The Asian financial crisis hit the Hong Kong Special Administrative Region (SAR) with full force, despite the economy’s strong fundamentals. Its open economy underwent a painful economic and financial adjustment, with periods of intense pressure on its currency board (or “linked”) exchange rate system. In accordance with the currency board arrangement, the adjustment took the form of deep asset price deflation, recession, and record unemployment.
But Hong Kong SAR’s economy demonstrated remarkable resilience and recovered from the crisis relatively quickly, aided by the authorities’ skillful stewardship of the economy. To mitigate the impact of the external shock, the authorities implemented a number of policy measures, including structural reforms to enhance the economy’s competitiveness and long-term prospects. Hong Kong SAR’s strong fundamentals—sound bank and corporate balance sheets, strong fiscal position and regulatory and supervisory framework, impressive policy track record, and flexible markets—served the economy well. Strong fundamentals and timely policy measures ultimately proved the key to minimizing the adjustment costs associated with the linked exchange rate system.
Contagion and financial crisis
Hong Kong’s exceptional openness—including its capital accounts and sizable cross-border financial flows, and its leading role as financial, business, and trade center for the region—exposed the economy to the financial turmoil that began in Thailand in mid-1997 and quickly swept through the region. The Hong Kong dollar, which was linked to the value of the U.S. dollar, came under speculative attack repeatedly between 1997 and 1998. In each case, liquidity conditions tightened and interest rates increased, which led to a quick reversal of capital outflows, as would be expected under a linked exchange rate system. But the “on-and-off” attacks left their marks—the risk premium stayed at higher levels, financial market volatility rose, and asset prices deflated—and had knock-on effects on the real economy, including the banking and corporate sectors.
The first major attack on the Hong Kong financial markets occurred in October 1997. Speculators launched a massive short-selling of the Hong Kong dollar following the floating of the New Taiwan dollar. In response, short term interest rates rose sharply with a substantial impact on the asset market. Hong Kong SAR’s stock market plummeted by more than 10 percent on a single day. But the decision to allow short-term interest rates to rise sharply helped arrest the speculative capital outflow, and pressure on the Hong Kong dollar subsequently abated.
In the aftermath of the October 1997 attack, however, financial market conditions remained volatile. The Hong Kong dollar came under renewed pressure several times as market sentiment toward the region deteriorated sharply (with Indonesia and Korea calling for rescue packages and mainland China’s economic outlook weakening) and market concerns of a potential renminbi devaluation rose. As a result, the differential between one-month Hong Kong dollar and U.S. dollar interest rates widened to 230 basis points on average in the first half of 1998, compared with 20 basis points over the same period in 1997. Asset prices also continued to drift downward, and the rapidly deteriorating external conditions spilled over to the real economy.
In August 1998, the linked exchange rate system again came under pressure—the heaviest since October 1997—as market turbulence intensified internationally. Stock and futures prices plummeted, with the stock market falling off almost 25 percent from its mid-July level. With speculators taking short positions on the stock and futures markets as well as on the Hong Kong dollar, interest rates rose and remained high for several weeks.
Market conditions subsequently stabilized, aided by favorable developments in international markets and an improved economic outlook for the region. The risk premium virtually disappeared by the end of the year and the foreign reserves of the Hong Kong Monetary Authority rose.
Economic adjustment and recovery
The rapidly deteriorating external conditions, the rise in interest rates, and the real appreciation of the Hong Kong dollar spilled over to the real economy, causing economic activity to slow sharply and triggering a deflation of the asset price bubble that had emerged in 1997. Real GDP growth turned negative by the fourth quarter, and one quarter later the economy was in a recession that would last five full quarters. In 1998, the economy experienced its first annual contraction in over three decades, and unemployment rose to unprecedented levels.
With the value of the Hong Kong dollar fixed against the U.S dollar, adjustment and a restoration of external competitiveness had to take place through price and cost deflation and productivity gains. Indeed, the adjustment proceeded rapidly, reflecting the underlying flexibility of the economy. Asset prices adjusted immediately, as higher interest rates and the uncertain outlook burst the asset price bubble. By mid-1998, property prices were down about 40 percent from their peak a year earlier.
The asset price deflation and the weaker economy spread to consumer and factor prices, causing inflation to turn negative around mid-1998. Rentals adjusted with a lag to the correction in property prices, owing to the prevalence of two- to three-year lease contracts, but nonetheless have fallen sharply since their peak in mid-1998. Although labor costs adjusted more slowly, they did moderate—largely through higher layoffs, slower wage growth, and sharp cutbacks in bonuses. Layoffs affected primarily unskilled workers, reflecting companies’ efforts to streamline their operations to achieve higher productivity growth. By late 1999, the Hong Kong dollar in real terms had reversed all of the overvaluation resulting from the Asian crisis, aided by declining domestic prices and the appreciation of the yen and other regional currencies, and the real effective exchange rate returned to precrisis levels.
Signs of a recovery began to emerge in the first half of 1999. Initially, these were visible in the asset markets, with a sharp rise in equity prices, driven in part by foreign capital inflows; a marked decline in the risk premium; and a stabilizing of property prices. The market firming then set the stage for a recovery in the real sector. At first, the recovery was led by exports aided by the pickup in the regional economy, but private consumption and eventually investment rebounded strongly as well. Although the unemployment rate fell gradually from its mid-1999 peak, it still remains above its precrisis levels. As the economy turned the corner, the government also prudently moved away from an expansionary fiscal stance to achieve a balanced budget over the medium term.
Domestic prices have continued to adjust downward, however. Although deflation began to ease from mid-2000 onward in line with the strong recovery, the continued decline in consumer prices largely reflected the lagged response of housing rentals to the correction in real estate prices and imported deflation from the mainland. Prices have declined now for 30 consecutive months and prices have slipped to 1996 levels.
Because a currency board arrangement precludes the use of exchange rate or interest rate policy to buffer the economy against an external shock, Hong Kong SAR’s fiscal policy bore the adjustment burden. In mid-1998, the authorities announced a major package of measures designed to strengthen confidence and mitigate the impact of the crisis on the economy and the property market.
Hong Kong SAR: selected economic indicators, 1996–2000
1 HIBOR is Hong Kong interbank offered rate.
2 LIBOR is London interbank offered rate.
Data: Hong Kong SAR authorities and IMF staff estimates
The 1998 budget adopted a temporary fiscal expansion of tax concessions and spending increases, including additional job creation and retraining programs. The authorities also took measures to stem the decline in property prices, suspending government land sales, scaling back production of public housing units, and removing or suspending several measures aimed at curbing real estate speculation. To improve credit and liquidity conditions, the authorities moved to exempt interest income on onshore deposits from corporate taxes to encourage repatriation of offshore funds. These steps, along with weaker revenue projections, led to a sharp budget deterioration.
The speculative attack in August 1998 prompted the authorities to take a more proactive, albeit unorthodox, set of actions. Suspecting market manipulation by a few large investors and fearing an erosion of confidence in financial markets, the authorities intervened directly in the stock and futures markets, purchasing HK$118 billion (US$15 billion) in stock—the equivalent of over 130 percent of July’s stock market turnover, part of which was financed with the sales of the government’s foreign currency assets.
Hong Kong SAR’s unorthodox stock market intervention stirred concern that this might signal a departure from the government’s traditional noninterventionist approach to the economy and thus undermine the functioning of the securities market and Hong Kong SAR’s position as a leading international center. The authorities quickly addressed these concerns, announcing that the government would divest, in an orderly and transparent manner, the equity holdings it had acquired in the intervention. The government immediately sought professional outside guidance and established an independent company to manage and work out a transparent liquidation strategy for the government’s shareholdings. The authorities also announced that they would reduce their equity holdings to 5 percent of the government’s total asset holdings, including the international reserves. In November 1999, the authorities successfully launched the Tracker Fund, a listed investment vehicle linked to the Hang Seng Index (that is, the broad market index), under which 18 percent of the government’s equity holdings (US$4 billion) were sold in the initial public offering. The divestment of stocks has progressed smoothly. So far, about a third of the government’s holdings have been sold at a substantial profit.
Immediately following the August 1998 intervention, the authorities also implemented a number of reforms to strengthen the transparency and operations of the exchange rate system. These reforms included a formal announcement that the Hong Kong Monetary Authority would convert all banks’ clearing balances into U.S dollars at the fixed rate of HK$7.8 and establish a discount facility. These measures were aimed at redressing operational features that had fueled interest rate volatility in the interbank market.
Moreover, the authorities introduced several securities market reforms designed to enhance transparency and improve the functioning of the markets, as well as increase the cost of speculative activity. These measures included tighter enforcement rules on short-selling and settlement of trades and an increase in margin requirements for investors holding large open positions in futures markets; enhanced disclosure requirements; increased penalties for illegal trading or reporting; and enhanced cross-market supervision through increased coordination among the regulatory agencies.
As part of the new international financial architecture, the authorities have also been pushing for greater disclosure requirements for highly leveraged institutions. Their concern is based on the potential destabilizing impact such investors can have on medium-sized markets (the “elephant in the pond” problem), such as Hong Kong SAR’s. Although some progress has been achieved (for instance, the Financial Stability Forum’s report on highly leveraged institutions recommends better risk management and disclosure practices for these investors), the Hong Kong SAR authorities view these measures as less than sufficient in addressing their concerns and would like to see even greater transparency.
Although financial market stability returned and the economy achieved an impressive recovery, the government has continued to press forward with reforms—notably in the financial markets—to enhance Hong Kong SAR’s standing as a world-class financial center in an increasingly competitive global environment.
While the short-term economic outlook is clouded by the global slowdown, the economy’s medium-term prospects are bright. Although the economy will face major structural challenges, largely because of China’s prospective accession to the World Trade Organization, the swift and smooth return of Hong Kong SAR to Chinese sovereignty (July 1, 1997) and the economy’s rapid recovery from the Asian financial crisis once again demonstrate Hong Kong SAR’s remarkable strength and resilience in the face of change and adverse external shocks. The economy is continuing to adapt quickly and flexibly, aided by its reputation as one of the most transparent, efficiently managed, and open economies.
The bottom two panels of the chart accompanying the story on military spending in the June 4 IMF Survey (pages 194-96) contained an error. The correct version of these two panels is shown below.
Public expenditures on military, education, and health care, 1996–20001 IMF program and PRGF-eligible countries
1 Military expenditure data refer to 1996–2000; education and health care expenditure data refer to 1996–99. IMF program countries refer to countries that have had an IMF- supported program for at least two years.
2Excludes transition economies.
Data: World Economic Outlook; country authorities; and IMF staff estimates.