The Evolution of the Hong Kong Currency Board

1. The Evolution of the Hong Kong Currency Board Catherine R. Schenk

2. Origins and Early Evolution • Hong Kong’s adoption of Colonial Currency Board System • Part of British colonial monetary system: ensure stability of local note issue – automatic link to sterling • Hong Kong is latecomer – Importance of relations with mainland China • Exchange Fund established 1935 after currency instability in China due to collapse of silver: China moves to peg to sterling and USD (de facto sterling peg) • Unusual arrangement with note-issuing banks rather than direct issue by crown agents for the colonies • Sterling pegged exchange rate successfully defended.

3. Challenges in the Post-War Decades • Occupation by Japan: duress note issue reduces foreign exchange cover below 100% (restored by 1949) • Rise of Hong Kong as an International Financial Centre with free foreign exchange market • expansion of domestic banking system (M2 and M3) • expansion of domestic industry • Gradual loss of global confidence in external value of sterling leads to regular crises of confidence during 1960s • HKD appreciates against sterling in November 1967 (follows RMB) • Exchange Fund provides forward cover for banks from 1968 • Exchange Fund issues HKD denominated paper • Foreign exchange cover for note issue falls below 80% in 1974 • Importance of sterling link for Mainland China erodes • Sterling’s instability • Political and Economic Rapprochement with the USA in early 1970s

4. Foreign Exchange Cover for Note Issue 1966-74

5. Monthly sales of sterling to Mainland Banks 1957-73

6. The End of the Currency Board Rules • Collapse of the International Monetary System poses challenges for Hong Kong as an IFC increasingly integrated with Mainland China • July 1972 peg shifted from £ to USD after sterling begins a floating regime: importance of stable RMB/HKD rate • Note issue against HKD balances rather than foreign exchange held outside the banking system • USD unstable, causes difficulties for countries that shifted peg • November 1974 HKD floats and loses monetary anchor: no serious adverse effects until late 1970s inflation and depreciation against RMB, 1980 HKD begins to depreciate against USD

7. Nominal HKD Exchange Rates

8. Daily Exchange Rates 1981-1984

9. May-August 1983: Re-adopting the Currency Board • May 1983 Banking Advisory Committee discusses Latter proposal to reduce liquidity in the banking system to constrain inflation and speculation against the HKD • July/August 1983 Latter: ‘Monetary Policy in Hong Kong a Personal View’ • ‘Hong Kong has been lucky to escape with as few monetary crises in recent years as it has in fact experienced. I think it would be foolish to continue to chance our luck indefinitely’ • Dismisses return to fixed exchange rate or foreign currency backing for note issue in favour of Govt intervening in money market; HSBC to hold its clearing account in the EF: ‘putting the govt firmly in the driver’s seat’ HSBC counters with Exchange Fund CD as a specified liquid asset: object to HSBC as fulcrum for govt control and don’t believe Latter’s plan will work (Patel and Gray take leave until 23 September, debate suspended)

10. HK Exchange Rate May to October 1983

11. September – October 1983 • HKD sinks • 8 September Blye (Sec for Mon.Affairs) and Bremridge (F.S.) call for rise in interest rates to 3% - rejected by banks incl. HSBC : ‘Blye remonstrated most strongly’ that HSBC did not support Govt • 14 Sept. Blye to John Hammond, Dep. Chairman HSBC • ‘you may have recognised some similarity between Latter’s analysis and that of John Greenwood, who some regard as a competent analyst of HK’s monetary affairs. It is of course easy to sneer at these academics’ • 25 Sept. ‘The Emperor’ Greenwood proposal (drafted 16/9?): • Bank of England, EF and Govt all guarantee £ or USD value of HKD, £ and USD to be flown into HK, return to currency board based on sterling. • Latter/Greenwood ‘A Plan for stabilising the Exchange Rate’ discussed 25-26 Sept. – USD based currency board • Market advised to expect new measures and interest rates increased, steadying the market. Renewed speculation 3/10

12. Re-adoption of Currency Board 17 October • HSBC views (DK Patel, John Hammond) 28 Sept. • some merit, ‘the problems we are facing are politically induced’ and require immediate action, ready to cooperate, but doubts about Govt’s ability to hold pegged rate convertibility for deposits as well as note issue • DKP: ‘to the best of my judgement a fixed exchange system is impossible to operate efficiently without exchange controls’ • JH to Blye: ‘Frankly I have no better alternative…but it is essential that we all know what we are letting ourselves in for before we start the scheme’ • 15 October draft Telex announcing currency board • 17 October HSBC agrees to trade at 780, Banks open USD settlement accounts with HSBC, demand for USD leads them to be overdrawn against clearing accounts at HSBC, charged penalty inter-bank rates of 20-40%: confidence restored