From today's SCMP:
"HK slips into negative interest rates. With local lenders responding to Fed cut, prime drops below inflation level of 3.8pc.
....
The result is a negative interest-rate scenario, reminiscent of the mortgage rate from 1991 to 1994. At 4 percentage points below prime, the mortgage rate now stands at between 3.1 per cent and 3.25 per cent, below the inflation rate measured at 3.8 per cent last month."
Effectively, if you have a mortgage, the Bank is now paying you, rather than the other way around! That is, you will pay back your loan in future, inclusive of interest, with less real money than the loan is worth today. And the likely result?
"Property agents said negative mortgage interest rates would help bring the market back to 1997's peak levels faster....."
Does that mean you should buy property? Not necessarily. First there are the transaction costs, that amount to about 5% of the value of the property, and then there is the risk of future property price movements. IF the US recession spreads to Asia, expect property prices to decline significantly, which would wipe out any gain from negative real interest rates many times over.
Showing posts with label Hong Kong. Show all posts
Showing posts with label Hong Kong. Show all posts
Thursday, January 24, 2008
Wednesday, January 23, 2008
Hong Kong Inflation
Inflation in the CPI is up to 3.8% in Hong Kong, according to the Census and Statistics Department. That is, the average price that consumers paid for consumer goods in December 2007 was 3.8% higher than than in December 2006. This is the highest level of consumer inflation since June 1998, almost 10 years ago!
The driving force behind Hong Kong's inflation is rapid growth across the border in Mainland China fueling increased demand here. As long as China's rapid develop continues, coupled with an appreciating RMB, increased demand for Hong Kong produced goods and services will put positive pressure on Hong Kong prices.
But now there is another force putting upward pressure on Hong Kong prices. Yesterday the US central bank cut interest rates by 75 basis points, or 0.75% (for an analysis of the rate cut, see James Hamilton's comments here). This implies that interest rates in Hong Kong will drop as well, as a result of Hong Kong's currency board system that effectively fixes the exchange rate between Hong Kong and the United States. (See earlier posts here and here to understand why).
These lower nominal interest rates imply cheaper mortgages and loans in Hong Kong, which will likely fuel further increased demand and therefore inflation in Hong Kong.
The bottom line: expect price increases in Hong Kong to accelerate further in the short run.
The driving force behind Hong Kong's inflation is rapid growth across the border in Mainland China fueling increased demand here. As long as China's rapid develop continues, coupled with an appreciating RMB, increased demand for Hong Kong produced goods and services will put positive pressure on Hong Kong prices.
But now there is another force putting upward pressure on Hong Kong prices. Yesterday the US central bank cut interest rates by 75 basis points, or 0.75% (for an analysis of the rate cut, see James Hamilton's comments here). This implies that interest rates in Hong Kong will drop as well, as a result of Hong Kong's currency board system that effectively fixes the exchange rate between Hong Kong and the United States. (See earlier posts here and here to understand why).
These lower nominal interest rates imply cheaper mortgages and loans in Hong Kong, which will likely fuel further increased demand and therefore inflation in Hong Kong.
The bottom line: expect price increases in Hong Kong to accelerate further in the short run.
Thursday, November 29, 2007
University Rankings....
Earlier this month, the Times Higher Education Supplment came out with its latest university ranking. And if you live in Hong Kong, you would have had to turn off all news media to have failed to learn that my employer, HKU, ranked 18th worldwide! That's an impressive performance by any means, and the University is rightly trumpeting its performance.
But university rankings are inherently problematic. In this case, the THES takes a series of relevant indicators (peer review, employer review, international staff, international students, staff/student ratio, and citations), combines them with a formula, and comes out with a number that can be compared between universities.
In general, these indicators are proxies for latent variables that cannot be accurately measured, and may be poor proxies at that. For example, I suspect the "international" variables are trying to capture the extent to which the university encourages its students to think outside the box, and take into account other viewpoints and perspectives. But just having international students and international staff is neither necessary nor sufficient for this to occur.
There are likely to be significant measurement issues as well. Who exactly are the peers and employers who are asked about their views of different universities? Is the sample biased towards one country, or one demographic? How do we count international students, and international staff? Are mainland students in HK domestic or international? Are exchange students, who come to HKU for one semester or one year, treated identically to international students who come for their complete degree program? Is "international" determined by passport, or birthplace? In the staff count for the staff-student ratio, who is included? Only permanent, tenured staff? Gardeners and cleaners? I could go on....
There are two reasonable responses to these problems. One would be to dismiss these rankings as noisy indicators of very little. The other is to treat the noise in the ranking as sampling error, and try to increase the sampling size, by considering more university rankings.
Unfortunately there's only one other well-known global university ranking, by Shanghai Jiao Tong University. And where does HKU rank here? Somewhere between 203rd and 304th.
Oops.... I guess we need a lot more rankings than two to get any accurate idea of where HKU really stands!
But university rankings are inherently problematic. In this case, the THES takes a series of relevant indicators (peer review, employer review, international staff, international students, staff/student ratio, and citations), combines them with a formula, and comes out with a number that can be compared between universities.
In general, these indicators are proxies for latent variables that cannot be accurately measured, and may be poor proxies at that. For example, I suspect the "international" variables are trying to capture the extent to which the university encourages its students to think outside the box, and take into account other viewpoints and perspectives. But just having international students and international staff is neither necessary nor sufficient for this to occur.
There are likely to be significant measurement issues as well. Who exactly are the peers and employers who are asked about their views of different universities? Is the sample biased towards one country, or one demographic? How do we count international students, and international staff? Are mainland students in HK domestic or international? Are exchange students, who come to HKU for one semester or one year, treated identically to international students who come for their complete degree program? Is "international" determined by passport, or birthplace? In the staff count for the staff-student ratio, who is included? Only permanent, tenured staff? Gardeners and cleaners? I could go on....
There are two reasonable responses to these problems. One would be to dismiss these rankings as noisy indicators of very little. The other is to treat the noise in the ranking as sampling error, and try to increase the sampling size, by considering more university rankings.
Unfortunately there's only one other well-known global university ranking, by Shanghai Jiao Tong University. And where does HKU rank here? Somewhere between 203rd and 304th.
Oops.... I guess we need a lot more rankings than two to get any accurate idea of where HKU really stands!
Monday, November 12, 2007
Japan's Phillip's Curve....
.... looks like Japan. That's from my former PhD Supervisor and co-author, Professor Gregor Smith of Queen's University. The same is apparently true of the Marshal Islands, the Netherlands, and the Czech Republic (see the links on Smith's homepage). It's not true for HK.... I checked.
Thursday, November 8, 2007
The Economics of Remittances....
Every year, domestic helpers in Hong Kong send money home to support their families. In this post, I want to briefly examine the economics of these remittances. (This post is motivated by this story about the remittances of polish truck drivers from the UK).
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
First, how large are the remittances? We can get some idea from looking at the level of "current transfers" in the Balance of Payments. For 2006, outflows were 24.6 billion. This is an upper bound on remittances, since it includes all flows of money that are not in exchange for goods and services, such as donations. Still, that's about 1.6% of GDP- a non-trivial sum by any measure.
So what's the effect of this outflow? Conventional wisdom is that this is a drain on the HK economy. But as is often the case with economics, the conventional wisdom is wrong. In order to remit finances home, the HKD earned in Hong Kong must be converted to some other currency. But there has to be a counter-party to that transaction: for every seller of HKD in exchange for Philippines Pesos, there's a buyer of HKD who wishes to sell Philippines Pesos. And why would someone want to buy HKD? In order to buy goods, services, assets, or some other item of value denominated in HKD.
So the bottom line is that there is no drain. This is simply a result of the Balance of Payments being zero- outflows must be matched with inflows.
But there are exceptions to this argument. What if the remittance is made in terms of HKD banknotes? If those bank notes are eventually spent in Hong Kong, then we return to the above case. And if they are not spent in Hong Kong (i.e. circulate elsewhere, or are stored in a safe somewhere), things are even better for Hong Kong. The Hong Kong economy benefits from the services of a worker in Hong Kong, and in exchange the worker contributes 100% of their earnings to Hong Kong's official foreign reserves.
Let me explain. When bank notes are issued, every 7.8HKD issued must be backed by a 1USD increase in the exchange fund. So additional banknotes result in the following transaction: the bank "sells" you banknotes (against your bank balance, say), and in exchange "buys" those banknotes from the exchange fund with USD. With the exchange rate fixed, this has negligible effect on the net wealth of the bank, but leaves you with your bank notes and the exchange fund with larger USD reserves.
If bank notes now leave Hong Kong, then approximately the same quantity of additional bank notes will be required to meet demand. So the reserves increase further by approximately the amount of the remittances. And the HK economy continues to benefit from the accumulated exchange fund balance in the form of interest income from the USD assets in the exchange fund.
If we did not have a currency board in HK, then bank notes circulating outside of HK would be similar to the example in the link above: effectively, the Hong Kong economy would have benefitted from the labour of a domestic helper in exchange for some pieces of paper that can be printed for a few cents each. This may be a trivial source of wealth for a place like Hong Kong, but it provides the United States with a windfall of 20-30 billion USD every year!
Monday, November 5, 2007
Pressure on the HKD peg...
The HKMA has been intervening regularly lately to maintain the HKD peg. The currency is nominally fixed at 7.80 HKD per USD, but allowed to fluctuate between 7.75 and 7.85. When it hits the weak side of the band (7.85), the HKMA is obliged to buy HKD in exchange for USD. And when it hits the strong side, the HKMA sells HKD in exchange for USD.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Lately, it has been stuck up against the strong side of the band. The most likely reason for this is the large value of IPO's in Hong Kong at present. To invest in an IPO, you need HKD. Ergo there is upward pressure on the value of the exchange rate. But this will pass, as the value of IPO's in the city returns to more normal levels in due course. (Indeed, it's back down as I write to 7.7659HKD per USD).
However, maintaining the currency board is not a costless policy. In this case, the total value of HKD in circulating is increasing, which must ultimately lead to higher inflation rates.
But let's put this into context. Seasonally adjusted M1 stood at 407 Billion HKD as of August 2007 (the latest available data). Based on media reports, the HKMA's interventions so far have amounted to about $10Billion HKD, or 2.5% of the money supply. The current level of intervention would need to be sustained for some time for the inflationary costs to become large.
Thursday, October 18, 2007
Oct. 19 1987: Could it happen again?
Oct. 19 1987 remains the largest one-day correction in world equity markets. The DJIA lost 22.6%, and the S&P 500 20.4%. Closer to home, the drop in the HSI lagged that in New York due to the time difference. But drop it did, from 3362.40 at close on Oct. 19 to 2241.70 at close on Oct. 26- a staggering 33.3% drop. (For the data, see here. This NYT story explains the lack of data for the intervening days: the market had already dropped 11.1% on Oct. 19, ahead of the US melt-down, and was closed for the following four trading days as a result).
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Could such a melt-down happen again? Nouriel Roubini of NYU and Roubini Global Economics draws the parallels between 1987 and 2007 here.
My take: yes, there are some strong parallels, and a major melt-down is certainly possible. But timing any such melt-down is extremely difficult. It could happen tomorrow, next week, next month, next year, or even next decade.
Monday, October 15, 2007
Why have a currency board?
"Notwithstanding the fact that the currency peg is very political, are there any compelling reasons why the HKD should not be "unpegged" from the USD, particularly in view of expected further depreciation of the greenback?"
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
That's an excellent question! To answer it, first we need to take a slight detour, into the world of currency unions. A currency union is a form of monetary policy where two or more countries use the same money- for example, the Euro area, or Ecuador and the US- who both use USD. There is a substantial amount of evidence that countries in currency unions benefit economically from large increases in trade, investment flows, and output (see the links on this page put together by Andy Rose at UC Berkeley, and my own modest contribution published in Pacific Economic Review that you can view here).
So currency unions are good- but what's that got to do with Hong Kong, with doesn't have a currency union, but a currency board? It's hard to say anything definitive, as there just aren't enough cases of currency boards to undertake the kind of empirical studies linked to above. But I think it is a reasonable conjecture that the same benefits that accrue to currency unions also accrue to currency boards. Both fix the exchange rate in a way that is politically costly to reverse; the main difference between them is that in one case, the countries retain different notes and coins from each other, and in the other case they do not. If my conjecture is correct, Hong Kong benefits from higher capital flows (important for the establishment of the growing international finance centre here), higher trade flows (one of the corner stones of the Hong Kong economy), and higher economic growth.
That doesn't mean that a currency board is without costs. Since the exchange rate cannot adjust to absorb shocks, other variables do instead- including output and unemployment. Our business cycles may be more volatile, but that may be a price that is worth paying.
Saturday, October 13, 2007
Housing wealth shock... US version
When the property bubble in Hong Kong burst, average Hong Kong apartment prices fell about 66% according to the official index between the peak (October 1997) and trough (July 2003) (for a graph, click here). The result of this was a long-term recession, deflation, and general economic malaise.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
The United States is now epxeriencing a bursting property bubble. Few expect the correction to be as large as that experienced in Hong Kong, and to date prices have only dropped a few percentage points. But this may be just the beginning- see this news clip on YouTube for more. Expect a similar consequence for the US economy as HK's.
Thanks to Calculated Risk for the link.
Friday, October 12, 2007
Hong Kong Tax Cut Harmony....
Continuing yesterday's post, William Pesak of Bloomberg agrees that Hong Kong's tax cut is a bad idea- although he adds some additional reasons to my argument about macroeconomic instability: (1) instead of cutting taxes, the government could have used it's largese to try to reduce inequality, and (2) the government should focus less on competing with Singapore (Hong Kong's closest competitor in the low-tax stakes in Asia), and more on forward planning- figuring out what Hong Kong needs for future growth.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
(2) is obvious: planning is good-provided such planning is focused solely on trying to ensure that Hong Kong has all the essential ingredients in place to allow for future growth. Here I'm thinking of physical infrastructure, and ensuring Hong Kong is an attractive location for human capital to locate. On the first one, the CE's announcement included some important news: expansions to the subway trains and highways to improve mobility. On the second one, there was further good news: new green-field sites for international schools (places in which are currently significantly over-subscribed, and are limiting the relocation of expats to Hong Kong). But there's still room for more. In my opinion, the greatest issue in making Hong Kong a more attractive location for human capital is the air quality- which is affecting the quality of life of all Hong Kong residents.
But forward planning is not necessarily a great idea, depending on what it entails. If it includes trying to determine which sectors will be the "winners" in the future evolution of the economy, as in Singapore, then Hong Kong may be better off without it. Think of the unpopular and unprofitable Hong Kong Disneyland and the mis-allocation of resources involved in the Cyberport project as the results of this type of planning. The private sector should be left to make these decisions.
Regarding (1), inequality in Hong Kong may be high by international standards, but is it too high? That's a difficult question to answer.... although from the point of view of contributing to economic stability, a large increase in government spending to increase equality (by spending on public housing, education, and health care, for example) may be just as destabilising as a tax cut! Someone receives that increase in government spending as income, contributing to overheating of the economy. Stability would be greater if the government increased such spending during a recession rather than the current boom.
For more of Pesek's column, see here.
Thursday, October 11, 2007
Hong Kong's fiscal policy is cyclical?
Further to my previous post, the Hong Kong government has responded to the healthy fiscal situation by announcing a tax cut. But is that a good idea? To answer that, we need to think about the role of Government policy.
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
In an ideal world, the government (and central bank) can use fiscal (and monetary) policy to try to smooth the economy over the business cycle. For Hong Kong, monetary policy cannot be used for this purpose, since it is effectively dedicated to maintaining the currency board system. That just leaves fiscal policy.
For fiscal policy to be a stabilising force in the economy, we'd like to see a relatively contractionary policy when the economy is booming, and an expansionary policy when the economy is contracting. That is, the government should be using it's policy to actively work in the opposite direction of the private sector to stabilise the overall performance of GDP.
Part of this work is automatic. In a recession, welfare payments and unemployment benefits automatically increase, spurring an expansionary fiscal policy, and this is further re-inforced by decreases in taxes as individuals experience pay decreases, and may even drop to lower tax rates due to the progressive tax system. We call these factors "automatic stabilisers" in the economy.
But the effect of the automatic stabilisers will result in the government tending to run a deficit in times of recession, and a surplus in times of rapid growth. And herein lies the rub.
For politicians trying to determine when and how to adjust taxes, they'll tend to cut taxes when the economy is booming, since they have a healthy surplus, and raise taxes when the economy is contracting, since they have an "unhealthy" deficit. This works against the automatic stabilization of the economy, and is in fact destabilizing.
It is easy to see this at work in Hong Kong. The following graph plots government revenue and spending- excluding transfers to and from funds- for Hong Kong over the past 12 years. First, we can see that revenue is far more cyclical than spending, with the government always running a surplus in the first quarter, and a deficit in the third quarter. This is simply due to the timing of tax payments.
The next graph demonstrates the (sometimes) destabilising nature of Hong Kong fiscal policy. The budget deficit as a percent of GDP, with the seasonal fluctuations smoothed out, (left hand axis) is plotted against the growth rate of real GDP (right hand axis).
In 2003/2004, for example, the government was running a large deficit, in large part due to SARS. The growth rate was also negative. What did the government do? They raised tax rates. (See page 20 here for details). That may have helped to lower the deficit, but it also helped to exascerbate the recession that hit Hong Kong.
Fast forward to the present time, and we have the same mistake being made, in reverse. The Hong Kong economy is booming- real GDP grew 6.9% last quarter- and the Government is running a large surplus. So now the Government cuts taxes, potentially fueling a further over-heating of the economy.
My preference would be for the government to limit any tax cuts so that they definitely do not need to be raised next time there's a downturn, or a SARS, or a birdflu, or a crash in mainland equity markets, or a..... I'm not being pessimistic here, but the reality of business cycles is that booms are followed by slumps. They always have been, and they always will be. And Governments should plan for them.
But in the meantime, if the government wishes to decrease my tax bill, I won't be saying no!
The CE announces tax cuts.... big deal
Just yesterday, the Chief Executive announced that tax rates in Hong Kong are coming down.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
From the news story today in the SCMP:
"Donald Tsang Yam-kuen announced that the standard tax rates for salaries and profits tax would be cut by 1 percentage point respectively to 15 per cent and 16.5 per cent from the 2008-09 financial year, which would cost the Treasury about HK$5 billion a year."
The standard tax rate discussed here has little effect on the taxes that most of us pay, since it is effectively the maximum average tax rate that a person may have to pay. Given the mildly progressive nature of HK's tax system (2% on the first 35,000 after exemptions, 7% on the next 35,000, 12% on the next 35,000, and 17% on the remainder) and the basic $100,000 exemption, the standard tax rate directly affects only those people earning more than $2,750,000 per year. The calculation is as follows:
Taxes paid under the progressive system on an income of Y are:
T(progressive) = 0.02x35,000 + 0.07x35,000 + 0.12x35,000 + 0.17x(Y-105,000-100,000)
Taxes paid under the standard rate are:
T(standard) = 0.16xY
Actual taxes paid are the minimum of these two equations; the former is lower for all incomes below 2.75 million. With only about 5,000 people in Hong Kong earning more than this threshhold, this tax cut alone will have no effect on most tax payers. So the announced cuts themselves are no big deal.
But the expectation is that there will be additional tax cuts- not yet announced- that will apply to the progressive tax system that affects a far larger number of residents. This can occur in one of two ways: reductions in the tax rates and/or increases in the threshholds at which the tax rates apply.
Wednesday, October 10, 2007
The HKMA is On Top of Things....
The Hong Kong Monetary Authority, Hong Kong's de facto Central Bank, is on top of things... literally! In fact, being housed in the top 11 floors of IFC2, the world's 7th tallest building (and Hong Kong's tallest.... at least until the new ICC building going up across the harbour adds a few more floors).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Of course that's just a play on words, and an excuse to post a photo taken from the 84th floor of IFC2 (below). I'm currently spending a few hours a week at the Hong Kong Institute for Monetary Research, an institute funded by the HKMA, writing a paper on Hong Kong's deflation.
Hong Kong has a unique experience of deflation, as the graph below shows. Out of all developed economies, none other has experienced as large and persistent a deflation in recent times as Hong Kong- Japan is included in the graph as a comparison. I am using this unique Hong Kong data to improve our understanding of the business cycle.
The reason why this data is unique to Hong Kong is in large part due to Hong Kong's monetary policy. With a currency board, the central bank cannot respond to a negative shock by loosening monetary policy, so the economy experiences the full force of the shock. Additionally, the exchange rate cannot adjust (that's what the currency board is designed to keep fixed); prices must adjust in their stead for Hong Kong to regain competitiveness after a negative shock. In the case of Hong Kong's deflation, there were actually four negative shocks in quick succession that resulted in continuous deflation for 68 months (from November 1998 until June 2004): a massive wealth shock, as the property bubble burst (residential real estate lost 70% of this value peak-to-trough), the Asian Financial Crisis, the dot-com bubble bursting, and SARS all contributed to Hong Kong's deflationary experience.
And here's the promised picture from the 84th floor, looking towards Sheung Wan, on one of those all-too-rare days in August when the pollution levels were low, and you realise that there are islands visible on the horizon that you haven't seen for years! (Click on the photo to enlarge).
Wednesday, October 3, 2007
Will India Catch up... continued
India and China are growing at a high, approximately constant rate. But will their growth continue at the current rate? Hong Kong, as a more mature economy, provides a good example as to what may be expected to happen as China and India continue to grow. As Hong Kong developed, it's progression was approximately linear until about 1988- and it's been slowing down since then. That's not really a surpise: high growth rates are easier to maintain the lower is your GDP, as you can grow simply by adopting the technology of others. But at some point, that process will run out of steam.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
And the point where growth starts to slow is likely to be a function of the level of "social infrastructure" (Hall and Jones, QJE, 1999) in society. Short of a major change in institutional quality in China and India, resulting in substantial reductions in corruption, expect GDP growth to slow at much lower per capita levels in these countries than it did in Hong Kong, which enjoys an excellent, corruption-free administration, at least by comparison.
Even this may be optimistic. Hong Kong has endured no major crises over that period shown on the grapth. Sure, 1989 and the Asian Financial Crisis shook up markets, but there have been no major events that have significantly threatened the functioning of the economy or the political structure of Hong Kong since our data begins in 1961. Will the same hold true for China and India over the coming decades? We can only hope so.
Tuesday, October 2, 2007
Mysterious Markets....
So the markets have decided that the credit crunch is over, and equity valuations have jumped. The DJIA is at all time highs, and closer to home, the HSI is growing in leaps and bounds. What is going on here?
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.
The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.
The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.
If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....
Tuesday, September 25, 2007
Hong Kong's Money...
Want to know how monetary policy is really set in Hong Kong, and the intricacies of the Currency Board system? Look no further than "Hong Kong's Money," a new book written by Tony Latter and Published by Hong Kong University Press. Mr Latter is a former Deputy Chief Execuative of the Hong Kong Monetary Authority, and his association with monetary policy stretches back to the formation of the currency board in 1983. But his understanding of Hong Kong's monetary history stretches back a long way before then....
Friday, September 21, 2007
Arbitraging the HKD
"What is the role of arbitrage in HK's exchange rate arrangement?" - Vincent
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
Arbitrage plays an important role in ensuring that the interest rate in Hong Kong remains close to the value in the United States. To illustrate this point, suppose interest rates in Hong Kong were significantly higher than in the United States. It would then be profitable to borrow large sums of money in the United States, convert them into Hong Kong dollars, and deposit them in the Hong Kong banking system- because the interest income earned on your HKD deposits would exceed the interest that must be repaid on your US dollar loan. When the loan comes due, you would withdraw your HKD deposit, convert it back to USD, repay your USD loan, and have money left over!
Of course there are more efficient ways of taking highly leveraged positions to benefit from any interest rate mis-match. Using currency futures markets, you could take a long position in HKD and a short position in USD- if the exchange rate remains fixed, your profits would be approximately equal to the difference between the interest rates in the two economies, multiplied by the size of your position held.
When investors take advantage of interest rate differentials like this, the very act of arbitraging will move interest rates closer together- borrowing USD will raise the US interest rate, and lending HKD will lower the HK interest rate. So interest rates in HK will remain close to those in the US- adjusted for relevant risks between the two markets.
The above argument only applies to currencies with fixed exchange rates. For most currency pairs, there may be large and persistent differences between interest rates, as taking leveraged positions across currencies is very risky due to exchange rate volatility. Exchange rate movements are often large, and may more than cancel out any gains from trying to arbitrage away interest rate differentials- see the previous story about the volatility of the Canadian dollar. But the presence of exchange rate volatility doesn't stop people trying to profit from interest rate differentials. Strategies designed to take advantage of this are typically referred to as the "Carry Trade." For an earlier discussion about this, see the comments here.
Tuesday, September 18, 2007
China Trade is Changing....
According to this story, the structure of Mainland China trade is changing. In the past, China imported intermediate goods from the rest of Asia, assembled them into final goods, and exported the final goods to the Western world. Thus China ran a massive trade surplus with the US, while running a trade deficit with most of Asia.
This appears to be changing, with China importing more raw materials and constructing the intermediate goods within its borders. If this process continues, China's continued growth will increasingly come at the expense of the rest of Asia, who will no longer assured of a large market for their intermediate goods.
However, an exploding trade surplus is neither efficient nor optimal for China in the long run. If China continues on its current development trajectory, I expect Mainland demand for finished goods imports to grow rapidly, as consumers demand access to the vast range of goods and services available elsewhere. The beneficiaries from this process will be final goods producers (such as Japan, Korea, and Europe), rather than the less developed intermediate goods producers who have done so well off China's growth to date.
See the full story here.
This appears to be changing, with China importing more raw materials and constructing the intermediate goods within its borders. If this process continues, China's continued growth will increasingly come at the expense of the rest of Asia, who will no longer assured of a large market for their intermediate goods.
However, an exploding trade surplus is neither efficient nor optimal for China in the long run. If China continues on its current development trajectory, I expect Mainland demand for finished goods imports to grow rapidly, as consumers demand access to the vast range of goods and services available elsewhere. The beneficiaries from this process will be final goods producers (such as Japan, Korea, and Europe), rather than the less developed intermediate goods producers who have done so well off China's growth to date.
See the full story here.
Monday, September 17, 2007
HK and US inflation....
"Why Must the HK inflation rate stay close to the US inflation rate in the long run?" - Ronnie
In the long run, the inflation rate must be similar across any countries with a fixed exchange rate. Consider the alternative: suppose prices in HK were to increase at a much faster rate than in the US? Given enough time, it would be profitable to buy goods in the US, export them to HK, and sell them at a profit. The act of such arbitraging would put upward pressure on prices in the US (since demand in the US would rise), and downward pressure on prices in HK (since supply would increase), thus pushing their inflation rates closer together.
This argument strictly only holds for tradeable goods- for non-tradeables (for example haircuts and apartment rentals), it's impossible to arbitrage away price differences, since there's no gain from renting an apartment in the US if you live in HK, no matter how much cheaper it is! But tradeables are a large enough portion of the total consumption bundble (about 40%-70% of goods in the CPI) that HK and US inflation rates will always tend together in the long run- provided the exchange rate remains fixed.
In the long run, the inflation rate must be similar across any countries with a fixed exchange rate. Consider the alternative: suppose prices in HK were to increase at a much faster rate than in the US? Given enough time, it would be profitable to buy goods in the US, export them to HK, and sell them at a profit. The act of such arbitraging would put upward pressure on prices in the US (since demand in the US would rise), and downward pressure on prices in HK (since supply would increase), thus pushing their inflation rates closer together.
This argument strictly only holds for tradeable goods- for non-tradeables (for example haircuts and apartment rentals), it's impossible to arbitrage away price differences, since there's no gain from renting an apartment in the US if you live in HK, no matter how much cheaper it is! But tradeables are a large enough portion of the total consumption bundble (about 40%-70% of goods in the CPI) that HK and US inflation rates will always tend together in the long run- provided the exchange rate remains fixed.
Sunday, September 9, 2007
Interest Rates and Recessions....
"Why do bond prices increase in a recession?" - Catherine
That's an excellent question! First not all bond prices necessarily increase.... it depends in part on the conduct of monetary policy, as we'll see.
But first lets step back and think about how bonds work. A bond is a financial asset that will pay out a fixed sum of money at some point in the future, along with a stream of interest payments until then. Without loss of generality, we'll ignore the interest payments, since they can be accounted for by appropriately adjusting the bond price. So we'll focus on a bond that pays only at maturity.
Suppose you hold such a bond. For the purpose of our example, we'll suppose that the amount paid at maturity is $1. Further, suppose that the bond has a market price today of $B. The return (or interest rate) on that bond until maturity can be easily computed as Int = (1-B)/B. That is, the return less what you paid for the bond, divided by what you paid. The point to notice is that the interest rate is inversely related to the bond price: an increase in B causes Int to fall, and vice versa.
So we've established that the bond price and the interest rate that the bond pays are inversely related. Now, in a recession bond prices may increase significantly, for at least two reasons:
1) "flight to quality." Uncertainty about the state of the economy may lead investors to be worried about holding too many equities or other risky assets, and instead wish to hold relatively low risk assets like bonds instead. If investors start buying bonds in large numbers, the demand for bonds rises, driving up the price of bonds. The increased price of bonds provides a windfall for existing bond holders, and results in interest rates falling (as per our formula above).
2) monetary policy. In many countries, the central bank sets monetary policy to try to stabilise the economy in response to shocks. In a recession, they seek to reduce the severity of the economy by cutting interest rates and stimulating demand. But if interest rates for some classes of assets start to fall, investors will re-allocate their investment portfolios to take advantage of the new lower interest rates. The end result will be that interest rates tend to fall across most classes of assets. Again, a fall in interest rates on bonds implies an increase in bond prices, and therefore a gain for existing bond holders.
Of the two effects outlined above, 2) is the most important, as the case of Hong Kong illustrates. Here the Currency Board mechanism ensures that monetary policy is committed to maintaining the fixed exchange rate, rather than stabilising the economy in response to shocks. So the central bank cannot cut interest rates in response to a recession.
Further, the fixed exchange rate ensures that interest rates remain similar between Hong Kong and the United States; otherwise arbitrage opportunities would open up (borrowing money at low interest rates in one economy to lend at higher interest rates in the other economy). Given the relative sizes of the Hong Kong and US economies, that means our interest rates will tend to fall when the US has a recession, regardless of what is happening in Hong Kong!
So if you think there's going to be a recession in Hong Kong, holding Hong Kong Dollar denominated bonds is unlikely to offer much protection, or prospective profits!
That's an excellent question! First not all bond prices necessarily increase.... it depends in part on the conduct of monetary policy, as we'll see.
But first lets step back and think about how bonds work. A bond is a financial asset that will pay out a fixed sum of money at some point in the future, along with a stream of interest payments until then. Without loss of generality, we'll ignore the interest payments, since they can be accounted for by appropriately adjusting the bond price. So we'll focus on a bond that pays only at maturity.
Suppose you hold such a bond. For the purpose of our example, we'll suppose that the amount paid at maturity is $1. Further, suppose that the bond has a market price today of $B. The return (or interest rate) on that bond until maturity can be easily computed as Int = (1-B)/B. That is, the return less what you paid for the bond, divided by what you paid. The point to notice is that the interest rate is inversely related to the bond price: an increase in B causes Int to fall, and vice versa.
So we've established that the bond price and the interest rate that the bond pays are inversely related. Now, in a recession bond prices may increase significantly, for at least two reasons:
1) "flight to quality." Uncertainty about the state of the economy may lead investors to be worried about holding too many equities or other risky assets, and instead wish to hold relatively low risk assets like bonds instead. If investors start buying bonds in large numbers, the demand for bonds rises, driving up the price of bonds. The increased price of bonds provides a windfall for existing bond holders, and results in interest rates falling (as per our formula above).
2) monetary policy. In many countries, the central bank sets monetary policy to try to stabilise the economy in response to shocks. In a recession, they seek to reduce the severity of the economy by cutting interest rates and stimulating demand. But if interest rates for some classes of assets start to fall, investors will re-allocate their investment portfolios to take advantage of the new lower interest rates. The end result will be that interest rates tend to fall across most classes of assets. Again, a fall in interest rates on bonds implies an increase in bond prices, and therefore a gain for existing bond holders.
Of the two effects outlined above, 2) is the most important, as the case of Hong Kong illustrates. Here the Currency Board mechanism ensures that monetary policy is committed to maintaining the fixed exchange rate, rather than stabilising the economy in response to shocks. So the central bank cannot cut interest rates in response to a recession.
Further, the fixed exchange rate ensures that interest rates remain similar between Hong Kong and the United States; otherwise arbitrage opportunities would open up (borrowing money at low interest rates in one economy to lend at higher interest rates in the other economy). Given the relative sizes of the Hong Kong and US economies, that means our interest rates will tend to fall when the US has a recession, regardless of what is happening in Hong Kong!
So if you think there's going to be a recession in Hong Kong, holding Hong Kong Dollar denominated bonds is unlikely to offer much protection, or prospective profits!
Subscribe to:
Posts (Atom)