Is Hong Kong Ready To Delink the Currency?
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
Dr. George Yu is assistant professor in the School of Economics and
The University of Hong Kong.
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