The Linked Exchange Rate System and 作 為 一 種 貨 幣 局 制 度 ， 香 港 的 聯 繫 匯 率 安 排 ， 既 不 古 典 ， 亦 非 現 代 ， 現 鈔 套 戥 的 效 率 極 低 。 要 鞏 固 聯 匯 ， 一 是 提 高 現 鈔 套 戥 的 效 率 ， 二 是 設 立 AEL（ 指 阿 根 廷 、 愛 沙 尼 亞 、 立 陶 宛 三 國 ）模 式 的 無 鈔 套 戥 機 制 。 此 外 ， 從 適 合 的 角 色 來 看 ， 短 期 內 香 港 毋 須 放 棄 聯 繫 匯 率 。 Historical, Institutional and International Backgrounds Crisis. The linked exchange rate system of Hong Kong was launched on 17 October 1983, in reaction to a currency crisis arising from the Sino-British dispute concerning the political future of Hong Kong after 1997. The Hong Kong dollar was floating rapidly downwards, indeed plunging, in the foreign exchange market at that time, and the local authorities were desperate to find a solution to save it. New bottle, old wine. The solution, i.e. the linked exchange rate system, or simply the "link" which pegged the Hong Kong dollar to the US dollar at the rate of 7.80, was not a new invention. It was in essence a resurrection of the "currency board" scheme adopted in the territory from 1935 to 1972, with some modifications. Pure currency board. In its pure form, a currency board can only issue domestic notes when it has an equivalent amount of a designated foreign currency as international reserves at a fixed exchange rate. This supposedly imposes strict monetary discipline on the conduct of economic policy, where the expansion of money (at least in its narrow definition) is permitted if there is a balance of payments surplus in the economy. Exchange rate stability is underpinned by such discipline. Heyday. Currency boards have a long history. The first one was established in Mauritius in 1849. Eventually, as many as 70 economies adopted similar arrangements and the system reached its heyday in the 1940s. In the post-war era, they were out of fashion as newly independent territories sought monetary autonomy by setting up their own central banks, and then floating exchange regimes replaced the Bretton Woods system. Revival. Currency board economics seems to be enjoying a revival. Hong Kong resurrected it in 1983. Then Argentina adopted a similar scheme in 1991, Estonia in 1992, and Lithuania in 1994. At present, there are about ten countries and territories in the world which host such a system. Theory. As an exchange rate system, a currency board differs from a pegged rate regime based on foreign exchange control or market intervention by the monetary authority. It relies on fixing a parity rate on a narrow definition of money (typically bank notes) that the authority can control (because of sufficient reserves), and, like the gold standard, it stipulates concurrent arrangements that invoke arbitrage and competition activities which will push the exchange rate on wider definitions of money (e.g. deposits) towards the parity rate, if any deviation between the two rates occurs. Currency board with central bank. In its modern versions, a currency board is in some cases augmented by a central bank with various tools at hand, which may strengthen exchange rate stability. This is the case in Hong Kong (since 1993), and also the case now in Argentina, Estonia and Lithuania (AEL). Hong Kong's idiosyncracy. However, Hong Kong's linked exchange rate system differs from the classical currency board as well as the modern AEL model: (1) In both the latter cases, currency notes are issued either by a genuine currency board or a unit in the central bank, but HK$ bank notes are issued by authorized note-issuing banks (NIBs) outside the Hong Kong government. An indirect note issuing and withdrawal mechanism (NIWM) is thus in operation in the territory. (2) In the AEL model, a centralized clearing and reserves system is operated by the central bank, which deals with each bank directly. No such system is yet in place in Hong Kong. In other words, Hong Kong has a system which is neither classical nor modern. This explains some of the remaining problems in the link. Technical Viability Reasonable performance. On the surface, the link has held quite well in Hong Kong even in face of major political and economic shocks since its inception (in 1984, 1987, and 1989). However, the deviation of the market rate from the official parity of HK$7.80/US$ was up to 3% (at one very brief point) in the 1980s and about 1% in the 1990s. In the last six years, the market rate has persistently been on the strong side of 7.80. Which cannot be clearly explained. Such deviations may have been "tolerable"or even "welcome", but beg the question why they had not been eliminated by effective arbitrage and competition, the supposed forces that should uphold the system. No such deviations could theoretically exist in the classical currency board, except to the extent of the so-called "transaction cost" of doing arbitrage (which nobody can accurately quantify in Hong Kong). Marked deviations like Hong Kong's are also not empirically observed in the AEL model when it has been fully established. Lack of transparency and immediacy. While past success may be the best reason for maintaining the status quo, it is no guarantee for future security. The biggest problem with the Hong Kong link is that the theoretical underpinnings (arbitrage and competition) have apparently not been functioning effectively, and nobody could quite clearly elucidate as to why it has been, is, and will continue to be robust. There is a certain lack of transparency and immediacy in Hong Kong's indirect NIWM, which leads to doubts about the viability of the system under extreme cases. A nightmare of correlated disasters? The link has gone through a number of tests, but not one in which bank run and attack on the link occur simultaneously (not in 1984, 1987, or 1989). In such a scenario, banks in Hong Kong would be in serious shortage of cash (because of bank run), and therefore severely handicapped in doing or facilitating cash-based arbitrage activity that could defend the link. It will be useful to have a system which keeps the exchange rate intact and channels pressure away to other aspects of the economy which have more absorbing power, as in the AEL system. Reforms should not be destabilizing. Hence the present system should be improved to provide a more dependable floodgate. During the process, however, any reform must not generate any destabilizing effects, society-wide controversies or confidence-shaking results. The aim is to reduce the transaction cost of doing arbitrage under the link. Bank-based reforms. It is the banking sector which is crucial in ensuring the viability of the link. Since for various reasons the present system has not been performing the theoretically assumed activities of arbitrage and competition to force a closer alliance of the market rate and the official rate, two options are proposed for consideration: (1) Option 1: The modified clearing house option. HK$ notes are to be admitted for interbank settlement. The problem of the inconvertibility between HK$ cash and deposits for banks in the present indirect NIWM (except through exchange transactions against the US$ that eliminate any possible arbitrage profit), which undermines the arbitrage efficiency of the link, is alleviated. But the extent of cash-based arbitrage will be limited by the set-up and the viability of the HK$ cash inventory of the settlement institution. (2) Option 2: The convertible reserves system along the line of Argentina, Estonia and Lithuania (AEL): where the Hong Kong Monetary Authority (HKMA) could institute a normal banking reserves system and then guarantees the convertibility of the "monetary base" (or its total financial liabilities) into the US$ at the fixed rate of 7.80. Cash-based arbitrage will then be largely implicit, or unnecessary. Steady progress towards both options. Both options are greatly facilitated by the introduction of the real time gross settlement (RTGS) system in Hong Kong to be operated by the Hong Kong Interbank Clearing Ltd. (HKIC), which provides the fundamental hardware and software. Option 1 requires less institutional changes, but there is an admitted limit to its efficiency. Option 2, the AEL model, is a proven case of success, but it requires more institutional changes, which may meet some resistance. However, Hong Kong does not need to go the full length to achieve the effects that the AEL model ensures. In other words, we can have an AEL model with Hong Kong characteristics. Option 1 first, then maybe option 2. Whether option 1 or option 2 should be adopted also depends on the changing political and socio-economic climate. It requires judgement other than economic analysis. With the RTGS system coming on-stream, it may be worthwhile to try option 1 first, to see if cash-based arbitrage succeeds in closing the gap between the market rate and the peg rate. If that does not occur, or serious problems emerge, option 2 should be considered. No need for permanent window. The institution of a window for universal arbitrage as a permanent feature of the system is not recommended because it is not necessary. Nevertheless, in a crisis situation, it can be temporarily employed as a confidence-boosting gesture, just as what Estonia did in the launching of her new currency. It is however a two-edged sword, and should only be used carefully. No peg adjustment or refloating under pressure. Given the historical origin of the link and the possible difficulties lying ahead, peg adjustment (changing the official rate to a higher or lower level) or refloating should never be used as means to ward off pressure because they will be seen as defeatist moves . Economic Optimality Virtues and vices of currency boards. In terms of Williamson's (1995) summary of the "four virtues and seven vices" of a typical currency board, Hong Kong has been in a very good position to capitalize on the advantages and to minimize harmful effects of several potential disadvantages. From that perspective, the link is suitable for Hong Kong. Seigniorage and transition problems. A key factor is the very "healthy" fiscal position of the Hong Kong government. The huge foreign exchange reserves accumulated over the past decades, however, highlight the seigniorage and the transition problems pointed out by Williamson (1995)---the difficulties of earning sufficient returns on foreign assets in a situation of high domestic inflation. A typical currency board requires 100% reserves cover for currency issuance. But by June 1996, the Exchange Fund's cover for currency in circulation was 566%. It appears that in the pre-occupation to build up reserves to "defend the link", the Hong Kong authorities have not in the past given enough attention to optimality considerations. Inflation. The lack of instruments to offset the inflationary pressure in the 1990s, on the other hand, points to a management problem in a fixed exchange rate system. There can be two channels through which external inflationary pressure filters into the local economy: (1) inflation imported through trade; and (2) asset inflation. An analysis of relevant data does not yield any convincing evidence that the link has been responsible for trade-related inflation. As for asset inflation, major problems only emerged in the 1990s. Refloating for optimality? The rigidity of the exchange rate (or the lack of exchange rate flexibility) might have been a cause for some laments in the inflationary situation in the 1990s, but the complaint has to be set against the potential benefit and cost of the hypothetical re-gaining of flexibility through the refloating of the currency. Contradiction between inflation control and growth promotion. The case for a flexible exchange rate in Hong Kong cannot be true for both fighting inflation and promoting growth in the 1990s. Most would agree that if the HK$ had been in a floating state in 1990-1995, it would have appreciated against the US$. Inflation might have been alleviated to some extent, but growth might also have been adversely affected. Fixed versus floating exchange rate regime. In general, the more flexible the real sector of an economy is, the more suitable is a fixed exchange rate to it, because there is no need to change nominal prices through exchange rate movements to offset external shocks. The real sector will do the job by quickly adjusting. Hong Kong is such a flexible economy. Moreover, for a small open economy with a huge financial sector, a floating exchange rate system may bring instability and risks, as speculative capital movements and attack on the currency are difficult to contain. A fixed rate regime does have the advantage of diverting pressure away from the exchange rate to other aspects of the economy and thus provides an important anchorage. No baskets: The re-pegging of the Hong Kong dollar to a basket of currencies is not recommended as it will lead to a loss of transparency in the system and possibly the total disappearance of arbitrage. Economic linkage with China: Pegging to the Renminbi? In the long run, if on optimality considerations the authorities decide that a different link is desirable, then a simple horizontal currency realignment, e.g. to the future freely convertible Renminbi because of increasingly close ties between the Chinese and the Hong Kong economies, is always a choice and can be done quite easily. All the HKMA has to do is to choose a relatively calm period when the Renminbi/US$ exchange rate remains stable, say at Rmb7.80/US$, and to announce a re-denomination of the link at HK$1.00/Rmb1.00. Conclusions 1. The continuation of the linked exchange rate system is recommended on the basis of both technicality and optimality considerations, through the 1997 transition and into the 21st century. 2. Technically, the robustness of the link should be improved by pursuing the modified clearing house option, and failing that, the convertible reserves option of the AEL type. Maintaining the status quo carries a risk, because the link has not been tested in a scenario of simultaneous bank run and attack on the HK dollar. 3. Both the modified clearing house and the convertible reserves options, as floodgates against external shocks, need time to implement. In other words, they cannot be instituted overnight to handle a crisis. Hence, preparatory work must be done before hand. 4. In time of crisis, the HK dollar should not be re-pegged or floated to ward off pressure. The authorities should use whatever means to defend the link. The temporary operation of a universal window can be used, but carefully. 5. The re-pegging of the Hong Kong dollar to a basket of currencies is not recommended. 6. In terms of optimality, there is no strong case to replace the link with a floating exchange rate regime in the foreseeable future. 7. If economic linkage between Hong Kong and China further strengthens, and the justification for pegging the HK dollar to the US dollar becomes weak, a horizontal realignment to the future freely convertible Renminbi is always an option and can be done quite easily. |