Challenges and opportunities facing business in Asia

8 October 2010

Keynote speech given at the opening of the Asian Business and Management Conference in Osaka, Japan, sponsored by the International Academic Forum

Mr Chairman, Ladies and Gentlemen,

I am deeply honoured to have been invited to present the keynote address at this, the inaugural conference of the Asian Business and Management Conference.

It’s a great pleasure for me to be back in this great city of Osaka.

But I confess that I’m also somewhat daunted.   I’ve been asked to speak about the challenges and opportunities facing business in the Asian region, implicitly not just this year but over the medium-term.

This is a truly enormous task because the challenges, and yes, the opportunities facing business in Asia over the next decade are very great.

I could give an entire speech about

  • the implications for business of the tensions on the Korean peninsula;
  • or of the potential problems in the South China Sea;
  • or of the potential for friction between the giants of the Asian mainland, China and India;
  • or of the dangers of militant Islam in the Philippines, Indonesia, Thailand and Malaysia;
  • or of the implications of the rapid ageing of the Japanese population, and the changing age structure of the Chinese population;
  • or of the rapid depletion of water resources in many parts of Asia;
  • or of the possible withdrawal from international involvement of the United States;
  • or of the significance of any possible regime change in China;
  • or of the consequences of a changing climate, and national and international efforts to deal with those consequences.

I’m not going to talk about any of those issues, partly because I assume that I was invited to address you because of my experience as a central banker and an economist, not as an expert in international relations, and partly because any one of those subjects could take an hour or so in its own right.

Rather, I’m going to talk exclusively about the economic challenges facing the Asian region, and indeed facing the world.

When I started thinking about how I would handle this speech, I asked a few close colleagues for how they saw the world.  One of them, a man with a life-time of experience in international affairs, a training in economics, and several years living and working in Asia, said that he had a strong view that too much analysis of the current situation is biased towards pessimism.  He felt that this was entirely unwarranted and pointed to the massive wealth creation underway in the Asian region, and indeed in much of the developing world as a whole.

And it’s easy to see what he means.  Over the last half century, and especially over the last 30 years, more people have been lifted out of poverty than in the entire previous history of the planet, in large part because of the quite extraordinary growth rates of first the countries we used to refer to as the Asian Tigers, then the astonishing growth of China, and now the almost equally rapid growth of India.  If somebody had claimed in the middle of last century that the GDP per capita of China and India would be growing at over 5% per annum for decades on end by now, they would have been regarded as wildly optimistic, if not certifiably insane.

Nobody today expresses surprise at being told that, if present trends continue, within 10 years, three of the five largest economies in the world – China, Japan and India – will be in Asia.  Or that within 10 years there will be more middle class consumers in Asia than in North America and Europe combined.

Nobody today expresses surprise at being told that China and Japan hold more foreign exchange reserves than any other country.

Nobody in my own country, New Zealand, expresses surprise that China is now our second largest trading partner – only a few short decades ago, trade with China was lumped into the “Other” category in the official statistics!

So was my friend right to be optimistic?

One thing we all know is that the future will surprise us.  In my opinion, one of the most profound books written in recent years was The Black Swan: The Impact of the Highly Improbable, by Nassim Nicholas Taleb.

As I suspect most of you know, Taleb argued that, although we all behave as if we knew what the future will look like, in fact we don’t know.  Totally unexpected things happen – think the development of the internet, or 9/11.  In retrospect, both things that can in some measure be “explained”, but neither was expected, and both changed the world. 

He warns of the danger of financial institutions assessing their exposure to risk by using that very widely used tool, VaR, or Value at Risk.  VaR works beautifully IF, and only if, the future evolves broadly in line with the past.  And Taleb argues that it won’t.

In 1865, an editorial in the Boston Globe newspaper observed that “Well informed people know it is impossible to transmit the voice over wires, and that were it possible to do so, the thing would be of no practical value.”

A few years later, in 1878, a professor at Oxford University by the name of Erasmus Wilson commented that “When the Paris Exhibition closes, electric light will close with it, and no more be heard of.”

Much later, in 1932, a great scientist noted that “There is not the slightest indication that nuclear energy will ever be obtainable.  It would mean that the atom would have to be shattered at will.”  His name was Albert Einstein.

And little more than 30 years ago, in 1977, the president of Digital Equipment Corporation argued that “There is no need for any individual to have a computer in their home.”

It’s hard to remember that just 20 years ago people were claiming that the value of the land under the Imperial Palace in Tokyo was greater than that of all the land in California.

So we do not know what the future holds, and I don’t want to pretend that my crystal ball is a great deal better than that of my colleague.

But I admit to being profoundly worried.

Where are we now?

As we all know, the world economy has just been through its most serious slowdown since the depression of the ‘thirties.   Virtually all developed countries have seen a sharp slowdown in activity – indeed, a fall in total output – and a sharp increase in unemployment.  And that’s despite aggressive measures in all countries to stimulate activity – monetary policy settings with interest rates very close to zero in most major developed economies, quantitative easing in several of the largest economies, and fiscal policy running very large budget deficits.

In the United States, many commentators are claiming the economy has stalled, and some are predicting a double dip recession.  Unemployment had been projected to be almost 9% without the government’s stimulus package and well under 8% with the stimulus package – and actually is nearly 10%.  Following the sharp fall in house prices over the last three years, some 11 million homes, or 23% of all mortgaged properties, owe more on the mortgage than their current market price – in Nevada, that figure is 68%.  In many parts of the US, house prices continue to slide, with the number of existing homes sold in July being down 32% on the level in July last year, and a massive 80% down from July 2005.  It’s estimated that at these very low rates, it may take a decade to clear the backlog of houses already owned by the banks.  Robert Schiller is predicting that house prices will continue to decline for another five years.  With many people seeing their most valuable asset decline in value, and facing an increased likelihood of being unemployed, potentially for years to come, it’s not surprising that consumer spending is relatively weak.

The situation in Europe varies a little from country to country, but all countries have seen a fall in output and a rise in unemployment as compared with the pre-crisis period.  In Spain, unemployment now exceeds 20% of the workforce.  In Ireland, unemployment reached 13%, and GDP was 15% below its peak.  Because of a further need to support its banking sector, commentators are talking about the country’s fiscal deficit reaching 32% of GDP this year.

In Japan, as of course you are only too well aware, GDP shrank by nearly 8% over the 2007-2009 period, taking the total size of the economy back to where it was in the early ‘nineties.  While overt unemployment is not as high as in many other developed countries, there is considerable under-employment, and evidence of many people who would like to enter the workforce if jobs were available.  Land prices are still some 60% below their 1991 peak, with indices of residential and commercial property 44% and 73% below their highs respectively.

In many other developed countries, including the United Kingdom, France, Spain, Australia and my own country, house prices still appear to be over-valued, and the prospect of a correction in those markets has ominous implications for future economic activity.

In July, The Economist newspaper reported that the Baltic Dry Index – which measures the rates charged for chartering the giant ships that carry coal, iron ore and grain – had fallen by almost 60% in its longest streak of consecutive declines for nine years.  Many people saw that as a very bad indicator of things to come.[1]

And at the same time, we are seeing massively large fiscal deficits in many countries.  These are partly the inevitable result of a reduction in tax revenue and increased government spending on unemployment and other benefits as a consequence of the slowdown, and partly the result of aggressive attempts by the governments of most developed countries to bolster demand by undertaking specific “stimulus” measures.

In the United States and the United Kingdom, government deficits currently exceed 10% of GDP and, while the government deficit in Japan is very slightly lower, this year Japanese government borrowing is projected to exceed tax revenues.  Last year, the budget deficit in Ireland exceeded 14% of GDP (even before the need to provide additional funds to bail out the country’s banks), and substantial deficits are now the norm throughout Europe.

As a consequence, public sector debt, already high in many countries before the crisis, is rising strongly.  An IMF paper published at the beginning of last month about the sovereign debt position of 23 advanced economies notes that “on average, public debt rose from 60% of GDP on the eve of the crisis (end-2007) to almost 75% by end-2009.  More striking, IMF country teams project debt ratios to continue rising over the next five years, averaging more than 85% of GDP by 2015.”[2]

The same paper notes that the public-debt-to-GDP ratio of the G-7 countries averaged 102.5% in 2009, and is projected to average 117.5% by 2015.  The lowest public-debt-to-GDP ratio for any of the G-7 countries in 2009 was 68.2%, in the United Kingdom, and the highest was 217.7%, in Japan.[3]

Another IMF paper estimates the extent to which various governments will need to borrow in 2010 and 2011, relative to their GDP, taking into account both maturing debt and the size of the fiscal deficit.  For the United States, that figure is estimated at 32% of GDP this year and a further 19% next year.  For Japan, it is estimated that the government will need to borrow a gross amount equal to 64% of GDP this year (because of very high debt maturities), and a further 41% next year.[4]  This means that both governments are highly dependent on investors having continuing confidence in their ability to get their debts under control.

What is profoundly disturbing is that one of the authors of these IMF papers has observed that the fiscal stimulus packages put in place to combat the worst effects of the crisis account for only one-tenth of the increase in public debt projected for the period from 2008 to 2015.  The basic problem is that, in many developed countries, structural budget deficits have become deeply entrenched, at least in part because it’s now clear that the sustainable path of GDP is rather lower than it appeared to be before the recession.

In Japan, debt servicing already absorbs some 35% of all government revenues – and that despite the fact that Japan has been able to borrow at rates of interest which are historically without precedent – currently very close to zero for two year money and under 1% for 10 year money.  If Japan were faced with paying rates of interest even no higher than those paid by, say, Germany, servicing the Japanese government debt would absorb still more of government’s revenues – while if Japan had to pay rates equal to some of the more improvident European countries, the situation would be dire indeed, with little left to pay for all the other services which the government provides.

Late in August, Morgan Stanley analyst Arnaud Mares argued that in assessing the ability of governments to service their debts it’s important to look not just at the level of debt relative to GDP, but also at the level of debt relative to government revenues.  Using this approach, Spanish government debt is a relatively modest 153% of revenues; British government debt 169%; Irish debt 248%; Greek debt 312%; and American government debt 358%.  I don’t have the figure for Japan, but that would also be very high.

Laurence Kotlikoff, professor of economics at Boston University, argued in a recent Bloomberg article that “the US is bankrupt”.  He quotes another IMF paper from July this year which notes that “the US fiscal gap associated with today’s federal fiscal policy is huge for plausible discount rates…  Closing the fiscal gap requires a permanent annual fiscal adjustment equal to about 14% of US GDP.”  Professor Kotlikoff puts that in perspective by noting that current US federal revenue totals only 15% of GDP, so that a 14% adjustment would require a permanent doubling of the total tax take.   This takes into account not just what is currently being spent but what is scheduled to be spent by the US government on current programmes.[5]

Two months ago, Joergen Oerstroem Moeller, a visiting senior research fellow at the Institute of Southeast Asian Studies in Singapore, argued that it is likely that, before 2020, “the US will default on its sovereign debt”.  He defended this apparently preposterous statement by arguing that “the US cannot and will not accept the constraints on economic policy imposed by the burden of debt servicing…  In choosing between honouring its commitments and respecting the rules of the game (on the one hand), or stimulating the US economy (on the other), the second option will prevail.”[6]

So to summarise this part of my lecture, the economies of the developed countries are coming out of the Global Financial Crisis growing only slowly, with large fiscal deficits and very high accumulated government debt.  This is beginning to raise serious questions about the ability of even highly rated countries to service that debt.

What about the prospects for growth over the next few years?  Surely the combination of extremely easy monetary policy and very large fiscal deficits will lead to strong growth soon, if not this year then surely next? 

I’m clearly in the camp of those who believe that the developed economies of the world face a prolonged period of very sluggish growth, punctuated from time to time by further recessions.

This is partly because it seems inevitable that the governments of several major developed countries now have no alternative than to embark on a programme to get their fiscal positions under control.   Several of the smaller European countries – such as Greece and Ireland – have already embarked on aggressive belt-tightening programmes.  The United Kingdom has begun such a programme, and signaled their intention to go much further over the next 12 months.  Germany has written fiscal austerity into its constitution.  And it seems inevitable that the US and Japan will eventually have to at least make some attempt at moving their fiscal positions towards balance.

At very least, large-scale existing indebtedness, and increasing signs that the public is becoming wary of that debt, especially in the US, mean that there is little likelihood of further stimulus packages.

Secondly, the financial institutions in many developed countries remain relatively fragile.   They are clearly in better shape than they were at the height of the financial crisis, but many of them are in no mood to lend on any but the lowest risk commercial ventures.  They are being obliged by regulators to increase their capital/assets ratio, and to fund a higher proportion of their total assets from retail and term deposits, reducing their dependence on more volatile money market funding. 

Last year, Mervyn King, the Governor of the Bank of England, noted that “for the major UK banks, almost 25% of customer loans are now funded by short-term borrowing in wholesale markets.  At the turn of the new century it was close to zero.”[7]  Regulators have made it clear that they want banks to be much less reliant on that kind of funding.

And it’s not just the banks being reluctant to lend: many bank customers are reluctant to borrow.  People who assumed that real estate prices always go up have had a nasty shock.  People who assumed that share prices always go up have had a nasty shock.  Businesses which assumed that sales would grow every year have had a nasty shock.  The animal spirits which drove the strong increase in credit over the years prior to the crisis have entirely gone.

In a very important paper presented to the annual conference of central bankers in Jackson Hole, Wyoming, at the end of August, Carmen Reinhart and her husband examined “the behaviour of real GDP (levels and growth rates), unemployment, inflation, bank credit, and real estate prices in a 21-year window surrounding selected adverse global and country-specific shocks”.[8]  They presented evidence that the decade of relative prosperity prior to a shock was typically fueled by an expansion of credit and rising leverage that spans about 10 years; and was typically followed by a lengthy period of retrenchment that lasts almost as long as the credit surge which preceded it.

And intuitively, that surely sounds right.  Worryingly, in many developed countries the decade which preceded the most recent crisis saw an enormous expansion of credit to the point where the ratio of credit to household disposable income, or to GDP, reached quite unprecedented levels in some countries.  Slow growth seems the best that can be expected in most developed countries.

Well, perhaps China can be the locomotive of the world economy?   Certainly, I’ve seen no commentator suggest that China is about to stop growing, but increasingly commentators are suggesting that Chinese growth will slow over the next few years. 

Some people worry that Chinese residential property prices exhibit all the characteristics of an asset bubble – indeed, a very greatly inflated bubble, which could pop at any time.  Others have expressed concern that a very large amount of investment in China has been in wasteful areas – commercial property and infrastructure are often mentioned.  Some worry about the strength of the Chinese banking system, facing the prospect of very substantial loan losses on much of the enormous expansion of credit which has occurred over the last year or two.  Still others note that total public sector debt in China, including the debt of both central government and local authority enterprises, is probably close to 90% of GDP, a level which creates less flexibility for the Chinese authorities than is sometimes assumed. 

Much of China’s growth in the past has been pulled along by very rapid growth in exports and, with the developed world likely to grow much more slowly over the years ahead, that doesn’t seem a likely source of high growth.

A study by the China desk of Deutsche Bank published in mid-September suggested that China’s GDP would grow at an average pace of 7% annually over the next decade, as compared to an average of 10% annually over the past decade.[9]  For any other country, growth of 7% per annum would be spectacular, but even if achieved it might not be sufficient to provide strong stimulus to the rest of the world economy.

And at this point, I want to argue that China’s development model – based on the very rapid growth of exports to the developed world, driven in part by a persistently undervalued exchange rate – is almost certainly no longer sustainable.

Before I explain more fully what I mean by that, I want to put my comment in the context of the factors which drove the Global Financial Crisis.

It is, of course, fashionable to blame the GFC on the greed of avaricious bankers, especially American bankers, and the gross incompetence of those regulators who were supposed to be policing them.  Since I am a director of the largest bank in New Zealand, I should declare an interest, lest you think my comments are a defence of bankers!  There was certainly some outrageously irresponsible behaviour by some bankers, motivated by what motivates most people in a market economy, the opportunity to make a lot of money.

But I believe there were a great many other causes of the financial meltdown which began in the US in late 2007.

There was, for example, strong political pressure on US banks to lend to uncreditworthy, and marginally creditworthy, borrowers.  That was not a new phenomenon in the US, but the latest episode dates from the early ‘nineties.  Over most of the last 20 years, governments of both major political parties in the US encouraged banks to lend to borrowers who really should not have been able to borrow at all.

And then we had the curious American habit of non-recourse lending, whereby borrowers engaged in a “heads I win, tails the bank loses” game – knowing that if house prices rose, the borrower stood to make a lot of money, while if they fell, the bank stood to lose a lot of money.  I have been told that this non-recourse lending is in fact mandated by legislation in many American states.  While non-recourse lending might not in itself be a source of major difficulty if it’s priced appropriately, it certainly seems likely to have added some additional risk to the US banking system.

And what certainly added very considerable risk to the financial system was the widespread practice of securitizing residential and other loans.  What was seen by some observers as a powerful innovation enabling credit risk to be diffused across a multitude of financial institutions turned out to be the source of enormous danger.  Loan originators had little incentive to ensure borrowers were creditworthy because they had no intention of holding onto the risk.  They passed that risk on “down the chain”, with successive financial institutions clipping the ticket as the risk was passed from hand to hand but holding no exposure to the potential default.   There was no transparency or accountability in the credit chain, and significant parts of the process were largely unregulated.

Another major source of the recent difficulties was the practice in many urban areas, in several English-speaking countries as well as in the US, of tightly regulating the supply of residential land.  Once demand for residential property started to go up, there was little or no scope for an increase in supply to meet that demand, and house prices started to rise strongly.  While house prices hardly rose at all in a large and fast-growing city like Dallas, where restrictions on the supply of residential land were almost non-existent, they rose very strongly indeed in places like Los Angeles and San Francisco.  As Thomas Sowell has noted, 60% of all mortgage defaults in the US are concentrated in just five states, primarily those where the supply of residential land was subject to tight restriction.[10]

I also want to put at least some of the blame for the Global Financial Crisis on banking regulation and supervision.  I’m not arguing that the crisis wouldn’t have happened if bank regulators had been more assertive, or more attentive, but rather that banking regulation itself may have contributed to the crisis by leading both depositors and, worse still, bank directors to assume that the regulators had everything under control. 

I’ve never forgotten a conversation I had in Washington in September 1992, at the time of the World Bank/IMF annual meetings.  I found myself at one of those dinners which make the annual meetings so enjoyable sitting beside a man who, after a long and successful career in the British Treasury, had just become a director of one of the major British clearing banks.  I asked him how he found being a director of a bank after a lifetime in the Treasury.  Funny you should ask that he said.  I’ve always thought that banking was all about measuring and pricing risk, and of course I’ve had no experience of that in the Treasury.  But I’m relieved to discover that all I have to worry about is whether we are complying with the Bank of England’s rules.  (This was, of course, before the Financial Services Authority was established.)

In the mid-nineties, we in New Zealand introduced a system of bank regulation involving minimal rules and regulations, but instead imposing a requirement that all bank directors had to sign off a statement quarterly attesting to the fact that, in their opinion, their banks had adequate risk control systems in place, and that those systems were working appropriately. This prompted the CEO of the Australian owner of one of the largest banks in New Zealand to fly from Australia to tell me in no uncertain terms that what we were proposing to do was totally unrealistic.  Most bank directors, he told me firmly, simply had no understanding of banking.  For that reason, he wanted me, as the head of our central bank (which was and is also the banking regulator), to continue laying down a series of rules and regulations.  In other words, he wanted the banking regulator to make all the key decisions which would minimise his bank’s risks.  I told him, equally firmly, that I had no intention whatsoever of doing that – that that was his responsibility, and that of his directors.

All these factors played a part in causing the Global Financial Crisis. 

But I also want to argue that underlying the whole crisis was a profound imbalance in the global economy, between China and the US, that caused interest rates to be far too low for far too long in the US and some other developed economies.  

As you know, Alan Greenspan and the Federal Reserve Board have been accused of holding policy interest rates too low for too long in the early and middle part of the last decade, thus providing far too much encouragement for credit growth.  He has replied that the interest rates which are most relevant to the home mortgage market are longer term rates, over which the Fed has only limited influence.

What appears to have happened is that China kept its exchange rate at an artificially low level for years in order to encourage exports.  This had the direct effect of providing an abundant supply of cheap imports to the United States, helping to keep inflation in check there and justifying low policy interest rates.  It also had the effect of generating very large balance of payments surpluses in China, which China invested in US Treasuries, thus tending to depress yields on longer-term securities in the US.

There was what in Europe would be called a Faustian bargain, which in many ways suited both the US and China, at least in the short-term: the US got low consumer price inflation, low interest rates, rising asset prices, and inexpensive funding of its growing fiscal and current account deficits.  China got open access to the world’s largest market for its rapidly growing export industries, industries which were able to employ the hundreds of millions of people moving from the countryside into China’s rapidly burgeoning cities.

But there has been a cost, as there is in every Faustian bargain.

The bubble has popped in the US, and American homeowners and state and federal governments suddenly find themselves grappling with the consequences of bingeing on credit.  There’s resentment rather than gratitude for the flow of inexpensive imports from China, and frustration that China refuses to let its currency appreciate to reflect its vast foreign exchange reserves and huge balance of payments surplus.  Chinese policy is seen as being mercantilist, and aimed at generating employment in China at the expense of American workers.

On the Chinese side, there’s anger that the vast US dollar assets built up over many years are drifting down in value against other major currencies, and irritation at the criticism which US politicians express about their currency regime. 

In my view, this serious imbalance between the US and China caused by the substantial undervaluation of the yuan is damaging China, damaging the US, and seriously damaging prospects for international trade and economic growth.

It’s damaging China because, by keeping the cost of capital artificially low, it’s leading to all sorts of wasteful investment.  By keeping the cost of consumption artificially high – in other words, by keeping real wages artificially low – it’s keeping domestic consumption well below what might be expected in a more normal situation.  (It’s estimated that private consumption makes up only about 30% of Chinese GDP, compared with 60-70% in most developed economies.)  And of course, it’s channeling vast sums from China into low-yielding US Treasuries.

A country at China’s stage of development might normally be expected to run a balance of payments deficit, with resources flowing into the country to add to its stock of investment capital.  This was Singapore’s experience in the early stages of its development, and of course also that of many other now developed countries, such as Canada, the US, Australia, and New Zealand.  It’s extraordinary to see a country which, despite very rapid growth, is still one of the poorest countries in the world exporting vast amounts of capital to the US.  

Undervaluation of the yuan is also damaging the US and other countries by dragging a great deal of manufacturing production out of those other countries towards China.

And of course the risk is that in the current environment of high unemployment, very low growth and fiscal austerity in many developed economies there will be strong political pressures to “compensate” for the undervaluation of the Chinese currency by some form of protection against Chinese exports.  There’s already intense pressure for the US Congress to impose duties on Chinese exports to the US, and that’s become very much more evident in recent days.

And we all know how extremely dangerous such moves would be.  

There are some very tentative signs that China may be willing to allow the yuan to appreciate somewhat.  In July, Hu Xiaolian, deputy governor of the People’s Bank of China, gave a series of speeches in which she argued that a freer exchange rate liberates China’s monetary policy, spurs innovation in China’s export industries, and channels investment to its service sector, where many of China’s new jobs will be found.  “Adopting a more flexible exchange rate regime serves China’s long-term interests as the benefits… far exceed the cost in reorganizing industries and removing outdated capacities” she said.[11]   That is certainly true, and one must hope that China adopts a more flexible regime before highly damaging protectionist moves are taken in other countries.

The more general question which the tension around China’s exchange rate regime highlights is how best to deal with substantial imbalances in the world economy, and more generally what the “right” exchange rate regime is.

There is considerable resentment on the part of exporters in many developed countries at the big exchange rate fluctuations which they have to endure.  In my own country, exporters have complained that over the last two decades the New Zealand dollar has on two occasions appreciated against a trade-weighted basket of currencies by some 50%, and they’ve assumed that that is only because the New Zealand dollar is a very small currency, thrown around on the turbulent seas of international foreign exchange markets.  But actually, a trough-to-peak appreciation of 50% has been commonplace over the last two decades – it’s happened to the US dollar and the Canadian dollar, while the Japanese yen and the Korean won have experienced even larger appreciations.

So all floating currencies have an unfortunate tendency to experience big fluctuations.  At the moment, we see the monetary authorities of several countries – most recently Japan, Brazil and Switzerland – trying hard to resist an appreciation of their currencies, while the US would like nothing better than to depreciate the US dollar against the yuan.

Perhaps the answer, at least for smaller countries, is to peg to the currency of a large country, such as the US?  As Argentina did, with disastrous consequences in the ‘nineties.  As Hong Kong has done since 1983.  And yes, there have been benefits to Hong Kong of pegging to the US dollar in terms of maintaining confidence in that economy, but there have also been costs.  When inflation in Hong Kong was markedly higher than in the US, Hong Kong’s real exchange rate appreciated strongly, which was a contributing factor to driving manufacturing out of Hong Kong across the border into China.  And of course, Hong Kong has lost all ability to control monetary conditions in Hong Kong.  At the moment, Hong Kong has interest rates close to those in the US – in other words, Hong Kong interest rates are, like those in the US, close to zero – which is almost certainly a factor contributing to the raging property bubble in the territory.

A recent paper by Barry Eichengreen and Peter Temin argues that fixed exchange rate regimes – such as the gold standard, such as the euro, such as the peg between the US dollar and the yuan – work well in good times but can cause very serious problems in bad times.  The paper argues that, when things get out of kilter, it’s always assumed that it’s the country running a deficit which must adjust, not the country running a surplus.  As a result, there’s an inherent deflationary bias in the system.[12]

But actually, it’s not even clear that fixed exchange rate regimes work well in good times, as the Argentines discovered. 

Moreover, it now seems clear that the low interest rates which Ireland and Spain enjoyed when they first became part of the euro area – which were undoubtedly the source of much rejoicing at the height of the property boom in both countries – were quite inappropriate to the conditions in those countries.  Both countries may have been very much better off now, at least economically, had they had policy interest rates more appropriate to their own circumstances earlier in the last decade – in other words, higher interest rates.   I suspect that the monetary authorities in Hong Kong would welcome the opportunity of having higher interest rates there also at the moment.

Much has been written about the theory of optimal currency areas and there’s no doubt that more will be written in the next few years, as the tensions in the euro area play out. 

But nobody pretends that China and the US are an optimal currency area, and dealing with the tensions in that currency relationship is an issue of the utmost and immediate importance.  How that issue is resolved will have profound significance not only for business in the Asian region but for business throughout the world over the next decade.

[1] The Economist, 17 July 2010.

[2] Fiscal Space, by Jonathan D. Ostry, Atish R. Ghosh, Jun I. Kim, and Mahvash S. Qureshi, 1 September 2010, page 11.

[3] Ibid., page 13.

[4] Default in Today’s Advanced Economies: Unnecessary, Undesirable, and Unlikely, by Carlo Cottarelli, Lorenzo Forni, Jan Gottschalk, and Paolo Mauro, 1 September 2010, page 18.

[5] “US is bankrupt and we don’t even know it”, Laurence Kotlikoff, Bloomberg, 11 August 2010.

[6] The National Business Review, 30 July 2010.

[7] Finance: A Return from Risk, a speech at the Mansion House by Mervyn King, 17 March 2009.

[8] After the Fall, by Carmen M. Reinhart and Vincent R. Reinhart, 27 August 2010.

[9] China Macro Strategy: Lower growth, better structure, Deutsche Bank, 16 September 2010.

[10] The Housing Boom and Bust: Thomas Sowell on how government policies made the housing crisis possible, by Brian Doherty, on, 20 May 2009.

[11] Quoted in The Economist, 21 August 2010.

[12] Fetters of Gold and Paper, by Barry Eichengreen and Peter Temin, NBER Working Paper, July 2010.

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Copyright © 2020 Don Brash.