Costs and Benefits of Hong Kongs Currency Board System since 1983 - Case Study Example

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 exchange rate between two currencies belonging to two different countries is the price of one nation’s currency expressed in terms of the currency of the other country. (We assume that transactions are permitted between the two countries). Usually a country has trade partnerships with many countries each having its own respective currency. Thus there are many spot exchange rates of a single currency depending upon the number of trading partner it has. Thus for U.S.A there is a dollar-pound rate, a dollar-franc rate and so on. The Exchange Rate Theory analyses the effects of the various exchange rate systems (fixed exchange rate system, flexible exchange rate system) on different variables of the economy. (Krueger 1983 p21) We can distinguish between three main types of Exchange Rate Systems: Fixed Exchange Rate Systems, Flexible Exchange Rate Systems and Exchange Control System. Under the Fixed Exchange Rate System, the exchange rate is fixed at a particular level and all transactions are undertaken at this fixed rate. The Government buys and sells foreign exchange for maintaining the exchange rate at that level. Under the Flexible Exchange Rate System, the intersection of demand and supply of foreign exchange determines the exchange rate. Under both these systems, the currencies are fully convertible. However, under the Exchange Control System, the Government sets the exchange rate at a particular level but individuals cannot carry out their transactions freely at this rate. Under such a system, foreign exchange is only sold under specific conditions. Individuals are required to sell their foreign exchanges directly to the Government. The currency remains inconvertible under this system. (Krueger 1983 p22) ‘The Currency board arrangement (CBA) operates on the lines of the Fixed Exchange Rate Regimes where the “domestic currency is pegged to a foreign currency”.(Iyikoey, 2009, p1). It is a system based on rules rather than discretion that serves to establish credibility. (Balino, 1997). Hong Kong operated a ‘sterling exchange system which was a currency board system with note issue backed by holdings of Sterling assets’ (Crosby, 2000). Officially, this was known as the Exchange Fund. Then, ‘between 1972 and 1974, the HK dollar was set at a fixed rate to the US dollar which was a form of the Currency Board System. From November of 1974, to October 1983 the HK dollar floated freely against the US dollar’ (Hanson, n.d.). The main reason why Hong Kong migrated from a floating exchange rate system to the CBA was to halt the huge depreciation of the exchange rate that occurred from 1982-1983. (Due to the weak economic fundamentals in the country at that point of time, the exchange rate depreciated sharply). The Hong Kong Government used the US Dollar as the reserve currency and fixed the Hong Kong Dollar (HKD) at 7.8 HKD/USD. Under the CBA, the commercial banks, which were authorized to issue notes, were required to purchase Certificates of Indebtedness (CIs) from the Exchange Fund at the cost of one US dollar before they could issue notes worth of 7.8 HKD. (It is a historical custom in Hong Kong for commercial banks to issue notes instead of the currency board) (Chiu, 2000, p.5) This CBA was simple, transparent and easily comprehended by the general public of the country. The U.S.A was an important trading partner of Hong Kong and a sizeable portion of the latter’s trade transactions were done in exchange to the US dollar. Thus the U.S dollar served as a natural choice for the standard/anchor currency in the CBA. (Chiu, 2000, pp. 4, 5) The CBA which was ‘also known as the “linked exchange rate system” has revolved through several stages. From the late 1980s, the Hong Kong Government started its intervention in the inter-bank market to support the exchange rate. (Thus the Hong Kong Monetary Government deviated from the basic monetary rule of the CBA). In 1988, a new accounting arrangement was introduced between the Exchange Fund and the Hong Kong and Shanghai Banking Corporation. In March 1990, the HKMA introduced Exchange Fund Bills, which were similar to the short-term U.S Treasury Bills. The Government also introduced notes (from May 1993). The Exchange Fund issued the Exchange Fund Bills and the notes to promote the growth of the debt market of the Hong Kong dollar. The monetary proceeds gathered from the issue of these Bills and notes were then invested prudently by the Fund. On the other hand, the LAF (Liquidity Adjustment Facility) established in June 1992, was used for providing short-term liquidity to the banks. Under the LAF, banks that faced a dearth of liquid Hong Kong dollar were allowed to use Exchange Fund paper and other suitable debt instruments as repo securities to gather overnight funds. This could be dome at the LAF offer rate: an interest rate, which was determined with respect to the US Discount Rate (later changed to US Fed Funds Target Rate). Similarly, banks with surplus liquid Hong Kong dollars could deposit them to the Exchange Fund and was then given the LAF bid rate in return. This was the deposit facility of the LAF. In December 1992, the Hong Kong Monetary Authority was established to take over the power from the Exchange Fund Office and the Commissioner of Banking. These tools made the HKMA more efficient in market intervention and since then the HKMA has been active in adjusting inter-bank liquidity positions, while responding to changes in the demand conditions. (Tsang, n.d.; Ho & Yuen, 2003, p. 188 Chiu, 2000, p 8) There were huge capital inflows into the city from China, owing to the stability of the Hong Kong Dollar with respect to the US dollar, the most important currency in the world. This capital inflow was primarily a result of China’s efforts to provide an impetus to the Hong Kong economy and was also supported by Hong Kong’s well-developed financial system, its strong legal framework and the opportunity that the country presented to by-pass the regulatory constraints of the mainland. It was presumed, that if the CBA was abandoned, this would decrease Hong Kong’s importance as a financial centre to China and would lower the capital inflow from the latter. Similarly, the capital inflows from other countries to Hong Kong would also be adversely affected (Ho & Yuen, 2003, p188). On the other hand, one of the costs for maintaining the CBA was that Hong Kong had to deflate its currency over a period starting from 1998. Since the beginning of the CBA in 1983 to the start of the speculative attacks in 1997, the average rate of inflation in Hong Kong was consistently higher than that in the U.S.A. High inflation took place majorly in the non-tradable sector and was mainly due to rising prices in the real estate sector. When the asset prices were considerably high, capital outflow occurred in the country. This usually has different effects in the short run and long run. In the short run, it could cause speculative attacks and in the long run a period of devaluation could ensue. If Hong Kong opted to devalue its currency, the country’s international competitiveness would be restored, but all the advantages of maintaining a CBA would be lost. Hong Kong started a period of deflation in 1998. A general weakness of the CBA is that the local citizens may doubt the intention of the Government to maintain perfect currency convertibility at the specified exchange rate. The CBA was essentially a rule-based monetary system. The Hong Kong Government gradually introduced new accounting arrangements in the economy from late 1980s onwards, so that they could facilitate the Government’s intervention in the exchange rate market. This signified a deviation from the original structure of the CBA; it also indicated that the Government now relied more on discretion rather than on rules in controlling the exchange rate. Under the CBA, the fixed exchange rate of 7.8 HKD/USD meant that in case the exchange rate deviated from this level, the HKMA would at once intervene and bring it back to the same level. In 1992, the Hong Kong Monetary Authority changed the exchange rate slightly from 7.8 HKD/USD to 7.75 HKD/USD. This meant that the Authority would now intervene if there was a slight deviation from the 7.75HKD/USD exchange rate. As a result from April 1992, the exchange rate could hardly move above the 7.75 HKD/USD rate. However, this gave rise to a new problem. Whenever the exchange rate moved above the 7.75 HKD/USD rate, the general impression of the market was a fear that the HKMA would not intervene to bring it back to the original level. Therefore, The Authority was compelled to intervene in the market. Since it had already deviated from the rules of the CBA, there was no guarantee that the HKMA would not do away with the entire arrangement. (Kwan, Lui & Cheng, 2001, p 5) Converting HK dollars to US dollars would bring many benefits for Hong Kong. Firstly, dollarizing is a competent way of matching 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, 1992). 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, n.d.). Although the Hong Kong CBA had linked the Hong Kong dollar to only the US dollar, the CBA can link the nation’s currency to two or a basket of currencies as the base. If the Hong Kong dollar is linked to two currencies this would give rise to the Dual Currency Board System which follows the similar lines of the CBA only in a more rigid form. In this case, the native country needs to keep reserves in both currencies. 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, n.d.). As this type of an arrangement 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’. (Sevic 2002) The Theory of Optimum Currency states that countries which have close international trade links among themselves would potentially benefit greatly from a common currency and are likely to be members of an Optimum Currency Area (OCA). Hong Kong would be greatly benefitted if its currency is linked to a basket of currencies comprising of the currencies of its main trading partners. However, countries would adopt steps towards economic integration in order to satisfy the criteria for entering into a Currency Union. (Frankel & Rose, 1993, p3) However, the basket currency cannot be implemented as long as the Chinese renminbi remains non-convertible. This 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. In that case, even though the renminbi would be one of the currencies of the basket, its non-convertibility would result in not being linked to the Hong Kong dollar. Thus the entire purpose of linking the HKD to a basket of currencies would be lost because it would no longer be linked to one particular currency in the basket (the renminbi). In case the Hong Kong dollar is linked to the renminbi, then the appreciation and devaluation of the renminbi would affect the Hong Kong dollar. From 1994 – July 2005 China has also followed the policy of fixing its currency the reminbi or the yuan to the US dollar. It has maintained an exchange rate of roughly 8.28 yuan/USD. In July 2005, the Chinese Government linked the yuan to a basket of currencies containing the dollar, the yen, the euro and some other currencies. The exchange rate of yuan became adjustable on the grounds of the market supply and demand following the changes in the exchange rates of the currencies in the basket. The yuan also appreciated 2.1% against the US dollar where its exchange rate was revised to 8.11 yuan/USD. It was also declared that the yuan would be allowed to fluctuate by 0.3% daily (later changed to 0.5%) against the basket of currencies. When the renminbi appreciated against the US dollar, this generated positive effects on the Hong Kong dollar. (Wang, Liu, Wei, Thorbecke). The Chinese Renminbi (CNY) and US Dollar Exchange Rate (USD) can be observed over the years as follows: When the figures are plotted in a graph, we can obtain the following: (Chinability, n.d.) Similarly, the Chinese Renminbi (CNY) and the Hong Kong Dollar (HKD) Exchange Rate can be observed over the years as follows: When the figures of the CNY/HKD Exchange Rates are plotted in a graph, we obtain the following: (Chinability, n.d.) To sum up, there were many benefits of the currency board system to Hong Kong. Firstly, it reduced the volatility of the exchange rate, the output and the inflation. Thus it stabilized the macro-economic scenario of the country. As for its disadvantages, one of the costs that Hong Kong had to pay for maintaining the CBA was that it had to devalue its currency over a period of time starting from 1993 because starting from 1983-1997, the average rate of inflation in Hong Kong was consistently higher than that in the United States. People may also doubt the willingness and competence of the government to continue ‘perfect convertibility at the specified rate’ (Kwan 1999). The performance of the currency board system in Hong Kong is satisfactory but chances of a monetary collapse cannot be eliminated. References Balino, T (1997), “Currency board arrangement issues and experiences”, International monetary fund, Washington, D.C. Chinability, (n.d.) Renminbi (Chinese yuan) exchange rates 1969-2010, n.d., August 25, 2011 from: http://www.chinability.com/Rmb.htm China Analytics (2010), “The beloved Hong Kong dollar: how long will 1 country 2 currencies last?’, available at chinalytics.wordpress.com. Chiu P (2000) Hong Kong’s Experience in operating the Currency Board System retrieved on August 19,2011 from http://www.perjacobsson.org/external/pubs/ft/seminar/2001/err/eng/chiu.pdf Crosby, M (2000), “Exchange rate volatility and macroeconomic performance in Hong Kong. Frankel J.A & Rose A.K (1996) The Endogeneity of the Optimum Currency Area Criteria retrieved on August 19,2011 from http://www.nber.org/papers/w5700.pdf?new_window=1 Hanson, C,(n.d) “Hong Kong’s economic future: Is a currency board the answer?”, available at Lehigh.edu/-incntr/publication. Ho L.S, Yuen C.W (2003) Exchange Rate Regimes and macroeconomic stability USA: Kluwer Academic Publisherss Iyikoei G. (2009) Hong Kong’s Currency Board System: An Analysis Germany GRIN Verlag Krueger A.O (1983) Exchange Rate Determination Australia: Press Syndicate of the University of Cambridge Kwan, Y & Lui, F (1999), “How well the currency board performed? Guidance from Hong Kong”, Hongkong. Kwan K.Y, Lui F.T, Cheng L.K (2001) Credibility of Hong Kong’s Currency Board: The Role of Institutional Arrangements National Bureau of Economic Research 0-226-38676-7 (233-266) retrieved on August 19, 2011 from http://www.nber.org/chapters/c10736.pdf Labonte, M (2004), “A currency board as an alternative to a central bank”, CRS report for congress. Sevic Z (2002) Banking Reforms in South Europe UK: Edgar Elgar Publishing Limited Schuler, K (1992), “Currency boards”, PhD Dissertation, George Mason University, Virginia. Tsang, S (n.d), “The currency board arrangement in Hong Kong, China”,Viability and optimality through the crisis. Thorbecke W (n.d). "How Would an Appreciation of the Renminbi Affect the U.S. Trade Deficit with China?," Topics in Macroeconomics 6 (3) retrieved on August 19, 2011 from http://www.bepress.com/bejm/topics/vol6/iss3/art3/ Read More