatures to approve such funding. Hong Kong will play by the global rules and will participate, co-operate and contribute in whatever way it can within its resources towards international financial stability.

Fourth, while globalization calls for convergence of international standards, it is important to recognize that the strength of a global market lies in its diversity as much as its harmony. There is no strictly right or wrong path towards development. There is, for example, a growing dogma that flexible exchange rates are much more suitable for a world of change because they introduce two-way risk and allow for more macroeconomic policy flexibility. However, flexible exchange rates pass internal adjustment costs abroad, and can be highly destabilizing when competitive devaluation is triggered. For small, open economies like Hong Kong, which cannot determine their own exchange rates, very high fiscal and productivity discipline is imposed through a fixed exchange rate regime. There is nothing inferior in such a fixed exchange rate regime. Whatever kind of exchange rate system a small economy may like, its life has been made extremely difficult when the major G-3 currencies have even higher volatility than the minor currencies. Global stability requires that there is currency stability amongst the major reserve currencies.

Fifth, whatever the framework we must harness market forces in its aid. To counter-act the growing credit crunch, we need to develop deep domestic bond markets to mobilize domestic savings and foreign investments. I strongly believe that the multilateral development banks have a role in acting as catalysts or intermediaries for the development of these markets.

Hong Kong is for free markets

Before I conclude, I would like to say a few words about the Hong Kong government's recent incursion into the stock market. What we did was a matter of survival - as simple as that. We had to stop a contrived manipulation of our stock and money mark markets to protect the integrity of the linked exchange rate under our currency board system, as well as re-introduce a level-playing field into the stock and money markets. Despite Hong Kong's strong fundamentals, and rapid asset price adjustments, there was repeated speculation that did not reflect normal hedging activities. We detected a double play by a few over-aggressive players that went beyond the bounds of free market morality.

We have since strengthened our securities market regulations and our currency board regime by making them more transparent and robust. The high quality equities that we have acquired at very favorable prices will be managed in a separate asset management company for the people of Hong Kong. We will take a passive position in the market. If and when we decide to liquidate some of our holdings it will be done gradually, over time, so as not to cause any market disruption.

As an international financial center and the premier international window for China, we are committed to globalization and open markets. The Basic Law, our constitutional document, explicitly prohibits exchange control of any form. We firmly believe in our link to the US dollar, which is the anchor of our stability. Every Hong Kong dollar currency note is backed not once, or twice but a full eight times by foreign exchange reserves. The government has no external debt and we have fiscal reserves well in excess of the value of one year's public expenditure program. Asset prices may have dropped by more than 50% but the banking system remains strong and well capitalized, with a capital adequacy ratio of around 18%. Hong Kong is the most flexible and resilient economy in the world and we are determined to let asset prices adjust normally - and here I stress the word normally. Market manipulation does not fall within this definition in my book; and it is illegal in this country.

The view that the Asian crisis is a crisis of exchange rates is an aberration. It is a crisis of productivity, confidence and covert capital flows. I am confident that with Hong Kong's high savings rate, tremendous entrepreneurial spirit and deep reserves, we will be able to adjust and restructure our economy. Indeed, we have already. The Chief Executive's Policy Address last week set out major new initiatives to improve productivity and to increase competition and innovation. For example, we have taken very important steps to reduce the monopoly in fixed line telecommunications, and increase competition in media and transport. We are investing huge sums in education and infrastructure. We now need to build an international consensus on monitoring capital flows.

Finally, let me re-iterate Hong Kong's commitment towards free markets:

We believe that small government works.

We believe that the market works; but the government has a role in maintaining the stability and integrity in markets.

We believe in soundly-based capital flows.

We believe in greater transparency, fair competition and a global regulatory framework.

In short, we believe in making the market work better.

Thank you.

End/Wednesday, October 14, 1998

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