Speech by the Acting Financial Secretary, Mr Rafael Hui,
at the Opening Ceremony of the 19th Asia Pacific
Financial Markets Assembly

Friday, November 28, 1997

The acting Financial Secretary, Mr Rafael Hui, today (Friday) told a group of overseas delegates that Hong Kong's linked exchange rate system is here to stay and maintaining the link is the long-term commitment of the Hong Kong Special Administrative Region Government.

He stressed that this firm commitment to the link stemmed not from any political consideration but from economic necessity owing to the unique characteristics of Hong Kong being a completely open and flexible service-based economy.

He described as "a mistaken view" a belief that a depreciation in nominal exchange rate would ensure higher competitiveness, adding that Hong Kong had no choice but to improve its competitiveness through tighter cost controls, productivity improvement and product innovations.

He made the above remarks at the Opening Ceremony of the 19th Asia Pacific Financial Markets Assembly.

Following is the full text of the speech:

Ladies and gentlemen,

I am very honoured to be invited to address this distinguished audience on the occasion of the 19th Asia Pacific Financial Markets Assembly. I would like to congratulate the Hong Kong Financial Markets Association for bringing this prestigious event to Hong Kong. It provides an excellent opportunity for distinguished financiers from all over the world to come to Hong Kong and feel for themselves the vigour and vibrancy of our economy after the handover in July. This is despite the turmoil and shock that we have just experienced.

It is indeed an interesting time to come to this part of the world. As Asia is preparing for the arrival of the 21st century, the economies in the region have recently been overshadowed by a currency and financial turmoil that swept through East and Southeast Asia. Pundits have offered a wide range of views on how to interpret the recent events and the implications on the future development of the region. Is it the debunking of the "Asian Miracle", an inevitable ordeal in achieving economic maturity, a temporary setback, or a blessing in disguise?

To answer this, I suggest we should stand back from the heat of the moment and put recent financial turmoil in Asia in a global perspective. The world is in fact in pretty good economic shape. Although some of us may not recognise this, we are witnessing the longest stretch of economic boom the world has seen for a long time. According to the International Monetary Fund, developing country exports grew by 16.7% per annum in 1994-95, nearly 4 times faster than the average annual growth rate in 1979-88. The US economy is in its sixth year of straight growth, with the lowest inflation and unemployment level in decades. Of greater relevance to Hong Kong is that the Chinese economy is still expected to grow at a remarkable 9.5-10.0% per annum.

Amidst all this global prosperity, why is Asia suffering from the present round of turbulence? I would like to highlight three major factors which are relevant. First and foremost is the increased volatility in capital flows brought about by the globalisation and liberalisation of financial markets. Induced by the improvement in economic prospects and the higher rates of investment return, net private capital flows to emerging markets increased four times from US$46 bn at the beginning of the 1990s to US$239 bn in 1996. Over 40% of this total came to Asia, and about half of which were in the form of foreign direct investment. Another one-fifth was in the form of portfolio investment. International capital inflows have certainly contributed to the strong economic performance in East Asia. The substantial capital inflow, however, has also subject the economies to additional risks. It allows inefficient investment and consumption to expand, putting pressure on prices and undermining the competitiveness of the export sector. Financing current account deficits by short term external borrowings is also risky. Once sentiment turns sour, overseas capital will switch out, thereby exerting downward pressure on the domestic currency.

Second, overheating in the asset markets gradually crept in. Stock market indices on average rose by nearly five times within a ten-year period and property prices more than doubled within the past five years in a number of economies. Rapid increases in asset prices led to domestic inflation and undermined the competitiveness of the export sector. Excessive lending by banks to the property sector also exposed the banking sector to high concentration risks and the risk of a sharp growth in non-performing loans in an economic downturn.

Third, the competitive environment facing the Asian economies is rapidly changing. Since the 1980s, the transition of the centrally planned economies like China, India, and East Europe into market economies has unleashed more than 3 billion workers into the global market, posing increasing competition to the industrialising economies in East Asia. A development with more immediate impact on Asian's exports is the sharp movement in the yen exchange rate. From a high of 80 yen to 1 US$ in April 1995, it is now 127 yen within just a matter of two years. This has placed the Japanese goods in more direct competition with exports from other East Asian economies.

Overheating asset markets, a slowing economy and weakened competitiveness gradually crept in. Current account deficits are widening, and in some of the economies, 80% of such deficits are financed by short-term bank lending. The tide eventually turned against the Asian economies. Against a sustained economic expansion and the equity market rally in the US, the balance of risk and return becomes less attractive in Asia. The confluence of these factors created favourable conditions for speculators. As you are well familiar with the chain of events that unfolded, the currency turmoil broke out first in Thailand and the contagion effect rippled across southeast Asia, spreading later to northeast Asia.

What should be the response? I do see a need for a painful but necessary adjustment in the real economy to the new world of greater competition. The first option of what I call the "pain-killer approach" where governments typically inflate a slowing economy either by increasing government expenditure or by extending easier money is clearly not sustainable. Temporary relief can only prolong the period of hardship, and it is much harder and takes much longer to crawl back to healthy recovery. The better option is what I call the "cure" approach. An economy accepts the pain of adjustment, uses the pain as guiding lights to diagnose the weak points in the economy and takes measures to strengthen those parts. The correct response is clearly to take the right medicine and implement the necessary economic adjustment programmes, prescribed if necessary by the IMF.

The response of the regional economies is very encouraging. Following the recent turmoil, we are seeing the adoption of adjustment measures in Thailand and Indonesia with the help of the IMF. South Korea is also seeking help from the IMF. These policy packages are designed to ensure an orderly adjustment of the external current account in response to lower capital inflows and lay the groundwork for a resumption of sustained growth.

The currency turmoil can therefore be a blessing in disguise. It provides a strong signal that East Asian economies should continue to upgrade themselves through new technology, product innovation, improved management and expansion into new market segments.

Such hard adjustments should also coincide with a strengthening of the financial system. This is necessitated by several considerations. First, as evidenced in the recent currency turmoil, the stress and strains caused by capital flows will fall ultimately on the domestic financial markets and the banking system in particular. A safe and effective financial system is therefore vital for achieving sustained economic growth through channelling savings into productive investment.

Although the equity and debt markets in some of the Asian economies have been shaken by the currency turmoil, it is encouraging that most economies remain committed in their continuous efforts to develop the financial markets. None have backtracked from their financial liberalisation programme. In strengthening the financial sector, I expect increasing attention to be paid to improving prudential supervision of financial institutions with a view to ensuring financial stability.

Given the strong fundamentals and the critical mass that have already been built up in Asia, I am confident that the region will recover even faster and return to the path of growth with renewed vigour. Such optimism is shared by the APEC Economic Leaders who held their annual meeting in Vancouver earlier this week. In fact, greater regional co-operation is another important strength we could draw on to revitalise the region.

I have probably dwelled more than enough on regional dynamics. Let me now focus on Hong Kong. We have weathered the currency turmoil well. The Hong Kong dollar exchange rate has remained stable against the US dollar under the linked exchange rate system. Hong Kong is sometimes referred to as the last bastion of "fixed exchange rate regime" in Asia. Inevitably, questions are being asked on whether Hong Kong will also move on to a more flexible exchange rate regime, particularly as other regional currencies have depreciated significantly against the US$.

Let me assure you that our linked exchange rate system, which has served us so well in the past 14 years, is here to stay. Maintaining the link is the long-term commitment of the Hong Kong Special Administrative Region Government as it is the right policy for Hong Kong. Our firm commitment to the link stems not from any political consideration but from economic necessity owing to the unique characteristics of Hong Kong being a completely open and flexible service-based economy.

Some people believe that a depreciation in nominal exchange rate will ensure higher competitiveness. This is a mistaken view. Given the structure and the characteristics of the Hong Kong economy, allowing the Hong Kong dollar to devalue would in fact entail significant downside risks to our competitiveness. Inflationary pressure would accelerate as a result of higher import prices, raising the cost of producing goods and services in Hong Kong. Moreover, the uncertainty and disturbance caused by the change in the linked exchange rate system would significantly weaken investment sentiment. Interest rate was likely to stay at a high level as a result of the high risk premium associated with exchange rate uncertainty.

The costs of breaking the link are therefore exorbitant. If Hong Kong were to join in a "beggaring thy neighbour" competitive devaluation, it would be akin to fuelling a corporate price war. The right stance is to maintain price stability, and adjust by improving productivity and quality. During the past 14 years under the link, the Hong Kong dollar has fluctuated along with the US dollar against other major currencies such as the Japanese yen and the Deutschemark. The economy has never lost its flexibility to adjust to changes in the external environment and maintain its competitiveness.

Hong Kong has no choice but to improve its competitiveness through tighter cost controls, productivity improvement and product innovations. In the services sector, for example, the tourist industry which is perhaps hardest hit by our neighbours' depreciation, we are already seeing adjustments at work in terms of lowering of prices and efforts to expand into new market segments. We expect other sectors would make similar adjustments to maintain competitiveness in the global market. In overall terms, Hong Kong is relatively less affected by the currency depreciation in the neighbouring economies. With the structural transformation of the economy into a high value-added sector over the past decade, manufacturing accounts for less than 10% of Hong Kong's GDP. In terms of Hong Kong's exports, over 85% is re-export trade in which Hong Kong serves only as a middleman.

What are the lessons that Hong Kong has learnt from the currency turmoil? As we have seen, with the increasing globalisation of financial markets, instability in one economy can have contagion effects on the neighbouring economies. Hong Kong is not immune to these external shocks, especially when our asset markets are exhibiting some exuberance and overheating. When the HK$ exchange rate is under pressure, interest rate will go up, as it is expected to behave under the design of a currency board system. We are acutely aware that sudden and sharp hikes in interest rates do inflict considerable pain on the asset markets. The best way to reduce the pain of sharp rise in interest rates is to ensure that this kind of shock is a very short-lived one, as was the case on 23 October. This will instil confidence both locally and overseas that Hong Kong's resolve in defending the link is absolute and unqualified.

Recent events have also reinforced our conviction that Hong Kong must maintain a sound and well capitalised banking system and well-functioning financial markets. Despite exceptional volatilities, the stock and futures markets have functioned in an orderly manner. Our banking sector remains strong and robust. We cannot afford to be complacent. We are keenly aware that excessive lending to finance overheated asset markets will undermine the resilience of banks in adverse market conditions. Weakness in the banking system will in turn severely affect other economic activities and depositors' confidence. The Hong Kong Monetary Authority will continue to monitor closely banks' lending in the property sector and ensure that they manage the risks prudently.

To conclude, Hong Kong's economic fundamentals remain sound and stable. Quick and efficient adjustments in the economy can only mean that we are that much better-placed to take every advantage of the next upturn in the economic cycle. Furthermore, we will continue to benefit from strong and sustainable growth in the Mainland. With the correction in the asset markets, asset prices are now much more solidly supported by economic fundamentals. The easing of property prices will also help to improve our competitiveness as it helps lower the cost of doing business. I believe that the resilience of the Hong Kong economy in general and our financial system in particular in the face of the recent turmoil not only confirms, but has further reinforced the position of Hong Kong as a world class international financial centre.

We in the Hong Kong Special Administrative Government will continue to look closely at the structural side of global competition and consider appropriate measures to remove the bottlenecks to competition that obstruct our efficiency. In the Policy Address delivered by our Chief Executive, Mr Tung Chee Hwa, last month, he announced a series of measures to address the bottlenecks, including a housing programme involving the supply of 85,000 units per annum to tackle the shortage of housing supply. The Government would also ensure that our industries and businesses have the land and support facilities they need. In respect of our business and industrial development, we are committed to making Hong Kong an innovation centre particularly for high value-added products.

Regarding human resources, the Chief Executive has reaffirmed that education is the key to the future of Hong Kong. A series of initiatives are in hand to improve the quality of our system, from kindergartens to tertiary institutions. In particular, we will target special attention to improving the language skills of our students and to enhancing the professional status of our teachers. The Government has also committed efforts to improve Hong Kong's technological platform, which will sharpen our edge as an international financial centre. We all understand that there is no free lunch. If there is greater competition out there, we must adjust our quality and our skills and make us even more efficient.

Finally, I would like to take this opportunity to wish the Assembly every success.

Thank you.