The Financial Secretary, the Honourable Donald Tsang, JP, reviews one of Hong Kong's most difficult years

EXPERIENCE can be a harsh teacher and 1998 gave us all plenty of lessons. Hong Kong had its poorest economic result for more than 20 years, slipping into recession in the second quarter.

      The rest of the world experienced at least one bout of recession over those two decades, but Hong Kong maintained a remarkable growth rate through unprecedented political and economic upheaval. Fortune then turned and, by late 1997, the Asian financial crisis swept Hong Kong into a monetary maelstrom.

      Although the financial crisis posed real dangers, it also opened up new opportunities. We undertook radical reforms that in less difficult times would have been impossible. The crisis made them essential. Ten years from now I believe historians will see our actions as far-sighted. Widening our monetary base, removing doubts over short-selling and improving the monitoring of capital flows, are just some of the measures. The financial markets readily accepted them as sensible moves.

      Our incursion into the stock and futures markets in August was the most controversial action. But that, too, was no more than an exceptional measure to combat exceptional circumstances.

The sequence unfolds

Many of the world's finance ministers and central bankers met at the World Bank/International Monetary Fund Annual Meetings in Washington DC, in October. They agreed we were facing one of the greatest economic, political and social challenges of the past 50 years. We were all in the same boat, caught by the same swift tide.

      Just over a year earlier, on July 1, 1997, Hong Kong had returned seamlessly to China. The next day, the Thai Government devalued its Baht. In the 18 months that followed (to end-1998), the Asian crisis became a crisis with global implications. Governments fell, leaders changed and poverty descended on millions of people. It was a distressing end to an unparalleled era of growth.

      What caused it? How can we fix it? Is this the end of the free market? These are matters of critical concern for small, open economies such as Hong Kong's. These events have shown that a free market involves more than we had previously believed and promoted as dogma.


Complexity, speed and ferocity distinguished the Asian financial crisis. With the perfect vision of hindsight, there were many warning signals that the'Asian Miracle' could not continue unchecked.

      In the worst-affected countries, it was a combination of crony capitalism, private sector over-borrowing, inadequate bank regulation, poor risk management and tragic policy errors in the corporate and banking communities. Strong growth, fuelled by high capital inflows, created a big Asian bubble. When it burst, the fallout spread far and wide. The growth of derivatives and modern information technology accelerated the speed of the contagion.

      Before the meltdown, few could deny the impressive record of strong growth, general price stability, high domestic savings, an educated and highly flexible labour force, fiscal prudence and openness to trade and investments that were the hallmarks of Asia for more than a decade. By promoting intra-regional trade and investments, the region enjoyed unprecedented growth and prosperity during that period. Just before the turmoil began, even authorities such as the International Monetary Fund (IMF) and World Bank testified to these strengths and successes.

      Quite obviously, something else must have happened with the'Asian problem'. Indeed, it was not isolated to Asia, but had a more international flavour. The former Chairman of the US Federal Reserve Board, Mr Paul Volcker, thinks it may well be systemic.

      In the late 1980s and early 1990s, the private sectors of major emerging economies with strong growth potential became the target of financial institutions with the capacity and willingness to reach out for more exotic high-yielding investments. These economies - converts to the basic philosophy of open markets for goods and capital - welcomed the funds, which came in the form of loans, portfolio capital and in direct investment.

      Funds flowed in very rapidly - but little attention was paid to the fact that the money could flow out just as rapidly at short notice. The Bank for International Settlements (BIS) Annual Report showed that it was a combination of mutual and hedge funds pulling out of Asia, as well as the sharp reversal of bank lending, that did the true damage.

      Net private capital flows to Other Asia (excluding China and Japan) reversed by US$108 billion in the second half of 1997, compared with an inflow of roughly the same order in the previous 12 months. It is difficult to expect the IMF, the World Bank or any other organisation that advised developing economies in distress to come up with an effective and appropriate package to withstand these kinds of capital flows. The important lesson is that small and open economies are inherently vulnerable to the volatility of global capital markets.

      As long as the G-3 currencies - the Dollar, Deutschmark and Yen - can move as much as 75 per cent from peak to trough, there is tremendous pressure put on the smaller trading economies. It may be fashionable to believe that flexible exchange rates are the answer to small volatilities but no one has yet discovered an effective way to deal with huge volatilities caused by competing devaluations or exchange rates in a free-fall that readily develop into economic catastrophes or social upheavals that have pervaded East Asia.

      On the other hand, the mainland of China was cushioned from much of the impact of the contagion. Its economy grew by almost the forecast 8 per cent in 1998, a significant factor that must, in the longer term, work to Hong Kong's advantage now that we enjoy the full potential of the Mainland as our hinterland.

      Meanwhile, the crisis had a profound effect on Hong Kong. The figures for 1998 tell the tale. Real GDP contracted by around 5 per cent (compared with 5.3 per cent real growth in 1997), property prices dropped by 50 per cent, and rents were down by about the same amount. Stock market prices and turnover dropped sharply. Unemployment more than doubled to 5.7 per cent, wages fell, small businesses closed and consumer demand went into reverse. Other factors compounded the distress. A liquidity crunch (caused mainly by the repatriation of tens of billions of dollars to Japan) and sustained speculative attacks on the Hong Kong currency and stock markets were just some extraordinary problems that Hong Kong dealt with during a particularly fierce'Year of the Tiger'.

The 'flu

Why was the Asian 'flu so contagious? Global integration in trade, banking and finance carried the infection. And, 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 its excessive short-term foreign debt, promptly collapsed. This in turn led to bank failures, domestic and foreign capital flight and full-blown recession. The recession then cut intra-Asian imports, causing competitive devaluation in other Asian economies.

      Initially, everyone thought calling in the IMF would calm the markets. But in some cases this exacerbated the problem. The series of events, together with a delay in providing new capital to the IMF, dented the assumption that it had the technology and enough resources and capacity to deal with a global crisis. All this had enormous implications for the conventional belief in the free market and the financial architecture set up at Bretton Woods 50 years ago in the aftermath of World War II.

      Indeed, the Asian financial crisis pinpointed the need for new rules and codes of practice for the international financial system to cope with the massive volume of funds moving about the global markets, and the speed with which those funds moved. Heeding calls for urgent global action, the world's financial leaders began to address the problem at the annual meetings of the World Bank/IMF last October. The mere fact that they focused their attention on ways to solve the problem may have helped to avoid a global recession. That first meeting tackled the most pressing issues: the overriding need for greater transparency in national and international financial systems, the requirement for stronger international supervision and regulation, and the availability of sufficient capital to tackle liquidity crises when they occur.

      Developed and emerging economies need a mechanism for monitoring large international fund flows. If not, even the best-managed, best-regulated, most open and financially sound economies, like Hong Kong, will be vulnerable to attack.

      The year ended with a global consensus for stronger and increasing transparency in the international financial architecture. This included developing a code of best practices for monetary and financial transparency and principles of corporate governance. An enhanced IMF facility providing short-term line of credit, to be mobilised under improved procedures for crisis prevention and resolution, became an urgent mission for all. Financial stability was gradually returning to many Asian countries, stirring economic recovery, although the outlook for growth in Latin America deteriorated.

      Further meetings of the G7 nations were planned for early 1999 with a proposal to convene a Financial Stability Forum that would assess issues and vulnerabilities affecting the global financial system. It would then identify and oversee the actions needed to address them. At last, the world's strongest economies were paying serious attention to the severity of the Asian financial crisis and its impact on the global scene.

A matter of survival

In August, during a concerted attack on our currency and equities markets, the government was forced to intervene to stop a contrived manipulation which could have brought Hong Kong to its knees. We mobilised $118.1 billion defending the economy. Just as swiftly we set up a separate company, the Exchange Fund Investment Ltd, to manage the equities that we acquired. We were totally transparent about this, and in fact did no more than most governments do on a regular basis when they deal in their own bonds. I have commissioned professional studies on how to dispose of the shares the government owns and their reports will guide our actions in 1999.

      The incursion was a matter of survival to preserve local community confidence, protect the integrity of the linked exchange rate to the US$ as well as restore a level-playing field to the stock and money markets. Despite Hong Kong's strong fundamentals, and rapid asset price adjustments, there was repeated malicious speculation. We detected a double play by a few over-aggressive players that did not reflect normal hedging activities. We have since strengthened our securities market regulations and our currency board regime by making them more transparent and robust to deter such double plays.

      As an international financial centre and the premier international window for the Mainland, we are also committed to globalisation and open markets. We remain opposed to outright controls on the flow of capital but believe it helps everyone to see what is happening. These actions have left us with regulations similar to those in London and much less restrictive than, for example, on Wall Street.

The pain of reform

The net result of our reforms is that we have reduced the pain of extreme volatility in interest rates in maintaining the linked exchange rate during attacks on our currency. Essentially, we are accepting some fluctuations in the level of our foreign currency reserves in order to reduce volatility in interest rates. The Aggregate Balance of the banking system, a crucial part of the monetary base directly influencing interest rates, was merely US$ 250 million at the time of the incursion. By year's end, the liquidity buffer, including the cushion afforded by the discount window, was around US$7 billion. As a result, interest rates did not experience the wild swings associated with any pressure on our currency.

      We are slowly emerging from the turmoil. There is a long and hard road ahead before we can return to the days of full employment and strong economic growth. It is a rebirth - the chance for a new start - for our economy that was bloated by almost a decade of high property prices, high inflation and escalating wages which had seriously eroded our competitiveness.

      We have already seen interest rates edging down and stabilising. At year's end one-month HIBOR stood at 4.9 per cent, a big improvement on the 9.5 per cent at end-1997. Inflation was at an all-time low of 2.8 per cent for 1998 as a whole. Lower rentals and wages made it cheaper to do business in Hong Kong and the currency remained rock-solid, even in the aftermath of the massive speculative attack in the middle of the year.

      While 1998 was one of the worst years on record, there is hope that sustained recovery will begin in the latter half of 1999. The Hong Kong that is emerging from the economic woes will be leaner, keener and more competitive as it embarks upon the new millennium.

      The 1998 financial turmoil in Hong Kong revealed its real hero - the indefatigable Hong Kong people who could bear great pain and are determined to succeed despite adversity. Indeed, the hard work, skill, flexibility and entrepreneurial flair of Hong Kong's 6.8 million residents are some of the main reasons that we are the world's eighth-largest trading centre with a per capita GDP of about US$25,000 - the world's 15th highest in 1998. Times are tough but as the saying has it,'when the going gets tough, the tough get going'. That aptly sums up the attitude of Hong Kong people.

      With few exceptions, the government's policy of low, predictable and simple taxes has attracted business to Hong Kong and kept it here. While a survey by the Industry Department during the year indicated a drop of about 80 in the number of regional headquarters based here, only 11 actually left Hong Kong. The overall decline was mainly due to companies downsizing their presence, citing high operating costs and reduced business prospects as a result of the Asian financial turmoil.

      The vast majority stayed in Hong Kong. Not surprisingly, the significant factor was our business-friendly environment, which includes clean government, access to information, the rule of law, our infrastructure, banking and financial facilities and our tax regime. These assets, no doubt, explain why the same survey revealed that 65 enterprises established new regional headquarters in Hong Kong in the same period. More than half of the companies responding to the survey considered that our overall attractiveness as a regional headquarters or regional office had improved or remained more or less the same.

      It occurs to me that as we seek to recover and rebuild from such a severe and sudden downturn, we should remember the reality of our image - and look how far we have come. Just three decades ago, when most of Hong Kong's present population was yet to be born, we were embarking on our first cross-harbour tunnel.

      Some things, of course, don't change. In 1965, the banking system experienced a crisis of confidence attributed to imprudent lending policies in small industry and over-development in real estate. Water supplies, airport extension, provision of roads, and expansion of the telephone network were some of the projects undertaken in 1969, when there were 10 phones for every 100 people. Today there are about 54 exchange lines and 42 mobile phones per 100 people and we are still trying to meet the demand for other services. From the 1960s, Hong Kong developed a legendary ability to make the most of adverse circumstances and usually to profit from them. This time it is different in scale, but I believe we will again pull through to delight our friends and amaze the rest of the world.

      In the style that has made its private citizens famous, the government is playing an entrepreneurial role. We believe the recession in 1998 presented us with an unrivalled opportunity to undertake more radical reform and investment. We are pressing ahead with our infrastructure programme, which will see $235 billion spent over the next five years on major road, rail, land reclamation, housing and sewage disposal projects. (That is, 50 per cent more than was spent on the airport core programme over the past seven years.) These projects will consolidate our position as the pre-eminent transport and communications centre in the region. They will also provide more than 100, 000 new jobs.

      Our major infrastructure projects rely heavily on the involvement of overseas expertise and advice. The expatriate community *about 485 ,000 (including domestic helpers), or about 7 per cent of the population *has over the years made important contributions to the economy and Hong Kong's unique, cosmopolitan culture. One reason for our success is that citizens of so many nations have made their homes here. And that is why Hong Kong will always be Asia's premier international city.

      Given our special relationship with the Mainland, Hong Kong will continue to be the most vital link between the international community and China while at the same time developing further in its own right as a leading regional business centre and Asia's most cosmopolitan city.

      Now that we can look back on it, 1998 was surely a year to remember. Many of the lessons were far from pleasant but, so long as we learn from them, we can only grow and improve.