Following is the speech by the Financial Secretary, Mr John C Tsang, at the Paris Europlace Financial Forum this morning (September 24):

Good morning Ladies and Gentlemen,

     Thank you so much for the invitation to join you today. I am very happy that Paris Europlace is holding this event in Hong Kong because it helps to underscore our credentials as a global financial centre. It also helps to bring the Hong Kong and Paris markets closer together. And, by extension, it helps us all to understand each other a little better, and to look for ways in which we may complement each other.

     This is the second major financial forum to have been held in Hong Kong in the past four days. Last week, the Asian Financial Forum gave us all a chance to reflect on the ups and downs of the past decade in this region - and to look for ways in which we may leverage growth opportunities in the future.  

     This forum shifts the focus away from Asia towards France, Europe and the rest of the world. As a global financial centre, it is important that Hong Kong is engaged at all levels - national, regional and global.

     Since France is the centre of Rugby World Cup action at the moment, please allow me to draw a brief sporting analogy. In a global rugby team, Hong Kong would be the scrum-half. Quick, nimble, looking for opportunities, directing the action, thinking ahead - not the biggest nor the strongest player on the field, but certainly one of the key players managing the flow of the game. And, as the scrum-half has to mix it up front with the forwards, usually one of the toughest and most resilient as well.

     Hong Kong is not in the Rugby World Cup but we do have a pivotal role to play in the global financial system. We also have a pivotal role to play in the development of our nation's financial system as China continues to open up, reform and engage the world.

     And because Hong Kong is such an open and externally oriented economy that is fully plugged into the global trade and financial markets, it is inevitable that Hong Kong will be affected by global events. We are constantly on the lookout for danger signs to see how they may impact on our market, and on China's market. So today, I would like to talk about some of the issues on my radar screen at the moment, and how they have, or may, impact on Hong Kong.

     Let me start with the sub-prime issue, which is in the headlines almost daily.

     The issue has provided us with a warning signal that we need to look more closely at how global financial services are priced and distributed, and how we manage and assess risk. The current turmoil has spread from the US to Europe, and across the Pacific to Australia. This is a real problem that threatens global financial stability, investment, jobs and home ownership.

     As we have recently learned, the problem is not with individual sub-prime mortgages per se. Rather, it's with the way in which these mortgages have been repackaged and sold on. Securitisation of debt itself is a good thing. It allows risks to be spread. It makes the financial system more robust and efficient. And it makes credit more available to people who might not otherwise have access to it. But there are also pitfalls and uncertainties.

     In the process of off-loading risks through instruments such as collateralised debt obligations (CDOs), credit standards may become eroded. The banks used to bear most of the risk themselves. These days they may be less concerned about the credit-worthiness of borrowers if they know that mortgages and other loans will be securitised and off-loaded quickly.

     Home owners may be able to take out bigger mortgages than perhaps they should. That can push up property prices and create an asset price bubble.  If or when real estate prices fall, this can give rise to negative equity.  This is all too familiar territory in Hong Kong.  In the fallout of the Asian financial crisis, our property bubble burst and prices tanked by nearly 70%.  At one stage, we had as many as 105,700 cases of negative equity, which had a tremendous impact on consumer confidence and was part and parcel of a deflationary cycle that plagued us for more than five years.  But even with the severity of the asset deflation we had then, our banking sector remained resilient and no bank needed rescue.  Today, our banks are in a much stronger financial situation and negative equity cases have dropped to about 4,700.  

     But the painful memories of the collapse are still deeply imbedded in many people's minds. Once bitten, twice shy.

     On the whole, banks in Hong Kong do not have a large exposure to CDOs. However, we share the concern that, as credit risk is being spread further and wider, it is not always clear where it ends up, and who is bearing it.

     It could lie with investors who have not borrowed and can wait for asset values to climb again. Others may be able to absorb the losses.  But if credit risk lies with leveraged institutions that cannot bear the losses, problems will occur. Banks themselves may be providing funding, directly or indirectly, to institutions that purchase the CDOs.  As a result, some banks may be exposed to sub-prime or other similar risks without being aware of it.

     Fed Chairman Ben Bernanke recently estimated that losses arising from the sub-prime problems in the US could reach US$100 billion.

     For the record, in Hong Kong, we do not have a sub-prime mortgage market.  Generally speaking, the loan-to-value ceiling is capped at 70%.  A mortgage insurance scheme is an additional backup intended to keep the local market and banking sector robust.

     This, however, does not immunise Hong Kong's economy against the fallout from the sub-prime problem.  We are likely to feel the consequences, in part because the US is the world's largest economy and a big market for not only Hong Kong, but also an export-dependent Asia, including China. If US consumer demand falters significantly, Asian economies will inevitably feel the pinch.  Hong Kong will also be hit indirectly as Asia now absorbs two-thirds of our exports.  So we will be keeping an eye on the situation in the months ahead to see if there are any signs of a slowdown in Asian exports to the US.

     Another area we are watching closely is carry trades. Not because they affect Hong Kong directly, but because if the carry trades unwind, the ripples could impact on global trading and financial centres such as Hong Kong.

     The Yen carry trade is particularly popular for investors because of Japan's low borrowing costs.  But, just like the sub-prime problem, no one quite knows how big the carry trade is.

     The risk is that if borrowers can raise funds cheaply through carry trade, they can inflate the price of assets and eventually create a bubble.  These bubbles could also burst if carry trades unwind too quickly or in a panicked market.  The trigger for this unwinding, in the case of the Yen, could be interest rate increases in Japan, or a depreciation of the high interest currency such as the US or New Zealand Dollar.  Either way, the borrowers' profits could be wiped out. It is, as they say in the market, just like picking up nickels in front of a bulldozer - you can pocket the small change as long as you correctly guess the speed of the automobile.  But, if you miscalculate, you'll get creamed. And because nobody really knows the extent of the carry trade exposure, we don't really know how much and, if at all, it could affect a market such as Hong Kong.  But we do know that the amounts involved are probably so large that any rapid unwinding of carry trade could affect global stability.

     So what can we do in terms of better managing risks in the financial sector?

     For one thing, we have a strong focus on stress testing. Since 2003 the Hong Kong Monetary Authority, our de facto central bank, has required all authorised institutions to have stress testing programmes in place. The Monetary Authority and other regulatory bodies carry out regular stress tests on banks to make sure they are financially healthy and can bear the risks they are taking.

     Stress tests have become an integral part of the financial infrastructure in recent years. But global finance is evolving and advancing so quickly that some of the techniques employed have become outdated. So, there is a need to develop more sophisticated techniques. These would take into account not just direct exposure to risk, but also second and third round knock-on effects of a shock.

     Now to a question that has been worrying economists for years. How long can the US continue to run a large current account deficit?

     Since 2002, the US current account deficit deteriorated year after year. It topped US$811 billion in 2006, an alarming 6.25% of US GDP.  Economists all over the world keep saying it is unsustainable, and yet investors in economies with high domestic savings clearly continue to believe that lending to the US is a good bet.

     But how long can this continue? When and how might the imbalance be adjusted? The US deficit is the source of the demand for exports from the rest of the world, and if the US deficit continues, how will Asian economies adjust? And what will be the consequences for global financial and monetary stability? Will it be a soft landing, or a crash landing, for the US economy?

     These are not questions that I, or anybody else really, can answer with any degree of certainty. But, we are aware of the possible risks. And this by itself provides us with an opportunity to ensure that our banking and financial systems are in tip-top shape to deal with, for example, a slowdown in the US economy and the US consumers' appetite for imports.

     The most often cited trading relationship in the world is that between the US and China. The trade deficit between the two countries hit a record US$232.5 billion last year, and it looks like it will be even bigger this year. This is giving rise to protectionist sentiments in the US. There has been a constant call from some quarters in the US for the Renminbi to appreciate, which would make imports from the Mainland more expensive and US exports to China cheaper. There have also been calls in the US Congress to label the Mainland currency as misaligned as well as other punitive proposals to narrow the trade deficit between the two countries.

     Another aspect that has changed recently is the image of the "Made In China" brand in the US. Several Mainland products, such as brands of pet food and toys, have been labelled "unsafe" in the US. This may be an indication of non-trade restrictions on some imports. It is a concern to Hong Kong because a large number of our toy manufacturers are now based in the Mainland.

     We believe these are not purely domestic issues but international ones.  As such, they should be dealt with through the proper channels, such as the World Trade Organisation, rather than through unilateral protectionist policies.

     Also featuring prominently on my radar screen is the spectre of inflation.  Our figures up to now suggest that consumer price inflation for the past eight months has stayed at about 1.5%, but recent factors and sentiments in our key markets have seen significant shifts.  Changes in our latest set of economic figures indicate that it is likely that our estimate of inflation for this year as a whole could now be about 0.3 to half a percentage point higher than our original forecast of 1.5%.  This is still a moderate level given that our economy grew by an average of over 7% for the past four years.  But in line with the trend in many parts of the world in recent years, inflation is, indeed, creeping up slowly in Hong Kong as well. We have recently seen rising imported inflation because of a weaker US dollar and a stronger Renminbi, as well as rising food prices world-wide.  These factors will not go away any time soon, and they will continue to pose upside risks to Hong Kong’s inflation rate in the near term.  

     Beyond the near term, inflation remains potentially a main concern for economic management in the coming years if our economic performance remains strong.  Given our currency link to the US dollar, we have little room for any exchange rate or interest rate policy.  We will do all we can to make the supply of productive resources flexible to meet demand pressures in order to contain cost pressures.  We will also ensure that the market functions well so that competitive pressures will help to contain price increases.  Hong Kong, in general, should be able to cope with the increases.  My principal concern lies with the impact of escalating costs on people in the lower economic strata.  We are fully cognizant of this development, and we will be doing every thing we can to assist this group of people.

     The world economy is generally strong at the moment, so that augurs well. But, as global finance becomes ever more complicated, this is also the most opportune time to upgrade our financial infrastructure and to develop a more advanced framework to help manage crises or stop them from happening.

     I'm not saying there is a crisis coming tomorrow. Current indications are that the risks that worry us most today will remain contained. But risks are always with us - and we need to manage them well.

     Ladies and Gentlemen, I hope I have been able to give you an idea of some of the main issues featuring on my radar screen.  These are some of the challenges a small, open economy, such as Hong Kong, needs to deal with.  I'm sure - as the past decade has shown - that whatever crises that come our way, we should be able to handle them with the same degree of pragmatism, resilience and determination that has become a hallmark of our society.

     Once again, welcome to Hong Kong. I wish you all fruitful discussions and an enjoyable stay in Asia's World City.

     Thank you.

Ends/Monday, September 24, 2007
Issued at HKT 10:17

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