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.

• 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 currencies.

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