Tag Archives: Financial Stability

The Impact of China’s Slowdown on Hong Kong

China’s economy is slowing down, as its GDP grew at 7.4% in the first quarter this year, a level below the 7.7% growth last year and the double-digit growth many years ago.

Relatively, many people are concerned about the prosperity of Hong Kong, whose economy is heavily tied to China through trade, tourism, foreign direct investment, and financial channels. In my observation, there are two main risks for Hong Kong—export growth and credit quality.

China’s growth momentum has long been exports and government-led investment projects. Meanwhile, the country as the world’s second largest economy is also a significant importer due to its huge domestic market of 1.35 billion people. Therefore, many Asian economies, including Singapore, Taiwan, South Korea, and Vietnam, have heavy export exposure to China. In particular, Hong Kong appears to among the most exposed with almost 30% of its exports to China. Since domestic consumption is weakening on the overall economic slowdown and potential risk of a housing bubble, Hong Kong’s exports are highly likely to slide, dragging down the special region’s GDP growth.

Besides, surging loans to Chinese borrowers by banks in Hong Kong triggered concerns on the city’s financial stability. It is due to tight credit in China and lower interest rates in Hong Kong that lending to mainland businesses by all authorized institutions has increased from about 5% of total banking sector assets in 2007 to nearly 20% today, according to the Hong Kong Monetary Authority. As a result, total mainland-related exposure amounts to 165% of Hong Kong GDP, despite that 43% of the outstanding loans come from foreign banks operating in Hong Kong, rendering a comparison to the city’s GDP less relevant.

The worry is that the booming lending might increase uncertainties in Hong Kong’s banking sector and result in overwhelming integration with the Chinese economy. There are signals of credit quality deterioration in China, as the non-performing ratio of Chinese banks rose to 1% at the end of the fourth quarter from 0.97% at the end of the third quarter last year, which is the highest since the end of 2011. Many loans were made on the expectation of higher growth rate and the slowdown could lead to serious default issues.

In response to the higher risk of cross-border leverage, the HKMA decided to regularly conduct on-site examinations of banks’ credit-underwriting processes, as well as regular stress tests to assess banks’ resilience to credit shocks. Specifically, it said it has written to banks that have posted higher-than-average increases in total lending and asked them to make sure they have enough “stable” funds.

Forward Guidance: Changes Must Be Made

The Federal Reserve needs to change forward guidance because we are nearing the 6.5% threshold for unemployment and the economy is not even remotely ready to handle higher interest rates. The steadily decreasing unemployment rate is due to the decline in the labor force participation rate and inflation remains very below target. In addition, the rapid rate of economic growth in the second half of 2013 was partly because of temporary factors including inventory accumulation and strong exports. In short, I do not think the economy has recovered fully and I believe most would agree with that. Thus, how should the Fed alter forward guidance to take all of this into account?

I think there are two main approaches the Fed could take, which is either quantitative or qualitative. On the one hand, a quantitative approach would involve a guidepost such as an exact threshold for the unemployment rate (i.e. 6%). On the other hand, a qualitative approach would seem more vague and less concrete. (i.e. “full” employment). Although a quantitative approach would provide more clarity, I think a qualitative approach provides more space for the Fed to maneuver monetary policy. Whether quantitative or qualitative, I think there should be some mention of financial stability and inflation as two critical factors influencing interest rate decisions.

I believe that financial stability should be a factor impacting interest rate decisions for a few reasons. First, the choppy beginning to 2014 demonstrates more volatility than we saw in all of 2013. Second, the financial markets are trading at high valuations. The current bull market started in 2009 and continues to make new records. For example, the S&P 500 index is 0.4% away from a new record. Third, corporate fundamentals do not seem to have caught up to financial valuations. Increased volatility combined high valuations without strong corporate fundamentals concern me significantly especially as the Fed continues tapering.

I think that inflation should be another factor guiding interest rate decisions due to the velocity of money. Although the money supply has grown immensely, the low velocity of money has prevented inflation. Furthermore, the very low velocity of money sends a concerning disinflationary signal. Disinflation slows purchasing at both the household and corporate level of the economy. Although I believe the Fed is extremely aware of this, I do not think there is much they can do about it. As we learned in class, the low velocity of money is caused by the guaranteed zero percent interest rate on paper currency. If the Fed was able to lower the interest rate on paper currency below zero, then the velocity of money would increase as businesses and households spend their money rather than save it. As a result, inflation would increase and the spending would help the economy recover faster.

Regarding financial stability, I am having trouble determining whether the increase in United States household debt is healthy or worrisome. According to the Wall Street Journal, “U.S. consumers late last year drove the largest quarterly increase in credit outstanding since the third quarter of 2007”. On the one hand, I think this could be incredibly simulative as household debt includes mortgages, credit cards, auto loans and student loans. Thus, the increasing level of debt is an indication of more consumer spending and perhaps even higher consumer confidence. For these reasons, I am tempted to interpret this to be a vital support for an incredibly weak economic recovery.

On the other hand, the large portion of the rise in household debt was due to student loans. Although student loans are crucial means for funding education, student loans have a relatively high default rate compared to other forms of household debt. Furthermore, the rise in student loans was mainly concentrated among those with weak credit ratings. According to the Wall Street Journal, “the nation’s sharp rise in student debt is being driven largely by Americans with poor credit”. As a result, a large amount of this new debt might not get repaid and this is would not help the economic recovery. The quarterly increase in household debt since 2007, however, this preceded the worst financial crisis since the Great Depression. In short, credit should be created with caution and this might not be the case with some parts of the recent increase in household debt.

I believe it is imperative for the Fed to change forward guidance because I think we will likely fall below the 6.5% unemployment threshold by the next jobs report. The Fed might want to restate the importance of the 2% inflation target (a qualitative guideline) and make an explicit qualitative guideline for financial stability as key elements surrounding interest rate decisions. I would be surprised if the Fed does not make any alterations to forward guidance at its next meeting.

(Revised) QE: A plus for financial stability?

Market volatility is back.

After the record-high close in 2013, The Dow Jones Industrial Average fluctuated in the first month of 2014. This week, it plunged 3.5%, the biggest loss in seven months, on increasing market fear.

Where did the fear come from? Undoubtedly, it has to do with the Federal Reserve’s exit strategy – QE tapering.

The Quantitative Easing (QE) refers to the Fed’s monthly purchases of $45 billion in Treasuries and $40 billion in mortgage-backed securities, which is one of the two key strategies that the fed has been adopting to boost economy, while the other one is record-low (nearly zero) federal funds rate. With such an unconventional monetary policy, the Fed aimed to drive down long-term interest rate and stimulate spending, hiring, and investment. Furthermore, as Mr. Bernanke claimed in 2010 at the Kansas City Fed’s Jackson Hole conference:

“I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.”

Certainly, QE has been playing an important role on economic recovery from the financial crisis in 2008, as it injected sufficient (or excessive) liquidity to the capital markets and boosted the U.S. equity indexes to record-high in late 2013. However, as the overall economy started to show signs of improvements, indicated by GDP growth and employment, this asset purchase program could not be endless

Specifically, the Fed is expected to further taper its purchase by $10 billion on its next meeting on Jan 29, despite of the weaker-than-forecast December jobs report – that is the primary source of the market fear described above.

So people may ask: although the QE has fueled market growth, is it really a plus for financial stability? Sadly, the answer is “no” due to its significant adverse effects on many aspects.

First, the market volatility was driven up due to QE’s data dependent nature. Data-dependency meant that the fed would start to taper its bond purchase program if there is significant evidence in the improvements of economic conditions. Therefore, a piece of good economic news, such as stronger GDP growth or lower unemployment, might be a piece of bad news for the market since it would signal the start of tapering and less liquidity. To make matter worse, to what extent is the economy strong enough for tapering? The Fed has its own standards, which might be deviated from market expectations. For instance, in late September last year, when almost everyone forecasted the kick-off of tapering, the Fed surprised the market by choosing to keep the $85 billion pace, after which the Fed’s credibility was in doubt and the pace of tapering was even more puzzling.

Second, the fed’s balance sheet is just about five times its pre-crisis size — a whopping $4 trillion, because of the continuous purchase. Even Mr. Bernanke himself had to concede that “it’s also true that, as the balance sheet of the Federal Reserve gets large, managing that balance sheet, exiting from that balance sheet become more difficult.

Third, the tapering hits the financial stability of foreign countries as well. In the past few years, many of them, especially those developing nations that relied heavily on foreign investment, did benefit from the “cheap money” created by QE as capital sought higher returns abroad. However, as the Fed reduction continues, interest rates in the U.S. are likely to rise, drawing capital back in pursuit of safer and higher-yield investment. Given the fact that investors pulled $58.7 billion of cash from developing countries in the past year and most recently, the Argentinian peso tumbled more than 15% against the dollar this week on increasing growth concern, there are systematic risks ahead for emerging economies. International coordination on monetary policies is in need for worldwide sustainable development.