From Decoupling to Recoupling

The performance of the Asian stock markets may further add to our worries. By June 13, all Asian equity markets fell substantially, except for the Taiwan market which has benefited from the improved relationship with the Mainland. The Vietnamese market suffered the most, having fallen by more than 60%. Last year's brilliant performers - the Mainland and Hong Kong markets, fell by 42% and 19% respectively, while losses in the Thai, Philippine and Singaporean markets were within 10-20%. Decline in the Indian market was as much as 31%. While all these losses would be alarming should they appear in the western stock markets, only the Vietnamese market has been identified as suffering from a crisis. Their actual impacts may still take time to unfold.

In respect of economic growth, the Asian economies have been surprisingly strong this year, amid the U.S. subprime crisis and its economic slowdown. The Mainland maintained a high growth rate of 10.6% in the first quarter. Japan has also attained an annualised growth rate of 4% while Hong Kong's economic growth accelerated to 7.1%, beating any of the four quarters last year. Singapore's economy has also been particularly robust, reporting a 14.1% growth rate. As for India, South Korea, Taiwan, Thailand, Malaysia, the Philippines, Indonesia as well as Vietnam, their economies grew by 8.8%, 5.8%, 6.1%, 6%, 7.1%, 5.2%, 6.3% and 7.4% respectively during the period, seemingly suggesting they have decoupled with the U.S. economy.

The above developments would probably be temporary, however. Despite falling exports to the U.S., Europe and Japan, exports of Asia have maintained reasonable momentum, supported by intra-regional trade and other markets. Yet, growing inflationary pressure has emerged as a new threat. Vietnam has been the first to suffer. Contractionary policies implemented, after inflation surpassed 20% in the country, have given rise to capital flight. Together with a deteriorating trade deficit, Vietnam's sovereign rating was trimmed, bringing about a stock market slump and downward pressure on its currency under managed float. Although inflation in other Asian economies has been much lower, at least 13 of them are reporting negative real interest rates, including Japan, China, Hong Kong and Sri Lanka. Should fear of higher inflation mount under such a situation, economic and financial market disruptions may take place.

Actual inflation still varies among these economies, being only 1% in Japan but 7.7% in the Mainland and 5.4% in Hong Kong, and as high as 10.4%, 19.3%, 26.2% and 25.2% in Indonesia, Pakistan, Sri Lanka, Vietnam respectively. It can be envisaged that as inflation exceeds 10%, impacts would probably become much adverse.

High inflation may eventually induce a crisis through the following ways. Severe tightening of monetary policy to combat inflation would give rise to serious economic slowdown, adding pressure on asset prices and driving out hot money. For economies subsidising or implementing price controls on energy or food items, problems would arise should such practices bring about soaring fiscal deficits and hence downgrading. In the end, capital flight, currency depreciation and asset deflation would be inevitable. Economies experiencing a worsening trade gap would also face similar outcomes. For poor economies, relaxing price controls can lead to social unrest, and hence economic and financial crisis. According to the Interest Rate Parity theory, high interest rate caused by high inflation would inevitably result in currency depreciation. Therefore, even though an economic crisis can be avoided, failure to curb inflation would still bring along severe asset deflation and currency depreciation.

Hong Kong's Ability to Resist

Hong Kong is also facing mounting inflationary pressure. There are limited counter-measures as the roots are external and the Hong Kong Dollar is under a pegged regime. It should be emphasised, however, that though facing similar pressure, Hong Kong is much stronger than its Asian counterparts to withstand.

Firstly, Hong Kong has not implemented any price control, enabling energy prices to follow the international market trend. Its fiscal position is particularly strong, with a record high surplus of HKD123.7 billion for 07/08 and fiscal reserves of HKD492.9 billion. Measures to combat inflation are largely affordable. As there are no subsidies, negative impacts on public finance can be avoided, and should not lead to a crisis.

Secondly, Hong Kong's per capita income has almost reached USD30,000, much higher than many Asian counterparts. Therefore, it is very unlikely to see social unrest occur in the territory. As the government has specifically designed measures to help the poor without distorting the market prices, risk of economic crisis caused by social unrest is minimal.

Besides, over 90% of Hong Kong's merchandise trade belongs to re-exports, which is dependent on performances of the Mainland and intra-Asian trades. Dominance of re-exports implies a relatively more stable merchandise trade deficit. As Hong Kong's services trade has always generated a surplus, the possibility of experiencing attacks brought about by a worsening current account deficit, as in some export-oriented Asian economies, should be much lower.

Lastly, under a Linked Exchange Rate regime, the Hong Kong Dollar has followed the USD to depreciate, despite the fact that its economy attained 4 years' continual high growth. Therefore, in contrast with the Asian economies that experienced currency appreciation amid a weak dollar in the past few years, Hong Kong does not face the pressure to devalue. Should successive depreciation occur among other Asian currencies, Hong Kong can still largely remain unaffected.

Where are Hong Kong's Weaknesses?

Nevertheless, exchange rate performance is relative. Two years before the Asian Financial Turmoil, the USD had begun strengthening. Dollar strength was further intensified as Asian currencies tumbled after the outbreak of the financial crisis, pushing up the HKD as well. Eventually the HKD was also overvalued and became the target of the speculators. Therefore, in the current scene, the HKD could still become "expensive" should a series of depreciation among Asian currencies occur. It may face pressure just after a time lag. This is a potential risk for the Hong Kong economic and financial system.

Apart from the HKD exchange rate, Hong Kong's stock and property prices may face pressure should the Asian markets experience a crisis. The Hang Seng Index has declined nearly 20% this year, or over 30% from the peak recorded last October. The real economy has stayed largely unaffected, possibly due to the still substantial 40% gain last year and the limited implication the H-share induced market correction has on domestic economic prospects. Yet from a negative viewpoint, given the lack of response of the domestic stock market to the negative real deposit rate and mortgage lending rate situation, further capital outflow generated by huge regional market correction may add pressure on Hong Kong stocks as well as its economy.

Amid zero nominal deposit rate and negative real interest rate, as well as tight supply and income growth, the domestic property market has continued to decouple with counterparts in the U.S. and other advanced economies this year. Transactions have risen by 40% in the first 4 months, while average prices went up by 25%. Should market sentiment reverse in Asia and capital retreat, the positive factors may not be sufficient to support the domestic property market. When property price performance lags behind inflation, domestic asset prices would cease to become attractive. This may result in continued adjustment in property prices and pose a drag on consumption and economic growth.

Furthermore, attention should be paid on developments of Hong Kong's balance of payment and fiscal position. In 2007, Hong Kong's current account registered a surplus of HKD200 billion, with the HKD153.7 billion deficit in merchandise trade more than offset by the HKD330.2 billion surplus in services trade. An overall BOP surplus of HKD114.5 billion was also recorded. Yet should a crisis in Asia cause the current account or BOP surplus to shrink or even turn to deficit, as in 1998 and 2002, the Hong Kong Dollar peg - the foundation of domestic financial stability, may encounter pressure. On the other hand, while Hong Kong's fiscal health would not be harmed in the short term, it should be noted that some relief measures are permanent and the Budget has not taken into account the possibility of any serious market turmoil in Asia. High inflation will boost nominal economic activities and favour a rise in government revenue, but it will dent real economic growth. Should inflation exceed real growth, fiscal developments can turn negative.

Facing the above risks which are out of Hong Kong's control, the best to avoid possible shocks is to try to contain inflation, monitor capital flows and make contingency plans.
 

Asian Economic Indicators

*figures for June2008

Sources﹕Bloomberg, CEIC, BOCHK Research