(Reprinted from HKCER Letters, Vol. 8, May 1991)
Advantages of the Current Linked Rate System
for the Hong Kong Dollar : A Restatement
John G. Greenwood
Hong Kong has experienced numerous different monetary standards during its 150-year history. In the early years of the colony up to 1935, Hong Kong was on the silver standard. From 1935 to 1972, Hong Kong was on a sterling standard, i.e., the price of the Hong Kong dollar was fixed in terms of sterling. However, in 1967, when the dollar-sterling rate was changed from $2.80 to $2.60 the Hong Kong dollar-sterling rate was also changed from HK$16 per pound to HK$14.5 per pound. From 1972 to 1974, the Hong Kong dollar was fixed to the U.S. dollar, i.e. Hong Kong was on a U.S. dollar standard. Then, in November 1974, the Hong Kong currency was floated, and it remained floating, though with periodic official intervention, until October 1983. Finally, after a period of severe instability culminating in a run on the currency in September 1983, the currency was repegged to the U.S. dollar in October 1983, and it has remained firmly pegged to the U.S. dollar for the past seven and a halfyears.
Despite recent criticisms to the contrary, the U.S. dollar standard is a sound and stable basis for Hong Kong's monetary system. The inflation which Hong Kong is currently experiencing is more a product of changes occurring in the economy than problems in the monetary system. Sometimes it is argued that a managed, foreign exchange mechanism or a basket arrangement for the Hong Kong currency would solve some of the territory's problems, but a full analysis shows that it would not provide stability. This short article explains the reasoning behind these propositions.
Results of the Linked Rate System
One of the more obvious results of the link between the Hong Kong dollar and the U.S. dollar is to keep Hong Kong's money market interest rates closely in line with money market interest rates for the U.S. dollar. Occasionally there have been substantial deviations -- notably in July 1984, in late 1985, in December 1986, and in January 1988 -- due to large inflows or outflows.
These deviations between Hong Kong dollar interest rates and U.S. dollar interest rates occur either when there is an "internal drain" (i.e., a run on a bank in Hong Kong with depositors converting deposits to currency) or when there is an "external drain" (i.e., a speculative inflow or outflow of currency in anticipation of an upward revaluation or a downward devaluation of the Hong Kong dollar). Prior to 1988, these episodes threatened to become quite serious on account of the fact that the authorities had only partially implemented the pegged rate system. (By only granting convertibility of the Hong Kong dollar at 7.80 per U.S. dollar to the banks and not to the public, the effectiveness of the link was significantly reduced.) However, since July 1988, these deviations have been much less serious because certain central banking mechanisms have been added to the government's armory of monetary weapons, and as a result, official intervention operations have been much more effective.
The resulting alignment of money market interest rates in the Hong Kong and U.S. dollar credit markets is an example of what economists call the "law of one price," i.e., the tendency for prices of homogeneous products in different markets to equalize -- in this case, the price of credit in two currencies whose values are locked together.
At another level, a second result of the fixed link between the Hong Kong dollar and the U.S. dollar has been the enhanced stability of the growth of the quantity of money in Hong Kong. Before the pegged rate system for the Hong Kong dollar was implemented in October 1983, Hong Kong's monetary growth was highly unstable. Monetary growth fluctuated between zero rates of growth and 40 percent rates of growth (see Chart 1). There can be no doubt that these fluctuations added to speculative activity on the stock market and in the real estate market in Hong Kong, and more seriously, they amplified the magnitude of business-cycle fluctuations. In short, Hong Kong suffered from a severe form of stop-go. Since October 1983, it is very clear that monetary growth has been much more stable -- varying in the range of 10 percentto 25 percent instead of 0 to40 percent. Generally speaking, under the linked rate system, monetary growth accelerates during an export-led boom and decelerates during a period of economic slowdown overseas. This degree of instability is probably unavoidable given the openness of the Hong Kong economy.
A third crucial and fundamental result of the linked rate system for the Hong Kong dollar has been to tie the price level of Hong Kong's exports (i.e., traded goods) to the level of internationally traded goods prices in the U.S. This is clearly shown in Chart 2, which shows the levels of "traded goods" (export) prices in Hong Kong and the U.S., and the levels of consumer prices in the two economies. Since the implementation of the linked rate system (allowing one year for the effects of the currency crisis in 1983 to work through the system), the prices of "traded goods" in Hong Kong and the United States have remained roughly in line. This is another manifestation of the "law of one price" -- in this case, the tendency under fixed exchange rates for traded goods prices to move in line together.
The Problem of CPI Inflation
By contrast, since 1983, Hong Kong consumer prices have behaved rather differently from export prices. This has given rise to concerns in some quarters that the linked rated system may somehow be undermined by CPI inflation in Hong Kong. It has also caused concern among some who feel that it is eroding the living standards of people in Hong Kong and that therefore concrete measures should be taken to limit the growth of consumer prices. Both these anxieties are misplaced. First, it is traded goods which matter so far as the competitiveness of the Hong Kong dollar is concerned. Therefore, as long as the particular mix of goods and services which Hong Kong is selling abroad remains competitive, Hong Kong can continue to compete internationally at the fixed 7.80 rate. At times (such as the present), manufacturers may receive signals from the comparative level of prices that there are certain kinds of activities which are no longer competitive in Hong Kong, and this will cause the "basket" of goods produced in Hong Kong to change. Second, as far as living standards are concerned, wages regularly increase faster than consumer prices in Hong Kong during an upswing of the business cycle. In other words, for the vast majority of the population, real wages are rising, giving them a progressively higher standard of living.
To understand the behavior of Hong Kong's consumer-price inflation relative to the price of traded goods it is useful to examine the experience of Japan and the U.S. under the Bretton Woods system of fixed exchange rates. Between April 1949 and August 1971, the Japanese yen was pegged to the U.S. dollar at 360 yen = US$1.00. As shown in Chart 3, throughout this period,the price of Japanese exports remained very much in line with the price of U.S. exports; over the period, Japanese export prices rose at 1.6 percent per annum while U.S. export prices rose at 1.7 percent per annum. However, Japanese consumer prices rose at roughly double the rate of U.S. consumer prices, i.e., 4.4 percent per year as compared with 2.3 percent per year for U.S. consumer prices. The explanation for this is that productivity in Japan was rising much more rapidly than in the U.S., and therefore, incomes in Japan's service sector were able to rise without Japan as a whole losing competitiveness. Japan's CPI reflected the rise in service costs or, equivalently, the rise in wages in the service sector.
In the same way that Japan was shifting from agriculture to manufacturing, and from manufacturing to services in the post-World War II years, so Hong Kong today is experiencing a major change in the composition of its labor force and output or GDP. With the termination of relatively free immigration as a result of the abandonment of the "Touch Base" policy in October 1980, Hong Kong's labor force is no longer able to expand "horizontally" by importing low-skilled workers for the construction and manufacturing industries, so that Hong Kong today is being compelled to improve the productivity of its labor force through training and education. Lower value-added tasks such as assembly for simple manufactured goods are being shifted over the border into Guangdong Province. As a result, despite lower growth of the population and labor force in Hong Kong and relatively low rates of growth of GDP, per capita incomes in Hong Kong are rising quite strongly -- more rapidly than in the U.S. Today, with the Hong Kong dollar pegged to the U.S. dollar, and real incomes or productivity in Hong Kong rising more rapidly than real incomes or productivity in the U.S., as Hong Kong shifts from manufacturing to services, we can observe a very similar phenomenon to that observed in Japan under the Bretton Woods system. Traded goods prices in Hong Kong and the U.S. have remained very much in line while consumer prices in Hong Kong have been rising at roughly double the rate of increase of consumer prices in the U.S.
The Proposal to Shift to a Basket Link
Proponents of alternative monetary systems for Hong Kong frequently imply that Hong Kong's CPI inflation would be solved by a basket arrangement for the Hong Kong dollar. It should be noted by those who argue for a basket arrangement for the Hong Kong dollar that even if the Hong Kong dollar were stronger than 7.8, i.e., 7.50 or 7.00, Hong Kong's consumer price inflation would (a) considerably exceed inflation in our traded goods sector, and (b) would still substantially exceed the average of consumer price inflation in the countries whose currencies were included in the basket. In short, a basket arrangement would not solve Hong Kong's inflation problem. Those who take this viewpoint should also note that a stronger Hong Kong dollar would also accelerate the structural changes occurring in the Hong Kong economy, i.e. the already rapid decline in the number of people employed in manufacturing in Hong Kong.
Another argument put forward by advocates of a basket arrangement is that the Hong Kong dollar is fixed to the U.S. dollar which has been inherently unstable. However, the trading partners of Hong Kong are by no means the same as the trading partners of the U.S., and it is quite clear from even a brief examination of the data that the trade-weighted exchange rate index of the Hong Kong dollar has been much less unstable than the nominal effective exchange rate index of the U.S. dollar. The main reason for this is that in recent years China has kept its currency effectively pegged to the U.S. dollar, while at the same time it has become a major trading partner of Hong Kong. Taking the U.S. and China together, they now account for some 47 percent of Hong Kong's total external trade or 45 percent of Hong Kong's domestic exports and retained imports.
Furthermore, if we compare the movement of the trade-weighted index (i.e., nominal effective exchange rate) for the U.S. dollar with other major currencies in recent years, it is quite clear the U.S. dollar has been more stable than either the yen or the pound sterling, and only the DM among the major currencies has been on average more stable. The reason the DM has been more stable in terms of its nominal effective exchange rate index is that the DM is at the center of the European Exchange Rate Mechanism, and much of Germany's trade is with countries which are members of the ERM. In other words, Germany is in a similar position to Hong Kong, having most of its trade with countries to whose currency the DM is pegged. Moreover, if we consider that the vast majority of capital movements into and out of Hong Kong are in U.S. dollars, then taking the balance of payments as a whole, it is abundantly clear that the U.S. dollar is the right currency for the Hong Kong dollar to be pegged to. In sum, the case for maintaining the Hong Kong dollar's single currency link with the U.S. dollar is at least as powerful as the argument for keeping the DM in the ERM.
There is one other aspect of the proposal to link the Hong Kong dollar to a basket of currencies which is seldom alluded to by its proponents -- namely, the problem of how to operate the note-issuing system in Hong Kong under such an arrangement. At present, under the current single-currency linked rate system, all banks must pay U.S. dollars in the ratio of 1:7.80 to the Exchange Fund for every Hong Kong dollar bank note they issue (if they are a note-issuing bank) or receive from a note-issuing bank (if they are a non-note issuing bank). Conversely, they will receive U.S. dollars in the same ratio for every Hong Kong dollar bank note redeemed or taken out of circulation. It is this convertibility of the Hong Kong dollar at a fixed price which is the cornerstone of Hong Kong's monetary system today.
Now suppose that a basket arrangement is introduced to replace the fixed, single-currency link to the U.S. dollar. How will the note-issue mechanism operate?
Let us consider the case where the Hong Kong dollar is defined in terms of a fixed but limited basket of foreign currencies, e.g., the U.S. dollar, the Japanese yen and the DM. To be specific, we shall take the case where HK$1000 is defined as US$100 plus 2000 yen plus 25 DM. The banks will immediately wish to avoid the inconvenience of paying to and receiving from the Exchange Fund mixed baskets of currency in these ratios, so an agreement would no doubt very quickly be devised to pay U.S. dollars in amounts corresponding to these ratios at exchange rates prevailing at a specified time of day. The rate for the Hong Kong dollar against the U.S. dollar would still be the crucial centerpiece, except that instead of remaining fixed at 7.80, it would be changing from day to day.
Problems with the Basket Proposal
This type of system has three main problems associated with it. First, for "the man.in the street" or, perhaps more importantly, for the Hong Kong-based manufacturer of exported goods, the certainty that was previously associated with the 7.80 rate would disappear. I am frequently told by businessmen -- exporters and importers -- how relieved they were when the Hong Kong dollar was fixed in October 1983, and how awkward it would be for them if it were now to be shifted to a variable exchange rate system. My conclusion is that there would have to be other substantive advantages which would outweigh the loss of the certainty of the 7.80 rate before it would be worthwhile changing the system.
A second type of difficulty inherent in moving to this kind of basket system relates to the question of interest rates. Even with the Hong Kong dollar rigidly fixed to the U.S. dollar, there is considerable variation between Hong Kong dollar interest rates and U.S. dollar interest rates. If a basket system were adopted, it would be much more difficult to know what Hong Kong interest rates should be at any point in time, and this would further undermine the certainty and stability associated with the single-currency, fixed-rate link to the U.S. dollar.
Finally, the third drawback to the basket system, and one which I consider much more serious in the longer term, concerns the question of the composition of the basket. Whatever the initial ratios or weights for the component currencies of the basket, Hong Kong's trade and payments structure will change over time, leading to calls for a shift in the composition of the basket. Exporters would argue for the inclusion of weaker currencies; importers would argue for the inclusion of stronger currencies. Within a short space of time, I think it can be confidently predicted that Hong Kong would shift from a fixed basket to a variable or discretionary basket -- in other words, the level for the Hong Kong dollar currency against other currencies would be decided on a day-to-day basis by bureaucrats. These individuals would inevitably become the focus of great political pressure from a variety of interest groups -- exporters, importers, mortgage borrowers and others. In short, I believe that moving to a basket arrangement for the Hong Kong dollar would make our system much more subject to political pressures than it currently is. The Hong Kong dollar is currently subject to a monetary rule: convertibility of the bank notes at a fixed rate of HK$7.80 equals US$1.00, which minimizes the possibility of political manipulation. Moving to a basket system would soon make our currency system subject to bureaucratic discretion, which in turn would greatly enhance the likelihood of political interference in the system.
In conclusion, the current linked rate system for the Hong Kong dollar provides Hong Kong with monetary stability in four fundamental ways which would not be assured under either a basket arrangement or under a floating rate system. First, the fixed link with the U.S. dollar at HK$7.80 ties interest rates in Hong Kong closely to U.S. dollar interest rates. Second, it ensures greater stability for monetary growth than in the pre-link days. Third, it anchors the prices of "tradable goods" in Hong Kong to the price level of internationally traded goods in the U.S., by far the largest market in the world. Regrettably, however, the linked rate system does not guarantee stability of the CPI in Hong Kong, nor does it even ensure that Hong Kong's CPI remains in line with the CPI in the U.S.. As in the case of Japan under the Bretton Woods pegged exchange rate system, Hong Kong's CPI increases are likely to exceed increases in the U.S. CPI for some years to come. This is mainly a result of structural changes in the economy as Hong Kong shifts to a high value-added, service-based economy serving both the Asian region and the Guangdong hinterland. Since these changes would be occurring no matter what monetary system Hong Kong adopted, even a basket arrangement would provide no guarantee of price stability in Hong Kong. Finally, the supreme advantage of the fixed link is that it is clearly fixed at 7.80 and not subject to political, bureaucratic, or technical manipulation. In combination with the absence of foreign exchange controls, this gives Hong Kong citizens a far greater degree of freedom, certainty, and stability than almost anything else in Hong Kong's unwritten constitution except perhaps the rule of law itself.
Mr. John G. Greenwood is Chairman and Chief Economist of G.T. Management (Asia) Ltd.