Look out, it's boom and bust Ben

PUBLISHED : Saturday, 04 February, 2006, 12:00am
UPDATED : Saturday, 04 February, 2006, 12:00am

Most Hongkongers would have been too wrapped up in celebrating the Lunar New Year at the start of the week to pay any attention to a shuffling around of academic economists in faraway Washington. Nevertheless, the retirement of Alan Greenspan after 181/2 years as chairman of the Federal Reserve, America's central bank, and the appointment of Ben Bernanke as his successor, are likely to prove of momentous importance to Hong Kong's economy and to the prosperity of its people.


At first it will be hard to detect any changes, either of style or of substance. To ensure the smoothest possible transition, Mr Bernanke is sure to continue the policies of his predecessor. He is almost certain to raise US interest rates by a quarter percentage point next month and possibly again in May, before calling a halt to the increases this summer.


In the longer run, however, the new incumbent is likely to have a far-reaching impact on the way the Fed manages US monetary policy. In particular, Mr Bernanke is an ardent proponent of inflation targeting. He favours setting interest rates in an attempt to achieve an explicit inflation rate, rather than according to the more nebulous principles adopted by Mr Greenspan. If he goes ahead and makes the change, it could spell bad news for Hong Kong.


Like Mr Greenspan, Mr Bernanke will be an important figure in the economic life of Hong Kong. Because of Hong Kong's currency board, which locks the value of the Hong Kong dollar to that of the US dollar, Hong Kong's monetary officials have no say over local interest rates. Instead, our interest rates faithfully track those in the US.


In other words, for the past 18? years, the returns we earned on our bank deposits, the amount we paid each month for our mortgages, the financing charges on our credit card bills and the price our companies had to pay for credit were all ultimately dictated by Mr Greenspan.


It has been a rough ride. The former Fed chairman is generally reckoned to have done pretty well at his job of steering US monetary policy 'in pursuit of maximum employment, stable prices, and moderate long-term interest rates'. But his decisions have sometimes proved deeply painful half way round the world in Hong Kong.


The problem is that, while Hong Kong interest rates must march in lock-step with US rates, there have been times when our economy has been right out of phase with the US. When that happens, the best decision for US interest rates is all too likely to be the very worst for the Hong Kong economy.


The most obvious example was during the period between 1997 and 2001. With the US economy growing strongly, Mr Greenspan kept rates steady and then, after cutting briefly following the collapse of hedge fund giant Long Term Capital Management, began to tighten policy.


In Hong Kong, where the Asian economic crisis was in full swing, the effect was disastrous. Prevented by the currency board mechanism from cutting rates, Hong Kong Monetary Authority chief executive Joseph Yam Chi-kwong could only watch helplessly as local interest rates remained stubbornly high. Throughout the crisis, the prime lending rate remained stuck at levels near 9 per cent, only briefly dipping to a low of 8.25 per cent and peaking as high as 10.25 per cent at the beginning of 1998, right in the very depths of the regional financial turmoil.


Not surprisingly, the stock market crashed, property prices crumbled, deflation set in with a vengeance and the unemployment rate soared, rising from just 2 per cent in 1997 to about 6.5 per cent two years later.


The danger now is that similar periods when Hong Kong's economy gets out of step with the US are likely to become more frequent.


When the currency board was introduced in 1983, just four years before Mr Greenspan took up his position at the Fed, it made a lot of sense to link Hong Kong's currency to the US dollar.


The main objective was to stabilise the exchange rate. But as a small open economy focused on exports, Hong Kong's business cycle moved in close synchronisation with the economy of the US, its largest trading partner. It stood to reason that a good decision for US interest rates would also prove right for Hong Kong.


The benefits did not take long to appear. Within a year, Hong Kong's inflation rate halved, falling into line with US inflation (see chart).


Since then, economic conditions have changed and our inflation rate has seldom tracked consumer prices in the US. The discrepancy is only likely to get bigger in the future. As the local economy becomes ever more focused on providing services to the mainland, Hong Kong's economic cycle will increasingly mirror China's, rather than that in the US.


Now, if Mr Bernanke does adopt his beloved inflation targeting, the Fed may be about to abandon the policy flexibility favoured by Mr Greenspan and become a lot more dogmatic in the way it sets interest rates. That will make pro-cyclical interest-rate changes even more frequent in Hong Kong.


Interest rates are more likely to rise when inflation is low, threatening a return to deflation. Conversely, rates are more likely to fall when inflation is high or when the economy is powering ahead, raising the danger of overheating and asset price bubbles. For Hong Kong, Mr Bernanke could turn out to be boom and bust Ben.


 

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