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Hong Kong's economic planners should be asking themselves this: What if the Federal Reserve of the United States (Fed) abruptly ended its monetary easing program?

This could happen sooner than many economists expect, judged by the latest US economic data which suggested continuous improvement on the employment front. The most definite indication of a possible change in the Fed's policy came from Charles Evans, president of the Federal Reserve Bank of Chicago. In May, Evans was quoted as saying he expected the Fed will continue its bond-buying program, called quantitative easing, through the summer, but will end it abruptly in the autumn, if by then it is confident that the improvement in the jobs outlook is here to stay.

Indeed, the decline in the unemployment rate since the program was introduced two years ago has prompted some Fed officials to call for a slowdown in the purchase pace. Signs of the Fed's evolving stance on monetary easing in past months have caused jitters in the US and other international capital markets. Analysts have said they expect a continuation of the rough ride in coming months after Fed Chairman Ben Bernanke's testimony in US Congress last Wednesday in which he laid out the conditions that could lead to the trimming down of the bond-purchase program.

The Fed's program has a direct impact on Hong Kong because it has depressed the value of the US dollar to which the Hong Kong currency is pegged, and triggered a massive outflow of capital mostly to emerging markets, including the Chinese mainland, in search of higher returns. The resulting inflow of capital is known to have greatly pushed up asset prices in some emerging markets and the exchange rates of the local currencies.

It makes business sense for many companies, especially property developers, in emerging markets to borrow the depreciating US dollar at record low interest rates to fund investments in domestic projects that will generate income in the appreciating local currencies. This sounds reasonable except that an abrupt end to monetary easing by the Fed could upset the proverbial apple cart.

At the G20 meeting in April this year, the IMF raised concern about the potential impact on emerging markets caused by a sudden US exit from monetary easing and some other developed economies, notably Japan and Britain. In the worse case scenario, it could trigger a massive outflow of capital from emerging markets, resulting in a collapse in the price of assets, which are, in some cases, already overvalued.

The end of monetary easing could also lead to an increase in US interest rates and an appreciation of the US dollar, resulting in a sharp increase in debt-servicing costs to foreign currency borrowers in emerging markets at a time when the return of their domestic projects are depressed by falling prices. All of which makes it even more difficult for borrowers to meet their foreign debt obligations. This same vicious cycle triggered the outbreak of the Asian financial crisis in 1997 which brought down Hong Kong's property prices by an average 60 percent from their peak in just a few years.

Most Asian economies are now structurally stronger than in 1997, making them less vulnerable to sudden changes in financial variables. But Hong Kong is a different case because of the external-oriented nature of its economy and its rigid linked exchange rate system. For that reason, it will go through a different economic adjustment process to a reverse flow of capital. Unlike other economies, Hong Kong doesn't have an option to devalue its currency and, for that reason, the monetary tools available to its government for economic fine-tuning are limited.

Hong Kong's strength lies in its well-regulated financial market dominated by institutions with a long tradition of prudent management. But it is important at this time to take measures to limit the potential damage of the bursting of the housing bubble pumped up by overseas hot money. The crunch could come as early as the third quarter of this year.

The author is a current affairs commentator.

(HK Edition 05/28/2013 page1)