The US subprime mortgage problem has developed into a credit crisis that may trigger economic recession, Hong Kong Monetary Authority Chief Executive Joseph Yam says, and financial-market volatility is expected to persist. But he adds Hong Kong��s banking system is robust, healthy and well regulated.

In a written paper submitted to the Legislative Council's Panel on Financial Affairs today, Mr Yam said the recent financial turbulence did not have a systematic impact on Hong Kong's economy.

However, the recent market situation was worrying and individual banks in Hong Kong might suffer from their investment in asset-backed securities, he said.

In case of a hard-landing of the US economy or a continued slump in the US housing market, and if tightened credit conditions persist or get worse, growth might fall sharply. The impact on Hong Kong would be larger if the housing difficulties spill over to other sectors of the economy.

Banking system unaffected

Given the uncertainties regarding the outlook for the global financial markets and the global economy, Hong Kong could be affected through both the real economy and financial-market channels.

The subprime problem had no systemic implication for Hong Kong's banking sector and did not affect banks' overall safety and soundness as the aggregate sub-prime exposures were not material relative to their total assets.

The Hong Kong banking sector remains highly liquid, as the amount of customer deposits grew faster than that of loans.

Mr Yam said the market outlook for 2008 remains uncertain, though Hong Kong can withstand the financial turbulence with good risk management. He urged banks to set aside provisions and bad debts for assets affected by the subprime problem.

The authority has launched a tap issue of 91-day Exchange Fund Bills totalling $6 billion. Mr Yam said this issue has no significant impact on the Hong Kong dollar exchange rate and interbank interest rates.

The gap between one-month Hong Kong Interbank Offered Rate and the Exchange Fund paper yield had narrowed to about 100 basis points in mid-January, with the discount larger than normal. The authority may take further smoothing action as remaining discounts will be major concerns in the monetary market in the coming months.

Inflation expected to rise

There are other factors affecting currency stability, including local inflation, and the Mainland's monetary and financial conditions.

Mr Yam said there has been a rising trend in inflation. Rent increases were the main driver of underlying inflation, on top of the recent food-price rises and the weak-US-dollar effect.

Consumer prices are expected to rise further, reflecting recent rises in food prices, the US dollar's weakness, a strong renminbi, continued passthrough of residential rents, and solid growth in domestic demand.

Strong labour-productivity growth has kept inflation in check. Growth in labour productivity, measured in output per worker, has been increasing at an average year-on-year rate of 4.9% since the third quarter of 2003.

The change in unit labour costs has been modest in recent years, suggesting inflationary pressure from wage increases remains limited.

Promoting renminbi business

Mr Yam said the Mainland's financial situation has a crucial impact on Hong Kong, and Mainland authorities had started to use administrative tools to stabilise prices.

He said it was necessary to use administrative tools, which have a faster and more obvious impact on the economy. However, the measures may distort the distribution of resources and increase the cost of solving the problems. The impact on the financial market and on industries' operations would be difficult to predict.

The authority will focus on renminbi business in Hong Kong, promoting the renminbi bond market's development and working on a proposal for settling bills for imports from the Mainland in renminbi.

It will also study the feasibility of using Hong Kong for the orderly outflow of Mainland funds by working closely with Mainland authorities on implementing pilot schemes for direct foreign-portfolio investments by Mainland individuals, and developing Qualified Domestic Institutional Investors schemes.

Mr Yam also noted the authority's human-resources challenge. The financial market's recent active performance has put pressure on the authority's human-resources management, especially departments related to marketing and banking businesses. He will ask the Governance Subcommittee to study and manage the issue.