In September 2008, Lehman Brothers went into bankruptcy, triggering a global financial meltdown that dragged many economies down and altered many lives. After 10 years, it is a good time to look into how the worst financial crisis of modern times has changed the landscape of global financial conditions, and what Hong Kong could potentially face as major central banks reverse the accommodative monetary policies they introduced to deal with the crisis.

Maintaining price stability is the single goal of both the European Central Bank (ECB) and the Bank of Japan, while the Federal Reserve has additional mandates to promote maximum sustainable employment and achieve moderate long-term interest rates. Prior to the global financial crisis, central banks had a fairly narrow scope of responsibilities, but not any more. Without actually changing their mandates, central banks are now playing a much more significant role in ensuring economic and financial stability. 

As short-term interest rates had already been lowered to close to zero soon after the crisis, the central banks expanded their toolkits to clean up the mess and provide liquidity to keep the financial system afloat. In particular, central banks introduced the unconventional quantitative easing (QE) programmes – the act of printing money to buy assets (mostly long-maturity) on a massive scale, thereby pulling long-term interest rates down in order to stimulate their economies. 

As a result, the sizes of the balance sheets of major central banks have ballooned over the past decade (Figure 1). The Federal Reserve’s portfolio has become much larger than in any time in history, increasing from roughly US$890 billion at the end of 2007 to US$4.2 trillion at present. During the same period, the Bank of Japan’s assets have also grown from 111 trillion yen to 551 trillion yen, and ECB’s from 1.508 trillion euro to well over 4 trillion euro. Despite the recent uptick, longer-term government bond yields have been on a downward trend over the past decade, thanks to monetary easing (Figure 2). 

The QE experiment can be said to be successful in some ways, as it reduced the severity of the global economic downturn and prevented a repeat of the Great Depression in the United States in the early 1930s. The famous “whatever it takes” commitment by ECB chief Mario Draghi in 2012 restored financial confidence in the Eurozone, but most would agree that asset purchases on such a scale by central banks have helped inflate asset prices across the globe, as these policies have had spillover effects through cross-border capital flows. Investors searched for assets with higher returns as government bond yields in traditional markets had declined. 

Under the currency peg system, Hong Kong does not practise discretionary monetary management. Instead, it imports monetary policies directly from the United States. Therefore, unlike other places with independent monetary policies, the Hong Kong Monetary Authority cannot adjust interest rates as easily as it wishes, even if asset bubbles emerge. Consequently, Hong Kong, as an international financial centre with free movement of capital, has seen its monetary base and asset prices, such as housing prices, rise significantly over the past decade (Figure 3).

Everything will come to an end, and so will the ultra-loose monetary policies carried out by major central banks. According to the plan announced by the Federal Reserve last September, the Fed targets to reduce its holdings by up to US$420 billion in 2018, and up to US$600 billion a year thereafter until it regards the balance sheet as normalized enough “to a level appreciably below that seen in recent years but larger than before the financial crisis.” Total assets on the Fed’s balance sheet dropped from US$4.46 trillion in early October last year to $4.218 trillion by the end of August 2018. 

The Fed has also raised interest rates eight times since 2015. While the Bank of Japan has not outlined a timetable for scaling back QE, the ECB is expected to stop buying bonds at the end of the year; and the Bank of England raised interest rates to above 0.5% in August for the first time since the financial crisis. 

The reversal in dollar liquidity is of particular concern. The question now is what the retreat of QE and the gradual tightening of monetary policies – or at least the less accommodative global financial conditions – would bring to Hong Kong’s economy. 

Tightening of financial conditions is one major headwind facing Hong Kong, which has been overshadowed by the market’s recent focus on the China-U.S. trade war. In theory, if cheap money has in effect fuelled the boom in Hong Kong’s asset prices over the past decade, an asset price correction, such as a cooling of the housing market, would occur when the same money flows out of the city. This might have a more acute impact on the general public through wealth effects, compared to what a trade war could do. 

As Hong Kong’s monetary base has dropped in recent months and liquidity conditions in the interbank market have become tighter, most commercial banks have raised their mortgage interest rates in August for new borrowers. The rise in the prime rate in late September applies to existing mortgage loans and other types of borrowings, exerting larger impacts on the real economy. Higher interest rates will benefit savers, but they cause pain to borrowers. 

The impact on Hong Kong will depend on the pace of monetary policy normalisation. Although global market volatility has been on the rise, major central banks are clearly aiming to move away from ultra-loose monetary policies, in order to prevent unintended vulnerabilities built up in the economy, and give themselves a cushion for any future crisis. 

It is hard to predict the extent of the impact, as there is no history yet of such a reverse of QE, and the escalating trade war and the uncertainties it brings have complicated the situation. Nevertheless, one thing is certain: volatility is unavoidable in the process during the reversing course from QE. 

While Hong Kong has introduced some macroprudential measures over the past few years to enhance the resilience of the financial system, the recent emerging markets’ turbulence reminds us that any economy could be battered regardless of its fundamentals. It is difficult for an economy to stay immune in an increasingly integrated global financial market. 

On the bright side, central banks have generally become more transparent in the post-crisis era. The use of forward guidance to steer expectations about the economy and the likely future course of monetary policies should help reduce the chances of overreaction by the market.