25 March 2014
Half-Yearly Monetary & Financial Stability Report (March 2014)
Summary and overview
Tapering of asset purchases by the US Federal Reserve has led to a new bout of volatility affecting emerging market economies. Against this stormy external environment, the Hong Kong dollar exchange rate has been broadly stable and local financial markets have remained orderly.
As the authorities in Mainland China aim to steer the economy toward a slower but more sustainable growth path and achieve a gradual reduction in corporate and local government leverage, local banks need to be alert to and be prepared for possible increases in the credit risks of their Mainland exposures. At the same time, they need to brace themselves for risks associated with possible fund outflows and property market adjustments.
The external environment
The US Federal Reserve began tapering its large-scale asset purchase programme in January. The move signalled the start of what could be a prolonged and complex monetary normalisation process. Global financial markets initially reacted calmly, helped by improved prospects for advanced economies and expectations that major central banks would maintain loose monetary conditions for a prolonged period. However, a new bout of market volatility soon resurfaced as markets assessed how well emerging markets economies would withstand the withdrawal of US monetary stimulus.
The beginning of the US Federal Reserve’s monetary policy normalisation process may reflect improved growth momentum in the US economy, but there are still some concerns about the US economy. Continued decline in the labour participation rate and subdued capital investment may indicate lower potential output growth, which could complicate the judgment about inflation risks and the conduct of monetary policy. Indeed, the path of exit is not necessarily smooth, and interest rate volatility could be higher than currently anticipated. In the euro area, while the recovery has steadied, continued financial fragmentation and the debt overhang in both the private and public sectors make a stronger recovery difficult to attain. In Japan, growth and inflation have both improved but the outlook remains uncertain amid sluggish wage growth and current account deficits. High public debt and limited fiscal room to manoeuvre also mean if growth falters or government bond yields jump, sovereign debt dynamics may worsen in Japan.
In East Asia, some capital outflow pressures were felt in a number of economies after the announcement of tapering of asset purchases by the US Federal Reserve late last year, but financial markets have in general reacted more calmly compared to the heavy sell-off in the summer last year. Looking ahead, capital flows may have become more sensitive to shocks or events that could trigger risk aversion, and market volatility is likely to remain high as concerns over emerging markets linger amid the normalisation of monetary policy in the US. On a more positive note, most governments in the region have room to adopt counter-cyclical policies to cushion the impact of capital flow reversals.
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