What Have Been the Costs and Benefits of Hong Kongs Currency Board System Since 1983 - Case Study Example

Order 518713 Topic: What have been the costs and benefits of Hong Kong’s currency board system since 1983 This study will critically analyze the costs and benefits of Hong Kong’s currency board system since 1983. The analysis of the essay is achieved in three main sections. First, currency board arrangement is defined. Moreover, the costs and benefits of Hong Kong’s currency board system since 1983 is investigated before finally concluding. ‘Currency board arrangement is a special case of a rules-based monetary system. It is a system based on rules rather than discretion that serves to establish credibility and avoid losses resulting from decisions that can sometimes be undertaken within a myopic timescale’ (Balino 1997). Hong Kong operated a ‘sterling exchange system from 1935 – 1973, excluding the years of Japanese occupation. The sterling exchange system is a currency board with note issue back by holdings of Sterling assets’ (Crosby 2000). Then, ‘between 1972 and 1974, the HK dollar was set at a fixed rate to the US dollar. From November of 1974 until the return of the currency board in 1983, the HK dollar floated freely against the US dollar’ (Hanson). Hong Kong being a Special Administrative Region of China is dependent on mainland demand but its monetary system is still attached to the U.S. If ever China retaliates against pressure for the trade protectionism in the United States, then Hong Kong would be caught in between. ‘Where it comes to the real economy, Hong Kong’s fortunes are increasingly linked to the mainland; its manufacturing base is located across the border, in 2009 mainland tourists accounted for more than half of the total, mainland purchasers accounted for about 1/5th of real estate demand, and mainland firms accounted for more than half of total issues and market capitalization in the Hang Zeng’ (China Analytics 2010). Outside of Tokyo, Hong Kong attracts investors, businessmen, and economists because of its rule of law, its low tax regime and highly urbanized infrastructure. Hong Kong also played a significant part in China’s success economically speaking, posing as middleman for the mainland’s investments and trade. ‘In September 1982, while Hong Kong was under a free-floating system, officials began to plan for the regions’s future after its return to China. As a result, confidence in the HK dollar and economy began to diminish’ (Hanson). Also that year, the business scenario was not good – the stock market down by 50 percent, property market experiencing downturn and there were runs on the small banks. ‘The value of the HK dollar continued to decrease throughout the year and on September 24, 1983, reached an all-time low of HK$9.55 per US dollar’ (Hanson). ‘In less than a month, following a proposal made by Hong Kong business economist John Greenwood, the government announced that it would return to a currency board system, which would pursue an anti-inflationary policy and promote currency stability’ (Schuler). The CBA is an ‘idiosyncratic system since there is actually no currency board, and bank notes are issued by a few designated commercial banks, which alone deal directly with the monetary authority at the fixed exchange rate of HK$7.80 to the US dollar’ (Shu-ki Tsang). The CBA which was ‘also known as the “linked exchange rate system” or the “link” has revolved through several stages. From October 1983 – 1987, the Hong Kong government could not even define the monetary base and the theoretical forces of bank note arbitrage and competition did not seem to work’ (Shu-ki Tsang). The exchange rate was strengthened by the government interference in the foreign exchange market and interest rate handling. ‘To provide the Exchange fund with the necessary instruments to conduct “open market operations”, the Hong Kong government embarked on a series of programs to introduce Exchange Fund Bills (from March 1990) and notes (from May 1993). On the other hand, the LAF, set up in June 1992, allowed the Exchange Fund to supply additional liquidity to the banking system or absorb excess liquidity from it’ (Shu-ki Tsang). ‘In the period from 1988 to 1993, the imposition of the “accounting arrangements” gave the government a handle for the monetary base through the Hongkong and Shanghai Banking Corporation as the ultimate clearing bank. The launching of the Exchange Fund bills and notes, as well as the creation of the liquidity adjustment facility as a kind of discount window strengthened the ability of the monetary authority to influence interbank liquidity and interest rates in the two-tier system’ (Shu-ki Tsang). The monetary stability in Hong Kong was promoted through the currency board arrangement. It has ‘allowed the HK dollar-interest rate to closely follow the stable path of the US dollar-interest rate’ (Hanson). Since the establishment of the currency board system, there has been less fluctuation in Hong Kong’s monetary growth. ‘The system operates under a fixed exchange rate, which is extremely advantageous because it is not influenced by any type of political or technical manipulation’ (Hanson). With the ‘currency board system in place, Hong Kong has also been able to withstand the world-wide stock market crash in October of 1987, the effects of the Gulf War in 1990, the European currency crisis from 1992 to 1993, the Mexican currency crisis in 1994, and most importantly, the Asian Financial Crisis in July of 1997’ (Hanson) ‘With the discount window employed and liquidity readily available for banks facing shortages, the Hong Kong Monetary Authority (HKMA) has played a significant role in smoothing interest rates and consequently has helped to maintain economic stability and success’ (Hanson). Speculative attacks against the HK dollar causes its value to fall as Hong Kong’s currency board becomes more like a central bank. ‘A final alternative to the current system is to make the currency board more orthodox, or rule-bound, and actually go as far as “dollarization”’(Hanson). Hong Kong, in effect, replaces its dollar with the US dollar at a current fixed rate. Also, Hong Kong dollar assets such as bank deposits would be traded with equivalent US dollar deposits. To avoid inconvenience in having to transfer huge amounts of US coins, Hong Kong dollars can remain in coinage form. ‘Article 111 of Hong Kong’s Basic Law states that “the Hong Kong dollar, as the legal tender, shall continue to circulate” and must be backed by a “100% reserve fund’ (Hanson). But converting HK dollars to US dollars would bring many benefits for Hong Kong. Firstly, dollarizing is an efficient way of adjusting money supply to demand. ‘By dollarizing, exchange rate risk would no longer be an issue. This would enable banks that are short of reserves to borrow funds internationally at the same costs that they face within Hong Kong’ (Schuler). ‘The risk premium that lenders would normally charge borrowers to protect themselves against a change in the currency’s value would no longer be present; the elimination of risk would remove the cost of borrowing. Furthermore, dollarization would increase confidence in Hong Kong as a sound market for investment, thus strengthening Hong Kong’s position in the financial world’ (Schuler). However, dollarization is not without costs. The first problem would be political nature. The Hong Kong dollar is a symbol of Hong Kong. By replacing it with a US dollar might send a wrong signal to the people of Hong Kong. This move may be seen ‘as a blow to the region’s pride and even an infringement of their sovereignty’ (Hanson). Others also see it as untimely, they believe dollarization should only take place if Hong Kong’s economy enters a state of economy. On the part of the US dollar, if for some unfortunate event the dollar becomes an unstable currency, then Hong Kong’s economy would also be affected. ‘This option would deprive Hong Kong of its ability to deal with external shocks and would lower the flexibility of the Hong Kong Monetary Authority with respect to its discretionary monetary policy’ (Hanson). Moreover, Hong Kong would lose its interest earnings over the deposits of US dollars in the Exchange Fund if these reserves were to be converted into use for circulation. ‘The interest earned by producing Hong Kong dollars with 100 percent backing of US dollars is known as “seigniorage”. If dollarization were implemented, seigniorage would be passed to the US Federal Reserve. As of 1998, seigniorage accounted for Hk$5.1 billion a year, or about 0.6 percent of Hong Kong’s GDP’ (Hanson). If this will be the case then dollarization would be a costly alternative. Other presented alternative to the current arrangement other than dollarization are ‘flexible exchange rate, a link to the renminbi and a basket currency. Among the four options, ‘implementation of a basket currency would provide Hong Kong with the strongest foundation upon which future economic success can be built’ (Hanson). In the basket currency, the HK dollar is linked to a basket of currencies of its three largest trading partners, namely, China (being the largest trading partner), then followed by US and the European Union. ‘Under this proposal, the renminbi would make up the largest percentage of the HK dollar basket, with the US dollar and the euro as the remaining components’ (Hanson). Furthermore, Hanson added that this ‘type of link has the following advantages – it incorporates Hong Kong’s largest trading partners into the valuation of its currency, it allows for more stability in the Hong Kong exchange rate, Hong Kong would be better protected against major shocks in the economies of the basket currency countries and finally, there would be more stability in the Hong Kong dollar interest rate’. However, it has also disadvantages. The basket currency cannot be implemented as long as the Chinese renminbi remains non-convertible. Their being non-convertible would result to not being linked for the Hong Kong dollar even if it only comprises a portion of the HK dollar’s backing. Their removal from the basket would solve the problem but the advantage of trading between China and Hong Kong would be lost. ‘Until China allows its currency to become fully convertible, the best option for Hong Kong is to maintain the currency board system as it is now’ (Hanson). The Hong Kong Monetary Authority must exert more endeavors in maintaining the fixed exchange rate. ‘This will return the currency board to its traditional roots, and will decrease the uncertainty and financial instability associated with the system’. (Hanson). To sum it up, the benefits of the currency board system to Hong Kong are firstly, it eliminated high inflation rates – ‘Hong Kong indeed owns one of largest foreign reserves in the world’ (Labonte); it prevented time inconsistency – people are able to consume services and goods that matches their preferences and maximizes their choice between immediate and future satisfaction; and because of the currency board, stabilized floating exchange rates encourage investment and trading. As for its disadvantages, people may doubt the willingness and competence of the government to continue ‘perfect convertibility at the specified rate’ (Kwan 1999). All in all, the performance of the currency board system in Hong Kong is favorably decent but chances of a monetary collapse cannot be eliminated. References Balino, T1997, “Currency board arrangement issues and experiences”, International monetary fund, Washington, D.C. China Analytics2010, “The beloved Hong Kong dollar: how long will 1 country 2 currencies last?’, available at chinalytics.wordpress.com. Crosby, M2000, “Exchange rate volatility and macroeconomic performance in Hong Kong. Hanson, C, “Hong Kong’s economic future: Is a currency board the answer?”, available at Lehigh.edu/-incntr/publication. Kwan, Y & Lui, F1999, “How well the currency board performed? Guidance from Hong Kong”, Hongkong. Labonte, M2004, “A currency board as an alternative to a central bank”, CRS report for congress. Schuler, K1992, “Currency boards”, PhD Dissertation, George Mason University, Virginia. Tsang, S, “The currency board arrangement in Hong Kong, China”,Viability and optimality through the crisis. Read More