Exchange Rate Regimes and The Link Rate in Hong Kong

1. Exchange Rate Regimes and The Link Rate in Hong Kong Howard Davies

2. Basic Ideas on Exchange Rates • A country’s currency is SUPPLIED whenever there is a negative item in the balance of payments: • when residents buy imports of goods and services • when residents invest directly in other countries • when residents buy financial assets in other currencies

3. Basic Ideas on Exchange Rates • A country’s currency is DEMANDED whenever there is a positive item in the balance of payments: • when residents of other countries buy exports of HK goods and services • when overseas residents invest directly here • when residents of other countries buy financial assets in $HK

4. The BoP and currency market • If the ‘autonomous transactions’* in the balance of payments are in balance then demand for currency = supply of the currency • * autonomous transactions are those arising from the ordinary business of the public and private sectors - as opposed to ‘accommodating’ transactions which are purchases or sales of currency whose purpose is to affect the exchange rate

5. In a completely free currency market supply $US0.10? demand $HK

6. In a completely free currency market • Exchange rates would continuously rise and fall with supply and demand • As demand for and supply of the currency is determined by trade and financial flows, the e/rate will be affected by a very wide range of economic factors: • interest rates • relative wages and prices • government deficits,money supply and borrowing

7. In a completely free currency market • If the balance of payments develops a DEFICIT (most obviously because prices are high relative to prices elsewhere) • More of the currency is being supplied than demanded at the current e/rate. Hence the e/rate falls • As the e/rate falls, local prices become cheaper (and local incomes lower). Prices of foreign goods become higher. • The deficit should be eliminated.

8. What are the problems of a free-floating currency? • If markets work perfectly smoothly, there should be no problem • But - the adjustment process may be slow or might not work at all - prices of imported goods rise, raising inflation. There might not be enough capacity to produce extra exports or import substitutes • Uncertainty associated with exchange rate risk is a major barrier to trade. In HK 90,000 small trading firms may have significant problems

9. What are the problems of a free-floating currency? • Governments may use the apparent ‘ease’ of the solution to practice fiscal indiscipline - “if we cause inflation by spending too much and printing money, we can just devalue”. • Markets may be made ‘stickier’ by the lack of a need for domestic prices to fall - ‘institutionalized’ thinking -’money illusion’. DO YOU THINK PRICES ALWAYS GO UP? AFTER 40 YEARS OF INFLATION MANY DO, BUT WHAT IF WE NOW HAVE 40 YEARS OF DEFLATION?

10. In a fixed rate system • The authorities need to buy up ‘excess’ supply Supply 1 Supply 2 $US0.10? demand $HK

11. In a fixed rate system • The authorities must have enough ‘reserves’ of foreign currency to cover the supply/ demand gap at the fixed rate. • Reserves will rise when the balance of payments is in surplus at the fixed rate and fall when there is a deficit • Governments may borrow from other central banks or the IMF if they begin to run out of reserves. • When reserves run out, either currency transactions are stopped or the currency simply ‘floats’ to the free-market level.

12. Advantages of a fixed rate system? • Stability, stability, stability - certainty over currency values reduces ‘transactions’ costs. Capital can be raised overseas with less risk premium.

13. Advantages of a fixed rate system? • Governments are not able to take actions (or allow actions) that will cause a payments deficit big enough to make the reserves run out, like: • banks borrowing in foreign currency when they might not be able to pay it back (but it happened in Thailand) • having interest rates lower than trading partners • running large government deficits (the balance of trade must equal the amount by which domestic savings exceeds investment plus the government budget surplus) • BUT governments do not always understand this - then they blame ‘speculators’

14. Disadvantages of a fixed rate system • If prices get out of line with those in other places, domestic prices and wages must fall, which is painful/impossible in some places. • The government cannot have independent control of domestic monetary conditions - money supply and interest rates. • It is only possible to control one corner of the ‘triangle’ of interest rates, exchange rates and money supply. If you choose to control the exchange rate, you lose control of the others • Is this last one a real disadvantage? Do you trust the government?

15. The 1997 Crisis • Thailand has a fixed rate for baht/$US - central bank has reserves to sustain it. • Thai banks borrow in $US and lend in baht, believing that the fixed rate is permanent. Basic failure to manage risk • Many of the loans are poor quality (crony capitalism) and do not get paid back. Also failure of the banking system. • Lenders to the banks want their $US back so Thailand has a deficit bigger than reserves. ’Speculators’ see profit opportunities in selling baht

16. The 1997 Crisis • Baht is devalued and banks now cannot repay $US loans, even if their loans are good in baht • Banks default, general financial collapse in Thailand • Spreads to other countries in Asia as investors • Governments blame ‘foreigners’ and ‘speculators’ for their own mistakes. But speculators do not feed on healthy meat. • In Hong Kong the government intervenes to prop up prices on the Stock Exchange in order to reduce the pressure on the ‘link rate’ caused by investors panic selling of Hong Kong equities (and hence $HK)

17. Hong Kong’s Link Rate System • A ‘currency board’ system - a self-regulating device • Hong Kong is committed to converting HK$ to US$ at a fixed rate of $7.8 • Hong Kong’s banking system (the note-issuing banks) can only issue $HK notes if they have $US • The note-issuers pay US$ to the Exchange Fund in return for Certificates of Indebtedness (CIs), which allows them to issue $HK to the equivalent amount. • If the rate in the forex market differs from the link rate then the note-issuers can buy or sell in the market and buy or sell to the Exchange Fund

18. Hong Kong’s Link Rate System • The EFund must always be able to buy $HK with $US but that must be OK as the banks paid the EFund in $US anyway (EFund must hold its assets in $US) • HK interest rates cannot differ significantly from US rates (they will be a little bit higher to give a risk premium). • If there is a ‘run’ on the HK dollar i.e. large scale sales, there will be a shortage of liquidity in the HK banking system and interest rates will ‘spike’ until people are willing to hold $HK again.

19. Hong Kong’s Link Rate System • BUT more recently HKMA chief Joseph Yam has suggested that ‘we need our reserves to defend the peg’ • The currency board system is not a ‘pure’ one - HKMA may buy and sell in order to push interest rates up and down to a limited extent. • However, taken further, this could be very dangerous. If investors believe that HK Government is not prepared to take the ‘pain’ of the peg - high interest rates and falling local wages and prices - they can easily outspend the HKMA

20. Should we keep the peg? • AGAINST THE PEG • It forces our interest rates into line with the US, which meant negative real interest rates in the 90s, which fuelled the property bubble - in general HK may be at different points in the business cycle than US, requiring different i/rates • It makes us ‘uncompetitive’ (?????) - it requires HK people to accept lower wages and prices if they get out of line with those elsewhere - if they don’t unemployment will result. (BUT DON”T CONFUSE THAT WITH THE 2003 SITUATION) • It takes away any power from HKGovt to pursue its own monetary policy • It distorts the banking system by giving the note-issuers a kind of subsidy • a link with the RMB would be better

21. Should we keep the peg? • FOR THE PEG • stability, stability, stability - it gives investors confidence in $HK assets and allows traders to trade in a known value currency - CRUCIALLY IMPORTANT • It takes away any power from HKGovt to pursue its own monetary policy (which might be as smart as its housing policy, education policy, competition policy) • It forces people to accept the workings of the market in a place which is too small really to do anything else. If your income in $HK goes down how is it different than if your income in $HK is the same but the price of imports goes up?

22. Should we keep the peg? • WHAT WOULD REPLACE IT? • a peg to $US at a lower level, a peg to the RMB, a peg to a basket of currencies, or a floating $HK? • a lower peg to $US is a ‘one-off’ change - if pressure on the rate arises from long-term trends, the devaluation would have to be repeated. BETTER TO KEEP IT AT THE CURRENT RATE • peg to RMB? But RMB is non-convertible at the moment and in any case China’s export business is a $US business • float the $HK? In such a small place e/rate volatility is likely to be extreme - traders and investors who have some costs/assets in $HK may find it difficult to hedge the e/rate risk

23. On balance? • For a small open economy, subject to economic pressures that it cannot control, having flexible markets is a real benefit - the link rate forces that on HK. People here know that prices and incomes can go up and down • The increased transactions costs caused by a float would be a real problem • Changing the peg downwards, even once, would make it clear that a new link rate is not here to stay. • BEST TO KEEP THE PEG?

24. Is there a situation where the peg must go? • The Argentina scenario • If HK’s markets become impossibly ‘sticky’ - prices and wages will not move downwards - and the Government cannot control its fiscal deficit, then correcting the ‘over-pricing’ of HK becomes impossible. • Instead of wages and prices falling, mass unemployment results (not the minor structural unemployment we currently see) • In that situation we lose income, not just because our income is worth less in foreign currency, but because output is falling.