Will the Link Break?
The recent turmoil in Southeast Asian currency markets has spilled over to the Hong Kong dollar with the spotlight on the US dollar link. On fundamental grounds, the link appears sound. But general lack of understanding of the mechanism, and certain actions of the Hong Kong authorities, expose it to risk.
The five Southeast Asian countries that have experienced currency declines - Thailand, Indonesia, the Philippines Malaysia and Taiwan - each to a greater or lesser extent managed their currencies so as to track the US dollar. The recent fall of these countries' exchange rates has put pressure on another currency linked to the US unit: the Hong Kong dollar.
However, a direct comparison between the Hong Kong dollar and the other Asian currencies is not technically valid because of the very different mechanism under which Hong Kong's parity with the US dollar is maintained. The five Southeast Asian countries managed their exchange rate levels by a combination of intervention in the foreign exchange market and administrative measures such as foreign exchange controls. As each country liberalised its foreign exchange controls, it became more exposed to international market forces, and thus under more pressure to adopt prudent economic policies. This, however, they largely failed to do, and in consequence they suffered exchange rate declines.
A totally different mechanism
The Hong Kong dollar link with the US dollar is of a totally different nature. The link is maintained under a modified currency board system. Under this system, the Hong Kong dollar banknotes, which are issued by three banks, are backed by US dollars deposited with the Exchange fund at a rate of 7.8 to 1. The Exchange Fund stands ready to exchange Hong Kong dollars for US dollars at that fixed rate. The rate is maintained by an automatic self-stabilising mechanism.
The operation of this mechanism can be illustrated by the events that immediately followed the introduction of the system in October 1983. Immediately prior to the establishment of the link, the Hong Kong dollar had been trading at 8.3 to the US dollar, and hardly anyone believed that the link at 7.8 could hold. There was massive conversion out of Hong Kong dollars into US dollars to take advantage of what seemed a very attractive rate. The resulting shortage of Hong Kong dollars caused overnight rates to rise sharply, at one stage reaching 42%, and three month deposit rates rose to 20%. However, overnight rates returned to the level of Eurodollar interest rates within a week, and the situation stabilised.
Why did this happen? Essentially, people realised very quickly that they could earn high interest rates in a currency that was equivalent to US dollars, and converted Eurodollars into Hong Kong dollars to take advantage of this risk-free premium. This arbitrage mechanism proved very effective. During the fourteen years of operation, the link has been subject to several shocks, but the rate has been unaffected and after a relatively short period interest rates have reverted to normal levels.
Modification to mechanism
Nonetheless, the Hong Kong authorities have never wholly trusted the currency board mechanism, and have in several respects departed from it.
Simple mechanism preferred
The above departures form the currency board model are not accidental. Mr. Joseph Yam, Chief Executive of the Monetary Authority has said, "...we have... consciously and deliberately built up for ourselves a mechanism for monetary management, similar to those used by central banks engaged in discretionary monetary management" [Monetary Management in Hong Kong 1993, page 53]. The various mechanisms outlined above are seen as "an overprovided armoury", which offers additional safeguards against uncertainty. Yet far from overproviding the armoury, the departures from the currency board model may actually deplete it by weakening the operation of the arbitrage mechanism in the event of crisis.
Under the currency board mechanism, the Hong Kong dollar is effectively unified with the US dollar. Monetarily, Hong Kong is the 53rd state of the USA, and speculating against the HK dollar is like speculating against the currency of Texas. Better promotion of the simplicity of the link mechanism might spare HK much unnecessary strife.