The recent turmoil in Hong Kong's financial markets caused by the tug of war
        between speculators and the Hong Kong Monetary Authority (HKMA) has
        sparked calls for reviewing Hong Kong's currency policy. While the majority of
        local academics support the Hong Kong dollar's peg to the U.S. dollar and have
        offered schemes to improve Hong Kong's prevailing currency board system,
        quite a few practitioners as well as some politicians have voiced their preferences
        in favor for a free-floating Hong Kong dollar.

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        As evident in Hong Kong's own experience in the past few years, the currency
        board system, despite the benefit of offering currency stability, has its inherent
        drawbacks. Under the currency board system, the HKMA essentially surrenders
        its power to adjust the territory's monetary policy to the U.S. Federal Reserve
        (Fed). As Hong Kong and the U.S. are at different growth stages, the inflow of
        cheap foreign investment--due to low interest rates in the U.S. over the past
        decade--has made Hong Kong vulnerable to inflation and to asset price bubbles.
        In addition, because the exchange rate cannot be adjusted, the currency board
        system reduces Hong Kong's ability to deal with external shocks, such as the
        recent currency crisis in Southeast Asia, and thus, could lead to excessive
        financial market volatility whenever there are speculative attacks on the Hong
        Kong dollar.

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        However, an alternative to the existing regime, namely, a free-floating Hong Kong
        dollar, is no impeccable solution either. First of all, Hong Kong's current
        economic, and, perhaps even political considerations, render unpegging a
        nonviable option at this moment in time. Secondly, Hong Kong's monetary
        system as it stands now does not meet the necessary conditions for a
        free-floating currency system to function effectively.

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        If Hong Kong were to abandon the currency peg to adopt a free-floating Hong
        Kong dollar, the HKMA would have to switch from its current policy of
        maintaining exchange rate stability under the linked exchange rate system to a
        different objective, for example, a macroeconomic goal of fighting inflation by
        controlling the money supply. To do successful, however, would require that the
        HKMA become a real central bank like the U.S. Fed, endowed with the full
        spectrum of monetary policy tools that can be used to adjust liquidity, that is, (1)
        bank reserve requirements, (2) discount window and (3) open market operations.
        But, unlike the Fed, the HKMA does not yet have all of these necessary
        monetary policy instruments to achieve healthy growth in the money supply, and
        ultimately, stable domestic economic growth.

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        Indeed, despite the fact that the HKMA has skillfully developed Hong Kong's
        version of discount window, the Liquidity Adjustment Facility (LAF), and has
        been actively utilizing it to adjust interbank liquidity to defend the currency peg,
        the HKMA is not yet a real central bank and still lacks the other two monetary
        policy tools in its weaponry.

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        First, Hong Kong does not have reserve requirements on banks operating in the
        territory, thus depriving the HKMA of the ability to directly influence the
        behavior of commercial banks, and consequently of the ability to affect the
        supply of money and credit in the banking system. Because Hong Kong has
        operated under a currency board system for most of its colonial history, and the
        traditional currency board system requires no more than minimum management,
        there was neither the need to have a central bank nor the necessity to introduce
        such a monetary policy tool. Indeed, because of these reasons, the HKMA was
        established only in 1993.

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        Second, although the HKMA has been conducting open market operations to
        adjust interbank liquidity for the past five years, it is questionable whether the
        HKMA would be able to effectively use open market operations to achieve the
        purpose of controlling money supply should it face a free-floating Hong Kong
        dollar in the future. Open market operations consist of purchases and sales of
        government debt securities by central banks in order to nudge interest rates.
        Because of their great flexibility, open market operations have been the primary
        tool of central banks in developed countries to regulate the pace of credit and
        money growth in the banking system and the most frequently used tool in
        making monetary policy changes.

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        In Hong Kong's case, however, not only does the lack of bank reserve
        requirements prevent the HKMA from using open market operations to directly
        influence the money supply, the meager size of Hong Kong's government debt
        market also makes the interventions by the HKMA less effective in affecting real
        economic activity and inflation. At the end of January 1998, the Hong Kong
        government debt securities market, consisting of total issues of the Exchange
        Fund Bills and Notes, was only about HK$93.5 billion, much less than the total
        volume of interbank transactions in the month. Although the petty government
        debt market has been the result of the Hong Kong government's prudent fiscal
        policy and Hong Kong's robust economic performance over the years, it
        nevertheless impedes the HKMA's ability to implement an effective monetary
        policy tool at this stage. As a result, should Hong Kong abolish the currency
        board system and adopt a floating Hong Kong dollar, the HKMA may not be
        ready to credibly and smoothly manage an effective monetary policy.

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        Therefore, unless the HKMA introduces a number of measures to enhance its
        ability to manage the growth of the money supply, Hong Kong would be better
        off staying with the prevailing currency board system, and exerting efforts to
        strengthening the link. Of course, if Hong Kong were to prepare for a floating
        currency, the HKMA may have to impose necessary reserve requirements on
        banks. In addition, in order for the HKMA to have effective intervention power
        in its monetary policy, it is also imperative to let the market rather than the Hong
        Kong Association of Banks set interest rates, so as to make the relationship
        between money supply and interest rates less distorted.

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ªº¯à¤O¡A­»´ä³Ì¦nÁÙ¬OÄ~Äò«O«ù²{¦¨ªºÁp¨t¶×²v¨î«×¡A¨Ã¤Þ¶i·sªº¾÷
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        Finally, only after the government debt securities market has grown to a
        substantial size, will the HKMA be able to use open market operations to
        fine-tune liquidity conditions in the banking system, and to ensure a monetary
        policy that could promote prosperity in Hong Kong. Unfortunately, the current
        volatile and high interest rates environment caused by the Asian financial crisis
        has made the government efforts of expanding the Exchange Fund Bills and
        Notes program more difficult. Therefore, the journey to turn HKMA into a real
        central bank that could effectively manage an appropriate monetary policy may
        take much longer, and Hong Kong would certainly benefit staying with the
        current linked exchange rate system.

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Dr. George Yu is assistant professor in the School of Economics and Finance,
The University of Hong Kong.
 
 
 

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