|Will the Link
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
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
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
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.
- At the outset, the conversion facility was made available, not the general public, but
only to the banks. The thinking was that allowing the general public to convert would
result in queues forming outside banks in moments of crisis, which would in turn
exacerbate the fall in confidence and worsen the crisis. However, this modification
prevented the general public from experiencing the power of the arbitrage mechanism
directly. Thus the opportunity to bolster public confidence was lost. A further effect may
have been a certain weakening of the arbitrage mechanism itself.
- In July 1988 the authorities introduced so-called accounting arrangements with Hongkong
Bank. In 1992, these arrangements were developed into the current liquidity adjustment
facility. Such facility has been used from time to time to relieve a liquidity squeeze in
the interbank market. This may have had the benefit of reducing the volatility of interest
rates. However, such benefit has been at the cost of the pure operation of the arbitrage
mechanism. Consequently, the power of the automatic arbitrage mechanism is not felt so
directly by the players in the market, with the result that confidence in the mechanism,
and understanding of it, are less.
- In 1990, the Exchange Fund commenced issuing bills and notes. The Exchange Fund does not
need to raise money. However, the programme of bills and notes was intended to provide a
benchmark debt interest rate, and also to provide the Exchange Fund with central banking
tools to mange liquidity. From time to time these tools have been used with significant
effect on the money supply. Again, the use of such tools appears inconsistent with the
basic operation of the currency board.
- In 1991, the authorities raised interest rates in order to quell property speculation.
However, under the linked rate mechanism, changes to internal interest rates will affect
the link rate. The Government was trying to have its cake and eat it. Within a short
period the Hong Kong dollar was rising in the foreign exchange market, and the Government
had to retreat.
- The Exchange Fund manages the fiscal reserves, and has been permitted to retain the
extremely large retained earnings of its own. These reserves and the Land Fund are claimed
by the Monetary Authority to be needed to defend the Hong Kong dollar. Yet under the
automatic arbitrage mechanism of the currency board they should not be needed. Indeed, the
use of reserves to intervene in the process of stabilisation could even interfere with the
arbitrage mechanism on which the link relies.
- The Monetary Authority has arranged repurchase agreements with a number of Asian central
banks, for mutual provision of liquidity in case their currencies come under attack. The
Financial Secretary has spoken out in favour of an Asian currency fund to rescue
currencies under attack. The merit of such arrangements can be questioned in principle.
They give rise to a moral hazard that may actually encourage the counterparty central
banks to be more reckless than they might otherwise be. However, even if such arrangements
were accepted in principle, they would not appear appropriate for Hong Kong in view of the
difference between the Hong Kong dollar link and the peg approach of the other Asian
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.
Policy Committee, HKDF
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