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HONG KONG’S DOLLAR PEG July 2004 By: A. Chavali

Definition of a currency board A currency board is defined as a system by which one country’s currency is convertible with another currency at a fixed exchange rate. The primary goals associated with this mechanism are that of exchange rate stability, and macroeconomic discipline. Hong Kong’s currency has been pegged to the greenback at a fixed rate of 1US$=7.8HKD via the means of a currency board arrangement since October 17th 1983. The dollar peg (described by some as the “keystone of Hong Kong’s economy”) is one of the few remaining currency boards in the world following the collapse of a similar arrangement in Argentina several years ago.

History of Hong Kong’s Currency Board In July 1982, a major political row between the Chinese and British governments erupted concerning the future of Hong Kong as a British territory. The high levels of uncertainty and the lack of confidence in the economy at the time resulted in a significant degree of financial instability, capital flight and a fall in the value of the currency whose depreciation peaked on “Black Saturday” on 24th September 1983. The government then decided to peg the local currency to the greenback at the fixed rate of 7.8HKD =1USD in order to prevent the economy from collapsing. . The “dollar peg” (officially known as the linked exchange rate mechanism) was therefore set up with the primary objective of stabilizing the exchange rate and the financial system. The view was that this would help to restore confidence in the local economy, and provide an environment which was favorable to trade and foreign investment. It was seen as an end to the flexible exchange rates and the high degree of macroeconomic and financial volatility which were symbolic of the period from 1974-1983. The arrangement proved to be extremely successful in the end as it did help the economy to recover from the internal crisis of confidence, and avoid the possibility of financial collapse.

How does it work? Upward pressure on the exchange rate results from an increase in the demand for Hong Kong Dollars. The Hong Kong Monetary Authority (HKMA), effectively Hong Kong’s central bank, would then choose ( at its discretion) to buy US Dollars to counter this pressure, as it did in the second half of 2003. This would lead to an expansion in the monetary base, and a fall in interest rates, making the local currency less attractive to investors. Conversely, an outflow of capital caused by a fall in investor confidence would result in downward pressures on the exchange rate, as was the case during the Asian financial crisis. In the event that the rate reached 7.80, the HKMA would then respond by buying Hong Kong dollars at that particular rate. The size of the monetary base would then decrease. Interest rates would then increase, making the local currency more attractive to investors. The local currency is issued by the HSBC and the Standard Chartered Bank under the supervision of the HKMA. The peg mandates that the entire monetary base (defined in terms of Hong Kong dollar notes, EF bills and notes, coins and deposits with monetary authorities) is fully backed by reserves of foreign exchange (i.e. US dollars) at the linked exchange rate.

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The HKMA cannot issue new currency unless it has enough foreign reserves to back it, whilst the note issuing banks must hand over additional US dollars to match each increase. The resources for this backing are stored in Hong Kong’s Exchange Fund, which holds one of the largest supplies of foreign exchange reserves in the world today. Studies indicate that they were estimated to be at a level of 114 billion USD as of November 2003 - approximately 7 times the amount of money in circulation. This is crucial to maintaining the success of the dollar peg because it demonstrates strong internal commitment on the part of the local monetary authority. The Hong Kong Dollar is hence 100% convertible, because the monetary authority is required to hold enough foreign currency reserves to back every unit of local currency in circulation. Investors are therefore assured (on a de facto basis) that they can always switch to holding foreign currency in the event of a crisis. This in turn promotes increased levels of capital inflow and foreign investment, as it helps to reduce the risks of investing in the local currency. Such a high level of reserves renders Hong Kong’s linked exchange rate mechanism a strong and resilient currency board, and lends credence to the statement that the HKMA has the financial ability to defend the peg from speculators at whatever cost. The Dollar Peg has repeatedly been attacked by speculators since its conception 21 years ago. The most recent occurrence was during the Asian currency crisis, when many regional currencies came under immense speculative pressure. The currencies were seen as being overvalued in the light of deteriorating economic fundamentals. Every regional economy except Hong Kong experienced a sharp depreciation in the value of their currency as a result. The Hong Kong Dollar was the only currency which managed to retain its value, making it one of the most expensive currencies in the region at the time. The peg prevented Hong Kong from being able to adjust the external price for the Hong Kong dollar, and the economy was instead forced to endure a fall in its competitiveness, and in its domestic wages and asset prices. Studies show that the second half of the 1990s was indeed a period of considerable economic hardship with extremely high interest rates, zero or negative rates of economic growth, falling asset prices, high unemployment coupled with a fall in salaries, and a number of personal and corporate bankruptcies. The economy also experienced a sharp decline in its tourism sector as many tourists found that their currency was able to obtain less in Hong Kong than in the past. High unemployment and falling wages contributed to a fall in the overall level of aggregate demand, whilst the period of high interest rates also had a severe impact on the Hong Kong economy which is heavily dependent on real estate and financial services. Both sectors are highly sensitive to changes in interest rates.

Disadvantages of the linked exchange rate mechanism •

The currency board was imposed as a solution to the problems caused by the internal crisis of confidence in the early 1980s. Hong Kong was basically forced to peg its currency at a fixed rate on a particular day without being able to have a perfect forecast of future events. Whilst it can be argued that the mechanism has served Hong Kong well over time, the problem with this type of “rescue measure” is that it is extremely rigid and inflexible. The peg essentially prevents the government from being able to adjust the exchange rate accordingly in response to external shocks such as the 1997-98 currency crisis. Domestic wages and asset prices therefore have to adjust instead, whilst the peg also made Hong Kong less competitive in comparison to other regional economies due to the strength of the US Dollar in the past.

The local monetary authority has to relinquish all control over interest rates, because the dollar peg essentially requires them to follow the movements of US monetary policy. Hong Kong’s interest rates are essentially determined by the Federal Reserve (FED) in the US. The HKMA is therefore prevented from pursuing an independent

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monetary policy which might be more appropriate for the needs of the domestic economy. An example of this can be taken from the recession of the early 1990s, a period when the FED adopted a policy of low interest rates to encourage investment in the US economy. The low cost of borrowing and the undervalued Hong Kong Dollar led to the formation of an asset bubble in Hong Kong, which was primarily concentrated in the property sector. There was also the China factor in the development of an asset bubble in Hong Kong. Many mainland investors poured their funds into the local economy possibly in an effort to show their support for the new SAR. International fund managers soon followed suit, which led to escalating asset prices, and the emergence of bubble asset markets. Property prices in the 4th quarter of 1996 were extremely high. Still, the average price of homes increased by 50% over the following year, whilst stock prices for mainland companies continued to increase at that time. This indicated that economies which opt for a fixed exchange rate regime are also vulnerable to the risk of bubbles. •

Pressure on the exchange rate is a signal that the market believes that changes in monetary policy may be needed to sustain the rate of economic growth. The HKMA therefore needs to consider whether intervening in the exchange market should be done in conjunction with changes in monetary policy. The peg prevents them from doing so because they have no control over local monetary policy. This leads to capital flight, and deflation in asset prices.

There is also the issue of exit cost. This is related to the costs of quitting the peg. If the government undertakes certain measures in strengthening or guaranteeing the fixed exchange rate like they did in Hong Kong after the Asian crisis, they have to be willing to shoulder a large part of the burden when they do decide to de-link the peg because of factors which are outside their control.

Advantages of the linked exchange rate mechanism: •

The main argument for maintaining the dollar peg is for maintaining stability and restoring confidence in the local economy. The Peg plays a key role in this, as it helps to restore the confidence in the economic recovery from years of deflation, SARS, falling stock markets and high unemployment. The economy seems to be showing signs of a strong recovery (particularly in real estate and tourism) after the 2003 SARS health crisis. GDP growth is forecasted at 4% for the next couple of years. A number of mainland companies have also chosen to seek listings on the Hong Kong Stock Exchange, and this has led to the emergence of a strong market for Initial Public Offerings (IPO’s). Breaking the peg would result in a major decline in confidence in the economy, and a slowdown in the rate of economic recovery. It would also trigger off a new round of competitive devaluations around Asia and increased pressure on the RMB, as well as a massive sell off of assets and an increased level of capital flight from the region. The Chinese government would also have a more difficult task in helping firms which have been recently privatized by encouraging investment through Hong Kong.

Hong Kong seems to be showing more signs of diversification in its industries, with a movement of capital away from property management and trade for re-export to an increased development of human capital in areas related to management and hi-tech service industries. Examples of this include banking and telecommunications. Such products need stability in the exchange rate in order to encourage investment, and are less prone to exchange rate fluctuations than manufactured goods.

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The dollar peg plays an important role in the economy because of its role as an anchor. A fixed exchange rate is more optimal for a major financial centre like Hong Kong because of the 100% stability in the exchange rate. Hong Kong needs to maintain its reputation as a major financial centre in Asia. Investors benefit from the stability in the exchange rate because they can gauge the return on their investments accurately, and this leads to an increased level of confidence in the economy. Movements in capital caused by speculative attacks on the currency are also easier to prevent. The fixed exchange rate also helps to divert attention away from the exchange rate to other areas of the economy which are less easily influenced by fluctuations in the financial system.

Hong Kong has a small and open economy. That means that the business cycle is heavily influenced by what happens outside the local economy. Floating exchange rates may not lead to much monetary independence because local interest rates may not be too different from those in the US. For instance, studies show that there was hardly any difference between the 3 month HIBOR and the USD LIBOR in both cases of floating and fixed exchange rates.

What should be done? Hong Kong needs to think about whether the peg should be maintained, and if so, what level do we maintain it at? It is clear that the peg has served Hong Kong well in the past, but are there other systems which may be more useful for us given the changes in market conditions? The HKMA has repeatedly stated that it has no intention of de-linking the peg for its part, but analysts say some modifications will have to be made in future if the system is to remain in place. Several proposals have been put forward. •

Re-peg the local currency to the US Dollar at a higher rate given the appreciation of the local currency against the US Dollar in recent times. It is important to note that re-pegging the currency at a different rate is a lot easier said than done in reality. This is because the current system mandates that the local currency is issued at a fixed rate. Any decision to re-peg requires a change in the current framework, and careful thought over the exact level at which the currency should be re-pegged at. Any movements to re-peg the local currency could also be interpreted as a sign of a lack of commitment on the part of the government to maintain its firm commitment to the peg. This could therefore lead to an increase in capital flight, and a decline in confidence in the local economy as well as the Hong Kong Dollar.

Switch to a floating exchange rate system. The exchange rate is thus primarily determined by the market forces of supply and demand. Such a system would require the presence of an independent central bank that is capable of exercising monetary policy to affect the economy in an effective manner. Whilst it is true that the current central bank is already capable of making such decisions, it needs to be able to function in an independent and autonomous manner free from any political interference from the Financial Secretary. The government would need to think carefully about how to carry out this switch, and how this system would be viewed both locally and internationally. Evidence indicates that confidence in the local government is extremely low at this point in time. The government needs to be able to prove that it is fully capable of implementing important policies such as this before it can attempt this type of switch, otherwise the currency will only be more vulnerable to more speculative pressure in future. A floating exchange rate system would also lead to increased unpredictability in exchange rates and a fall in investor confidence in the local currency.

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Hong Kong is showing more signs of economic integration with the mainland. Many analysts have stated that the local currency should therefore be re-pegged to the RMB Yuan. The Yuan is however, only freely tradeable by exporters and importers. This means that a currency board based on the RMB and its present capital control regime would not be possible. A Yuan peg would reduce Hong Kong’s reputation as a major international financial centre, whilst it also may not provide the Hong Kong dollar with enough flexibility to adjust to the risk of continued external deflationary pressures.

Peg the Hong Kong dollar to a basket of currencies according to the amount of trade with each of these economies. The peg would then be managed within a certain band similar to the regime which is currently in place in Singapore. This system would provide a more flexible manner in which to adjust to external deflationary pressures, but it could also risk making the local currency more vulnerable to speculative pressure.

Dollarization - i.e. replace the local currency with the US Dollar. Many analysts believe that this would remove the risk of any speculative pressure in future because speculators would not have anything left to target in that case. All units of the local currency held in banks and in circulation would automatically be converted into US Dollars under this policy.

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HONG KONGS DOLLAR PEG  

• Pressure on the exchange rate is a signal that the market believes that changes in monetary policy may be needed to sustain the rate of ec...

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