(Reprinted from HKCER Letters, Vol. 69 January/February 2002)
The Link, Re-link and No Link
Ever since its inception in October 1983, the linked exchange rate system (henceforth the link) in Hong Kong has been a recurrent topic of dispute in public policy, and more so when the economy runs into difficulties.
In the discussion of public economic policy, sometimes the notion of market failure is called for, and since the market cannot carry out its functions satisfactorily, government intervention is considered to be justifiable. Nobel laureate George Stigler once likened such simple flaw in logic to a piano competition with two contestants. After the first contestant performed, the judges did not like it and offered the prize to the second contestant, without the latter having to play at all. The point is obvious: market failure does not necessarily imply government success.
Similarly, while the link is thought to be not serving Hong Kong right, there are voices and opinions that it be replaced. However, it is quite unfortunate that commentators pointing to the inadequacies of the link and asking for changes to be made seldom come up with clear alternatives, so that comparative analysis of the pros and cons of different monetary arrangements has been insufficient. Whether and how the current linked system should be replaced or modified should depend on whether there exist clear dominant alternatives.
The "disadvantages" of the link have become commonplace by now, after years of disappointing performance of the Hong Kong economy. The foremost "shortcoming" of the link is the lack of monetary autonomy, which is more felt in times of recessions than booms as people look for quick fixes for recovery. In connection with this aspect of the link is the possible danger that business cycles in the US and in Hong Kong do not synchronize. In this regard, Hong Kong was fortunate last year to have the Federal Reserve cutting interest rates eleven times in a row.
Furthermore, under the link, the burden of adjustments to shocks lie in domestic prices and wages instead of the exchange rate. Since changes in prices and wages tend to be less immediate and uneven than those in the exchange rate, the adjustment process tends to be more prolonged and may affect the relative well being of individuals in society.
The easiest prescription during recessions is to devalue the currency without making any change to the existing institutional setup. This amounts to changing the official rate at which convertibility undertaking is carried out by the Exchange Fund. Yet, simple as it may be, few analysts would find such devaluation justifiable. It is true that devaluing the Hong Kong dollar vis-à-vis the US dollar would make Hong Kong goods and services relatively cheaper, and thus has a stimulating effect on the economy. Yet, the effect can only be transitory, especially when the ultimate problem is a loss in relative productivity in Hong Kong. Devaluation is only a one-shot change in relative prices, while the loss in productivity is an on-going process. The "benefits" from devaluation will sooner or later be consumed by the lack of productivity, by which time another devaluation will become necessary.
More importantly, devaluation, albeit just once, would completely undermine public confidence in the link, which is paramount in a currency board arrangement. Should the official exchange rate be changed once, it would be deemed to be less untouchable. This could invite speculation against the currency and, what is more disastrous, even the general public would believe the authorities might lack the will power to defend the exchange rate. While our foreign exchange reserves are sufficient enough to withhold even large-scale speculation against the Hong Kong dollar in general, they would not be sufficient when domestic residents dump the Hong Kong dollar massively. A temporary relief through devaluation will certainly implant a time bomb in the economy.
Another proposal to change the link that has been mentioned from time to time is to peg the domestic currency to a basket of currencies, but still under the existing currency board arrangements. This has the clear advantage of alleviating problems arising from non-synchronization of US and Hong Kong business cycles, but it has the disadvantages of being less transparent to the public and more cumbersome in day-to-day operation. There are also issues of what currencies to be included in the basket and the value of their relative weights.
The Hong Kong economy is currently tied to the US in monetary and financial aspects, but more and more to Mainland China in the real (production, consumption, trade, etc.). To the extent that the Mainland economy has massive trade and investment relationships with the US, and that the renminbi has a managed peg with the US dollar, the link to the US dollar alone can still be justified. In the longer term, however, should economic development in Hong Kong deviate further and further from that of the US, the Hong Kong dollar peg to the US dollar would have to be reviewed and even revised.
Regardless of the optimal combination of foreign currencies in the basket, a move from pegging to the US dollar alone to pegging to a basket of currencies can camouflage to some extent an underlying devaluation of the Hong Kong dollar. However, as mentioned above, this would only have temporary stimulating effects on the economy. If weakness of the Hong Kong economy reflects ultimate weakness in productivity, devaluation is certainly no panacea.
While it is sometimes not clear what critics of the link have in mind as a substitute system, floating the Hong Kong dollar is one possibility. This obviously begs the question of whether a fixed or floating exchange rate regime is more suitable for Hong Kong. Yet, this question aside, floating the Hong Kong dollar is still more easily said than done. The authorities cannot responsibly just renounce the official rate of 7.80 or withhold convertibility undertaking. The mechanism to link the domestic currency to the US dollar has to be replaced by a mechanism that directly or indirectly controls the domestic money supply. In monetary policy, in general, either the authorities control the exchange rate, in which case they will have to let the money stock be market-determined, or the money stock, in which case the exchange rate will have to float. Hong Kong has experienced a brief period (1974 to 1983) in its recent history when the authorities did not control either, but the results were extremely high volatility in inflation, interest rates, and asset prices. The comment, sometimes prevalent in the media, that the linked exchange rate system was only a political measure to restore public confidence during the Sino-British talks over the future of Hong Kong, and so can be dealt with now after 1997, is certainly besides the point. Hong Kong's economy cannot afford to control neither the money supply nor the exchange rate.
A move to a monetary arrangement that targets some measures of monetary aggregates instead of the exchange rate will call forth some issues to be settled first, such as the appropriate monetary measure to be targeted and its desirable rate of growth. Hong Kong has been under a currency board since the nineteenth century, and has not had any experience whatsoever with determining and controlling the money supply. Moreover, experience in the US and elsewhere shows that pertinent use of monetary policy is no trivial matter. Of course, the lack of experience should not be sufficient reason for not attempting, but whether it is a good time to try a new monetary arrangement in Hong Kong now is debatable.
Fixing the official exchange rate of 7.80 is transparent and has been accepted by everyone in the market. It also has the merits to be a simple monetary rule and observable immediately at all times. Once we move to targeting the rate of growth of some monetary measures, the operation is less transparent and the policy is less observable as rule-based. After all, the value of monetary aggregates is the result of market interactions between the authorities, the banking system, and the general public. There is more leeway for the authorities to deviate from original targets and this will be observed only with certain time lags. In other words, monetary policy could become more discretionary when we have the authorities controlling monetary aggregates.
The room in the operation of monetary policy will readily invite political pressures on the monetary authorities to steer the monetary environment in directions favorable to certain political or interest groups. Political influence on monetary policy is the last thing Hong Kong would like to see, whether during booms or recessions. The current link has the merit that, as a hard and transparent rule, there is not much that the authorities can maneuver, and so they can be free from political manipulation.
Overall, there does not seem to be any clear dominant alternative to the current linked exchange rate system in Hong Kong, despite its ineptness in helping Hong Kong out of the current prolonged economic downturn. In any case, regardless of how inadequate the current system is, concrete options should be clearly identified as possible alternatives for meaningful public discussion.
Y.F. Luk is Lecturer and Director of the School of Economics and Finance, The University of Hong Kong.
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