(Reprinted from HKCER Letters, Vol.47, November 1997)
Should the Hong Kong Dollar Be Delinked?
The question of whether or not the Hong Kong dollar should be delinked is much more than an economic issue; it also has political ramifications. Most people realize that delinking the dollar is politically impossible at this point in time. Both Beijing and Hong Kong are eager to maintain Hong Kong's stability to convince the world that the one country, two systems plan is working. Therefore, it is unthinkable that the Hong Kong dollar will be delinked in the near future, even if economists say it would be better to let it float.
Is there a valid economic reason to delink the Hong Kong dollar? The answer is a qualified no. As long as the Hong Kong government adheres strictly to the linked exchange rate system, there is no convincing reason to delink. Many people within and outside Hong Kong have argued this point. I will not try to repeat the argument here, except to point out that whatever the pros and cons of floating the Hong Kong dollar are, the debate is irrelevant unless the government has a clear idea about what its macroeconomic policy's goal is, aside from maintaining the stability of the exchange rate.
The qualification mentioned in the preceding paragraph arises from the fact that the Hong Kong Monetary Authority (HKMA) must stop meddling with the linked exchange rate system that we committed ourselves to in October 1983. In a pure currency board system, of which the linked exchange rate system of Hong Kong is an example, the HKMA would have no role to play, and arbitrage by private banks would make sure that the Hong Kong dollar exchange rate did not deviate significantly from the official rate of 7.8 Hong Kong dollars to one U.S. dollar. For example, suppose that in a speculative attack, speculators sell Hong Kong dollars and buy U.S. dollars, driving the market exchange rate above 7.8. Any such slight deviation, however, will give private banks the incentive to arbitrage: they buy Hong Kong dollars from the market at, say, 7.81, and sell them to the Exchange Fund at 7.8, earning a profit. This arbitrage process decreases the supply of Hong Kong dollars and brings the market exchange rate back in line with the peg.
However, the arbitrage process of the currency board system has not been allowed to perform perfectly during the stock market crashes that have taken place during the last couple of weeks. Instead of letting banks make profits and bring the market rate back to the peg, the HKMA has stepped in and increased the interbank overnight lending rates. This did two things: it shored up demand for Hong Kong dollars (because the interest rate in the Hong Kong dollar is high), and it prevented arbitrage by banks (because arbitrage is a cash-based operation). One immediate result was a tumble in the stock market because higher interest rates hurt business prospects, especially in the property market. Of course, the stock market would have suffered even if the HKMA had not intervened, because investors bet on a devaluation of the Hong Kong dollar. But the reason for the intervention is not sound, and stepping in was probably counterproductive for several reasons.
First, intervening suggests to speculators that the current currency board system is not working perfectly. And they are right: the Hong Kong dollar has persistently remained on the strong side of the peg since 1990. This could not be the case if the arbitrage process were being allowed to perform perfectly. Argentina also has a currency board system, but the market rate for its currency has never been as different from the peg as it is in Hong Kong. Speculators need no reason other than the fact that the system is not working perfectly to attack the Hong Kong dollar.
Second, intervening suggests that the Monetary Authority of Hong Kong is concerned with the peg and with foreign reserves. In a currency board system like Hong Kong's linked exchange rate system, local currency is backed up 100 percent by foreign reserves (called the Exchange Fund in Hong Kong). Changes in foreign reserve are entirely determined by balance of payments. If the local economy runs a surplus (or if it has persistent capital inflow), it will accumulate foreign reserves, which is what has happened to Hong Kong, a city among China, Japan, and Taiwan with one of the largest foreign reserves in the world. These reserves are in the hands of the HKMA, which makes seigniorage profits by investing them in safe and low-return foreign assets such as U.S. Treasury bills. But do the seigniorage profits belong to the HKMA or to the Hong Kong government? No, they do not. In a pure currency board system, the HKMA should have no incentive to manage the reserves. When Hong Kong runs a payments deficit, the reserves will diminish. It is precisely the HKMA's incentive to manage the reserves that give speculators the impression that it is concerned with the peg. The reason is simple. When speculators attack by selling Hong Kong dollars and buying U.S. dollars, in the absence of interventions such as increasing bank rates, arbitrage by banks will force the HKMA to sell its reserves of U.S. dollars to speculators at the peg. Now, if the HKMA is planning to devalue the Hong Kong dollar, any sale of U.S. dollars at the peg rate of 7.8 is a waste of foreign reserves. The HKMA would be better off changing the peg sooner rather than later to save reserves. Of course, this is exactly what happened to Southeast Asian countries that devalued their currencies. But these currencies are not backed by foreign reserves, as is the Hong Kong dollar. For the HKMA to employ intervention to fight speculative attacks is for it to ignore the advantage of Hong Kong's linked exchange rate system and to put Hong Kong in the same boat as that in which other intrinsically less stable Southeast Asian countries find themselves.
Third, in light of the HKMA's intervention, talk of the quantity of Hong Kong's foreign reserves could be counterproductive in terms of stopping speculation. It is concern over the amount of reserves Hong Kong possesses that invites speculation. If the HKMA is not concerned about this issue, why doesn't it allow banks to make arbitrage profits and maintain the peg? If, to satisfy some ulterior motive, the HKMA must prevent this from happening, then it would be better off cutting short of the boasting of the massive Exchange Fund (and the massive government Land Fund, which is also mostly in safe foreign assets). Otherwise, it will not be long before people realize that the HKMA is indeed wondering whether the level of the peg is too high.
Since its formal establishment in 1993, the HKMA has stated that the principal goal is to maintain the stability of the Hong Kong dollar. This goal is best served by strictly adhering to the linked exchange rate system. The HKMA should take steps to roll back recent banking regulations that make arbitrage by private banks more difficult, such as the 1994 modification in the note issuance and withdrawal system that effectively excludes all but the three note-issuing banks from engaging arbitrage. The HKMA needs to renew and to strengthen its commitment to the open and automatic management of the Exchange Fund. Otherwise, it would be better for everyone in Hong Kong to let the Hong Kong dollar float, because an imperfect monetary system will be a constant target of speculative attacks.
Dr. Li Hao is lecturer in the School of Economics and Finance, the University of Hong Kong.