(Reprinted from HKCER Letters, Vol. 69 January/February 2002)


A Discussion Note on Hong Kong's Linked
Exchange Rate System and a Proposed
Reform of Hong Kong's Wage System


Paul S.L. Yip


1. Introduction

In this note, I do not propose the abandonment of Hong Kong's linked exchange rate system. To justify such a proposal would require showing that the cost of maintaining the system is substantially higher than the cost of abandoning it. The cost of abandoning it is highly dependent on the economic environment, and it is not easy, at least for the time being, to assess it. In addition, as I explain, we have already paid dearly for maintaining the linked exchange rate system during the Asian financial crisis and the post-crisis period. My purpose here is rather to point out the huge adjustment costs (in output and employment) that we may have paid for maintaining the system over the last few years. I then propose a wage reform that will benefit Hong Kong regardless of whether the system is abandoned or retained. As I explain, the reform would reduce adjustment costs and at the same time strengthen the credibility of the linked exchange rate system by convincing the market that the Hong Kong government has a powerful tool with which to limit adjustment costs. In addition, the reform would reign in the cost of abandoning the system by convincing the market that the government has a powerful tool with which to influence the long-term change in the exchange rate. This note is closely related to Yip and Wang (2002), which deals with the speed with which prices and output in Hong Kong adjust.

2. How flexible Are Prices in Hong Kong?

2.1 Price or quantity?

In Yip and Wang (2002), we first question a basic but important assumption behind the original justification for Hong Kong's Currency Board System - that prices will adjust fast enough to offset any misalignment in the exchange rate or shift in external demand. While it is indisputable that Hong Kong is one of the most flexible economies in the world, our paper points out that it is seldom made clear whether the high degree of flexibility refers to that of price or of quantity, and when flexibility is mentioned in relation to Hong Kong, it is often assumed that flexibility of prices are meant. This incorrect assumption is so ingrained that proponents of the linked exchange rate system have incorporated it into their discussion of the adjustment process (see for example, Greenwood [1984a, 1984b]).

However, as figure 1 illustrates, more than 4 years after the 1997 financial crisis, Hong Kong is still experiencing a persistent but moderate degree of deflation. While prices have been adjusting only gradually, employment and output plunged to low levels during the crisis and post-crisis period.

2.2 Results

To provide a rough idea of how fast Hong Kong's prices and quantities adjust, in Yip and Wang (2002) we estimate the adjustment speed of export prices and volumes. The result is shocking. We found that Hong Kong's export volume adjusted relatively quickly to disequilibrium in the export-volume equation (i.e., it could correct 41% of the disequilibrium in one quarter), while export prices adjusted slowly (i.e., they could correct 14% of the disequilibrium in one quarter). Thus, Hong Kong's Currency Board System's original justification for retaining the linked exchange rate system does not hold. As interactions between export prices and export volumes with the disequilibriums in a two-equation system could be more complicated than one based on two single equations, we conducted simulation exercises in which there was a reduction in world demand owing to a world recession caused by, for example, the Asian financial crisis or the September 11 incident or a realignment of the world exchange rate caused by a plunge in the value of Asian currencies during the Asian financial crisis, the continued strengthening of the U.S. dollar, or the weakening of yen.

The results of the simulation exercises were as expected; they showed that such shocks would cause a substantial short-run output loss in Hong Kong. (In addition to the price sluggishness discussed above, this type of shock could result in interactive sluggishness between prices and wages. That is, it takes at least a few rounds of small reductions in prices and wages to achieve a certain required long-run reduction in prices and wages. This type of interactive sluggishness is believed to have contributed to the more than four years of deflation in Hong Kong following the Asian financial crisis.)

2.3 Singapore's Experience

Given that Hong Kong's prices and wages adjust slowly, flexibility in the exchange rate could have mitigated the adverse impact of the crisis, the world recession, and the realignment of world exchange rates on the economy. Yip and Wang (2001) and Yip (2002) explain that Singapore has allowed a large enough (20%) depreciation of the Singapore dollar vis--vis the U.S. dollar for its nominal effective exchange rate to depreciate (moderately) against its major trading partner. This has in turn facilitated, or at least has not hindered, the recovery of the Singapore economy. On the other hand, as shown in figure 2, Hong Kong's linked exchange rate system has resulted in a more than 10% appreciation of its nominal effective exchange rate. Worse still, the appreciation shown in figure 2 does not take into account the impact of the latest yen depreciation, which is causing many other Asian currencies to depreciate. Should the yen depreciate beyond a certain level, China and Malaysia might have to accept a certain degree of depreciation in their currencies. This could in turn raise Hong Kong's nominal effective exchange rate and hence the burden of its price and wage adjustment.

2.4 Hong Kong's Recession

Thus, the linked exchange rate system did more than forbid the use of exchange rate depreciation to mitigate the adverse impact of the crisis, the world recession, and the re-alignment of world exchange rates. With the continued strengthening of the U.S. dollar, it also increased the burden of price adjustment and deepened the recession.

The strong Hong Kong dollar has a negative affect on not only wages and output prices (and hence on competitiveness) but also on property prices (and hence on financial distress and the problem of "negative-asset"). Depressed property prices would also spill over to a weaker aggregate demand through lower consumption and investment. Of course, the plunge in Hong Kong's property prices was also related to the bursting of the previous bubble and to the subsequent excess supply. It is, however, certain that sufficient depreciation of the Hong Kong dollar could have substantially mitigated the plunge in asset prices and hence have alleviated financial distress. In figure 3, I plot the property price indices in Singapore and Hong Kong. While it is clear that the property markets in the two economies are significantly different, at least in terms of the magnitude of the bubble before the crisis occurred and the changes in relative supply and demand, it is still the case that the far smaller decline in Singapore's property price index could have been in part the result of depreciation.

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3. A Second-Best Solution

Noting that prices and wages are not as flexible as assumed, I have up to this point briefly discussed the huge adjustment cost Hong Kong incurred during the post-crisis period. The question to be answered now is, if the linked exchange rate system cannot be abandoned in the immediate future because of cost, what can be done to mitigate the cost of retaining the system in case similar shocks occur in the future? I propose increasing the flexibility of our wage system through the creation of a substantial variable wage component similar to Singapore's.

3.1 Singapore's Reform

Having learned from its painful experience during the 1985/86 recession, Singapore recognized the importance of wage flexibility and restructured its wage system by incorporating a substantial variable wage component in the total wage bill. As I explain in Yip (2002), Singapore was able to mitigate the adverse impact of the 1997 Asian financial crisis, not only by accepting a depreciation of the Singapore dollar but also by reducing wage costs and by reducing the variable wage component and the Central Provident Fund contribution rate.1 Thus, despite the fact that Singapore's economic relationship with the economies most seriously affected by the crisis was much stronger than Hong Kong's relationship with the same countries, the unemployment rate in Singapore during the crisis and post-crisis periods increased much less than it did in Hong Kong.

3.2 The Proposed Reform

My proposal is as follows: For any subsequent wage increment put into place in the near future, the increase should be treated as a variable wage component until the variable component forms about 30% of the total wage bill. Employees should be informed that this component could vary in case of an adverse economic situation. This proposal adds flexibility to the wage structure.

The 30% is necessary because, unlike Singapore, Hong Kong cannot use exchange rate depreciation to mitigate economic adversity. The Hong Kong government should lead the wage reform by restructuring its payment scheme to the civil servant and semi-government employees as well as by convincing large companies to adopt a similar practice. In case of extreme economic adversity, the government could then announce a cut in the variable wage component so that private companies could impose similar wage cuts with little (bargaining and reputation) cost. If necessary, the government could also supplement a wage-cost adjustment by announcing a temporary reduction in the contribution rate into the Mandatory Provident Fund. By taking these steps, the government could guide an economywide wage adjustment when it deemed such an adjustment necessary. In other words, the government would have at its disposal a powerful tool with which to engineer a rapid adjustment of wages and prices to counteract extreme adversity and minimize the associated adjustment cost. In addition, such a tool would strengthen the credibility of the linked exchange rate system, as the market would know that Hong Kong was equipped to engineer an economywide wage and price correction, should the need arise. Even those who prefer the eventual abandonment of the linked exchange rate system will recognize that the reform would limit the cost of abandoning the system.

3.3 Why Reform Is Necessary

Why should Hong Kong institute this type of reform? The answer is simple. Our exchange rate is fixed. If it could be adjusted downward, that would be ideal; in that case we would not need a wage cut or a price cut to reestablish our competitiveness. We would not have had to absorb the substantial plunge in property prices that is still creating financial and social distress. And we would not need to accept a high unemployment rate, which is frustrating to the unemployed and worrisome to the still employed. However, since the exchange rate cannot be adjusted, we need a second-best solution. Within this second-best solution, we have two choices. We can let the market do the job through the automatic adjustment mechanism. Or we can put into place a guided wage cut (our proposed reform). Hong Kong has unintentionally, but collectively, opted for the first choice; however prices and wages are not as flexible as presumed. Putting the argument in more concrete terms, it is difficult to convince a worker to accept a lower wage until many are unemployed, a supplier to reduce his price until he experiences difficulties selling his products, or a property owner to lower his rental costs until the vacancies in the market are substantial.

Thus, to achieve deflation (i.e., a correction in prices and wages), the market needs a recession. This will no doubt be costly; we have experienced more than four years of deflation, recession, and high unemployment, all of which has resulted in enormous financial and social distress. If Hong Kong had ever put into place a wage system with a substantial variable wage component, and if people were aware that the variable wage component could be changed in case of extreme adversity, most of these costs could have been avoided. Should we allow history to repeat itself in the future?

4. Concluding Remarks

Economists normally do not dictate policymakers' decisions. However, it is our responsibility to inform them of the consequences of their choices. This note strives to make the following points:

Over the past few years, Hong Kong has incurred huge adjustment costs (in the form of a recession, a high unemployment rate, and a severe plunge in asset prices) for maintaining the linked exchange rate system.

If we choose to maintain the system because of the possibility that abandoning it will be very costly, our best option is an economywide wage and price cut. If we maintain the linked exchange rate system but do not implement the wage and price cut, the result will be prolonged recession with a high unemployment rate and unsold output. Prices and wages will still fall; all we will gain is a protracted adjustment period.

Looking to the future, if we choose to maintain the linked exchange rate system and want to minimize adjustment costs in case of extreme adversity, it will pay for us to increase wage flexibility by establishing a substantial variable wage component.

Editorial Note:

How to make our wage structure more flexible is of paramount importance. Focusing on the average high wage level misses the central issue of wage flexibility. Higher wages supported by higher productivity is the hallmark of a developed economy, and thus should not be of any policy concern. Flexibility is an area that deserves closer scrutiny.


1 During the adjustment process, many companies in Hong Kong also cut their bonuses - a form of a variable wage component. Unfortunately, the share of such bonuses in the total wage bill was in many instances insufficient to convince companies that retrenchment was unnecessary.



Greenwood, J.G., (1984a), "The operation of the new exchange rate mechanism", Asian Monetary Monitor, 8, pp 2-12.

Greenwood, J.G., (1984b), "Why the HK$/US$ linked exchange rate system should not be changed", AsianMonetary Monitor, 8, pp 12-17.

Yip, Paul S.L. (2002), "A Note on Singapore's Exchange Rate Policy: Empirical Foundation, Past Performance and Outlook",Singapore Economic Review, forthcoming in April 2002.

Yip, Paul S.L. and Wang R.F. (2001), "On the Neutrality of Singapore's Exchange Rate Policy" ASEAN Economic Bulletin, 18, 3, pp 251-262.

Yip, Paul S.L. and Wang R.F. (2002), "Is Price in Hong Kong That Flexible? Evidence from the Export Sector", Asian Economic Journal, forthcoming in June 2002.


Paul Yip is Associate Professor at the Division of Applied Economics, Nanyang Business School, Singapore.


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