I have, perhaps rather unwisely, got into the habit of devoting a Viewpoint article, at around the turn of the year, to what I see as the outlook for the coming 12 months. The trouble, of course, is that, particularly on monetary and financial issues, one can quite easily be proved wrong. So rather than giving forecasts of financial market performance, for which I imagine there would be considerable demand, I have focussed on identifying risks and opportunities that we in Hong Kong are likely to face in the coming year.

The much politicised global imbalance is still by far the most prominent factor on the radar screen. Another year has passed and the imbalance continues with little sign of significant adjustment despite being considered unsustainable. As a percentage of GDP, the US current account deficit is still at a historically high level of around 6.8%. The consensus seems still to be that the eventual adjustment will be an orderly one, since there is no precedent for the type of sudden stop in external finance, typical for developing economies, with destabilising consequences for the monetary and financial systems, happening to a major developed economy. Furthermore, we are talking about the largest economy in the world, whose currency is still the most popular reserve currency. I certainly hope that this is the case, although orderliness can be quite a subjective concept, depending on your perspective.

Hong Kong, because of its very liquid and open financial markets of considerable capacity, has increasingly been treated as one of the first international financial centres in which to obtain liquid funds in case of need. Whenever there is a need for a substantial supply of water to put out fires in the backyards of other jurisdictions, Hong Kong is one of the first pumps that people in international finance turn to. This makes us prone to greater financial market volatility than other centres. There is also a tendency for the impact of financial shocks in other parts of the world, whether or not they affect Hong Kong in a real economic sense, to be magnified in the financial markets of Hong Kong. What is orderly and benign in the eyes of others could well be quite troublesome for Hong Kong.

This is particularly so when the global imbalance has become so associated in many peoples’ minds with the bilateral trade imbalance between Mainland China and the United States, and there has been a correspondingly sharp focus on the trend of the exchange rate between the two currencies. This is obviously a subject that could readily be read across to Hong Kong, especially to our currency and our exchange rate policy, although our efforts so far to decouple the relationship between the Hong Kong dollar and renminbi exchange rates have been successful. Indeed, psychological levels have come and gone without significant movements in the foreign exchange and money markets, despite the abundance of comments, some quite emotional, at the retail level. Further complicating the situation is the fact that our capital markets have an increasingly heavy weighting in financial instruments of Mainland enterprises that have been attracting increasingly keen interest from international investors. While the Linked Exchange Rate means that Hong Kong dollar interest rates generally track their US counterparts in the medium to long term, there is a possibility of short-term deviations that we should all be alert to.

Macro adjustment and control on the Mainland is the second most prominent factor on our radar screen. The combination of administrative and market measures being taken seems to have been quite effective, when judged by the headline economic numbers. But there is still more to be achieved, in terms of more balanced growth, continuing control over inflation, increasing consumption and slowing domestic fixed capital formation, not to mention the many longer-term structural issues identified in the Eleventh Five-Year Plan. What we should be alert to are not only the headline numbers on the Mainland and their implications for Hong Kong through the close economic and trade channels, but, arguably more importantly, developments that might affect us through the financial channels. Financial markets, particularly free and open ones with considerable depth like those in Hong Kong, typically give a telescopic view of the future and reflect it efficiently in spot prices, which then may exhibit behaviour quite different from what the headline economic numbers suggest.

There are other factors on our radar screen, but none as challenging as these two for maintaining monetary and financial stability, which is an important area of our responsibility. But I certainly hope the risks I have identified will not materialise. On the other hand, what I would really like to see happening is that Hong Kong as an international financial centre will play an even more significant role in the coming year in increasing financial efficiency on the Mainland and serving as the laboratory for the Mainland’s financial liberalisation and reform.

Joseph Yam
28 December 2006

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