(Reprinted from HKCER Letters, Vol. 49, March 1998)
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 Kong dollar. 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 Finance, The University of Hong Kong.