Hong Kong SAR's strong fundamentals, policies generate quick recovery from Asian crisis

• Author: Jeanne Gobat
• Position: IMF Asia and Pacific Department
• Pages: 202-204

Page 202

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 shortterm 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...