Is Hong Kong Ready To Delink the Currency?
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George Yu
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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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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.