If the government itself is already heavily indebted or has incurred a huge amount of debts after bailing out the private sector or introducing measures to stimulate the economy, the market may start to doubt the sustainability of its fiscal position. A case in point is Ireland, where the government incurred a huge amount of liabilities by bailing out the banking system, calling into question the government’s fiscal sustainability and triggering the sovereign debt crisis. (f)  The crises unfolding in the US and Europe are not new to Asia. This region had its share of suffering during the Asian Financial Crisis of 1997/1998. In Hong Kong we went through almost seven years of painful economic adjustment after the burst of the property bubble in late 1997. Our economy shrank by 8.7% in five quarters. Unemployment increased fourfold from 2.1% to 8.5%. Property prices dropped by 70% in six years while the general price level fell by 15% in five years. The hard lesson we learned from our experience is to face the reality, take the pain in stride and do whatever it takes to restructure the economy, to increase productivity and improve competitiveness. If this can be done, it should be possible to return to the track of sustainable economic growth. BIS central bankers’ speeches  3  4  BIS central bankers’ speeches  BIS central bankers’ speeches  5
Researchers have documented and studied how asset valuations seem to move far more on news that affects risk premiums than on news on future cash flows. This was vividly illustrated by the market turbulence of 2008–2009, as well as the last few weeks. In their investigation of why risk premiums vary so much, researchers have moved far beyond the simplest models of introductory finance classes. Theoretical progress, data availability and computational advances have made it possible to study the implications of potentially important features:   investors are different and not necessarily fully informed or rational;    markets are incomplete and have frictions;    returns might have fat tails and face sudden disasters;    and government regulations are important. Models of investor heterogeneity, non-tradable, non-financial risk, market frictions and timevarying uncertainty go a long way in accounting for variations in market risk premiums. This has profound implications for portfolio theory and practical portfolio strategies. Modern portfolio theory builds on differences in defining characteristics between investors. Investors with distinctly different non-tradable, non-financial risk, who are affected differently by market frictions and regulations, should hold different portfolios. In the NBIM Strategy Plan for 2011–2013, we stated that we will implement an investment strategy built on the Fund’s defining characteristics – with strategies that are long-term oriented, scalable, and focused on underlying value. This sentence covers a wide range of interesting questions. All the speakers today will, in fact, offer perspectives on the challenges outlined here.