(Reprinted from HKCER Letters, Vol.14, May 1992)
What Does Hong Kong Need a Central Bank For?
The Hongkong Bank has been viewed as a quasi-central bank for Hong Kong, with its prominent roles as a note-issuing bank, as the clearing bank, the bank for the government, and the lender of last resort. However, its announcement to shift domicile to the U.K. in late 1990, and its recent bid to merge with the Midland Bank, have raised concern over its commitment to the territory. Some critics believe there is the need for Hongkong Bank to shed its central bank functions, or at least for some of these functions to be shared by other institutions. The establishment of a central bank or some kind of monetary authority is also considered to be a clear alternative.
As a matter of fact, the power of Hongkong Bank over monetary affairs in the economy has been tremendously weakened since July 1988 with the introduction of the New Accounting Arrangement (NAA). On the other hand, the Office of the Exchange Fund (OEF) has gradually taken over through the NAA, through the introduction of Exchange Fund bills, and most recently, the introduction of the Liquidity Adjustment Facility (LAF). The emergence of the OEF in monetary management in the past few years has been particularly notable. It has also been reported in the press that it is going to be merged with the Banking Commission to form a central monetary authority.
The rapid changes in monetary institutions in Hong Kong warrants close attention. It is imperative to make clear what a concentrated power in monetary management, be it called a central bank or a monetary authority, can and cannot do for the economy. It is even legitimate to ask if it is necessary.
Despite the nonexistence of an actual central bank in Hong Kong, the normal functions of a central bank have been carried out by various private and public agencies in the territory, as has been pointed out repeatedly. While note-issuing, the clearing mechanism, and government banking are done by commercial banks, the control of liquidity, the stabilization of exchange rates, and the lender of last resort are in the hands of the OEF. The Banking Commission is in charge of bank supervision and regulation. As for the money supply, so long as the Hong Kong dollar is pegged to the U.S. dollar, it is automatically determined in the market. In other words, there is no major central banking job that is missing.
The lack of a formal central bank by no means indicates any deficiency in institutional arrangements in Hong Kong. On the contrary, it might well have been a blessing to the economy. It is well known that the Hong Kong economy compares favorably with most other economies that have central banks. A central bank is neither necessary nor sufficient for good economic performance.
What, then, could the establishment of a central bank contribute to the Hong Kong economy? There may or may not be a gain in administrative efficiency by putting all central bank functions under one roof, but in any case, this is a minor consideration. The main implications of a central bank are monetary: the control of the money supply, interest rates, exchange rates, and price level.
Under the current monetary arrangement, Hong Kong chooses to fix the value of its currency vis-a-vis the U.S. dollar. In fact, during the greater part of Hong Kong's recent history, the local currency has been tied to some outside value, and it has been the major responsibility of the Exchange Fund to stabilize the official parity. The introduction of the NAA and the LAF can be seen as efforts to strengthen the OEF in this regard. As such, the upgrading of the OEF to a central monetary authority would not enhance its ability to maintain the official exchange rate.
Some have argued that a central bank can help control inflation. This is particularly appealing given the current high rates of inflation in Hong Kong, coupled with low interest rates due to low U.S. interest rates. This begs two questions: What do we want the main responsibility of a central bank to be? And can a central bank maintain price stability?
With regard to the first question, it has to be noted that once the authority decides to fix the exchange rate, there is not much it can do about money supply, interest rates, or the price level. Any attempt to manipulate the latter would destabilize the official exchange rate. In other words, we have to decide what we want from a central bank: exchange rate stability or price stability. If we want to preserve exchange stability as we have been doing before 1974 and since 1983 under the linked exchange rate system, there is no need to set up a central bank. Existing institutions have proven sufficient for the job. This would mean, however, foregoing the control of money and interest rates. A central bank is necessary only when we want to regain control of the money supply. However, this would mean severing the link, a great departure from the kind of monetary system Hong Kong has been adopting, as well as from the official role of the Exchange Fund since its inception in 1935. Whatever the choice, we have to be aware of the necessary trade-offs. Failure to do so would result in wavering monetary policies and would create an uncertain monetary environment for the economy, with detrimental effects.
With regard to the second question, suppose that the OEF takes over the control of money supply and floats the H.K. dollar, then it has to decide how much money supply there should be or how fast it should grow. This is not an easy task. One might think that the money supply should be controlled so as to attain some policy goal, for example, low inflation. But there are certain difficulties. First, almost all policies incur side effects. A tight monetary policy to curb inflation would raise interest rates, with implications on the stock and property markets and businesses. These may not be undesirable at the moment, but the point is, it is difficult to know what the optimal policy should be, and opinions will vary. Second, the effects of policies are not necessarily immediate, with various and variable time lags on different items. Again, this makes it hard to prescribe the appropriate policy. Third, people do not react to policies passively. They would take into account the behavior of the monetary authority in their economic calculations, and this could offset policy effects, rendering the policies ineffective. The authority may need to apply stronger policies the next time to counter public expectations, and this may again in time be incorporated in people's calculations. Such interaction between policymakers and the public could be destabilizing. Fourth, policy goals as decided by the authority may change as the authority sees fit. This introduces an extra measure of uncertainty since the public has to guess what are the priorities of monetary policy decisions now and in the future.
An alternative in monetary management is to remove discretionary power in monetary policy from the authority and let the money supply be determined by rule. Examples of rules are a fixed percentage increase every year, or changing the money supply so as to maintain some predetermined interest rate or exchange rate. The benefit of monetary rules is to avoid policy mess-ups and let market forces decide the outcomes. However, for rules to be operable, they have to be credible, or are expected to be maintained for a considerable period of time. This requires that the monetary authority be independent and able to resist various political pressures, and that the stated rules be free from political meddling. In this regard, it is extremely doubtful whether Hong Kong should have a central bank now or in the near future because of the increasing politicization of practically every public issue. There is little recognition, not to speak of consensus, at the moment, that independence of the monetary authority is a desirable goal. Even if there were such a consensus, it is not clear that political realities would permit that goal to be realized.
With all these difficulties in conducting monetary policy, it is not at all clear if central banks can help maintain price stability. Experience elsewhere in the world indicates mixed results. There are the renowned records of the Bundesbank and the Bank of Japan, yet there are also runaway inflation experiences in South America and other economies. A central bank could be an important force in battling inflation; it could equally be an engine of inflation itself with its power over money supply. At the same time, it could easily eliminate any fiscal discipline the Hong Kong government has established over a long period of time.
Fighting inflation is only one thing that some critics expect a central bank in Hong Kong would do. There are others who argue that a monetary authority would strengthen Hong Kong as a financial center. This is again doubtful. Financial centers thrive on little intervention and on the rules of games that ensure fair play, plus on other supporting infrastructure. The existence of a central monetary authority is not directly relevant. However, this indicates that there are already various expectations from a central bank even before its establishment, which may not be consistent or justifiable. There would certainly be more demands of various types from a central bank once it is there. It is imperative that we have to ask if we really want a central bank, and if we do, what do we need it for. The reason for having a central bank has to be overriding and upheld, regardless of any political pressure.
Government officials have, on various occasions, denied that the rapid changes in monetary institutions are steps leading to the set-up of a central bank. They have also tried hard to convince people that the linked exchange rate system is here to stay. Nevertheless, irrespective of government intention, the institutional changes have gradually provided a framework to get rid of the link. This is alarming, as there is no basis to believe that Hong Kong is ready for central bank-guided monetary policy through political uncertainty. After all, central banking is neither necessary nor sufficient for monetary stability or economic growth. There should be no illusion that central authorities necessarily facilitate economic prosperity.
Dr. Luk Yim-Fai is a lecturer in the Department of Economics at The Chinese University of Hong Kong.