For most of its monetary history, Hong Kong has issued its own currency under a currency board system backed 100% by a highly liquid international currency. Until June 1972 the HK Dollar was fixed against the UK Sterling and since October 1983 it has been fixed against the US Dollar. During the interim period it was initially linked to the US Dollar but from November 1974 to October 1983 it was floated.
figure 1 shows the fluctuations in the value of the HK Dollar against both the UK Sterling (on the left axis) and the US Dollar (on the right axis). In the period before June 1972 most countries were on fixed exchange rates therefore the exchange rate of the HK Dollar against the UK Sterling and the US Dollar was essentially flat except for episodic devaluations and revaluation. After October 1983 the HK Dollar is flat against the US Dollar. However, against the UK Sterling it fluctuates considerably because the world has been on a floating exchange rate since 1972.
China’s Opening and Hong Kong’s Structural Transformation
The linked exchange rate regime tied Hong Kong to the international economy and provided an important anchor that keeps the community’s faith in the currency and maintains trust in the government’s management of monetary policy. However, these benefits come at a price. Under the linked exchange rate system, adjusting the value of the external price (that is, the exchange rate) ceases to be a policy option. Hong Kong must therefore rely entirely on changing its internal price level (that is, domestic prices) to make all the necessary adjustments to accommodate any external shocks.
And there have been shocks. The impact of China’s opening from 1979 on Hong Kong was inflationary; the Asian Financial Crisis in 1997 was deflationary; and the Global Financial Tsunami in 2008 was also inflationary. These events placed conflicting requirements on the direction of price adjustments and subsequently imposed huge costs on Hong Kong. Hong Kong’s flexible private market economy has adjusted well, but its public and quasi-public sector has not. The distribution of wealth, especially property wealth, has probably been adversely affected.
For a small economy like Hong Kong, it is vital to be open so as to enlarge market reach and benefit from the innovations of neighbors and economic partners. But there is a flip side to being connected, because it means inevitably suffering from the downs, as well as ups, of these neighbors and partners. The linked exchange rate limits the range of policy choices available to the authorities to insulate Hong Kong from external impacts. In particular, since the nominal interest rate cannot deviate significantly from levels in the US, this key tool for credit management is no longer effective or available.
The linked rate is the unfettered superhighway for transmitting external effects. Like the permeable border with the Mainland, it demands the domestic economy and its various sectors to be flexible and agile in order to accommodate and absorb the external shocks.
The opening of China presented Hong Kong’s manufacturers and producer services suppliers with enormous opportunities to engage in outward processing and support other forms of export oriented manufacturing activities in Guangdong on an unprecedented scale. Manufacturing operations soon moved across the border, while the Hong Kong economy underwent a structural transformation and became a service economy. The adjustment was relatively painless and swift in the private market sector, but much less so in the public and quasi-public sector. Productivity and incomes increased rapidly, but so did inflation.
The first effect of China’s opening was to increase the productivity of externally oriented manufacturers and producer services suppliers (the traded sector) relative to the domestically oriented consumer service sector (the non-traded sector). This meant it took relatively fewer resources to produce a unit of output in the traded sector than in the non-traded sector and as a result, there was a massive re-deployment of resources from the traded to the non-traded sector. The non-traded sector went on to take up a larger share of the economy because it used a larger share of resources due to its relatively lower productivity.
Increased productivity in the traded sector also led to an increase in domestic output in Hong Kong. Domestic income and consumption spending also rose together in lock step. Hong Kong’s investment across the border produced an another effect that would cause consumption spending to increase more than the rise of domestic income. The total income of Hong Kong residents is the sum of domestically produced income and income derived from overseas operations and investments. As the scale of Hong Kong manufacturing operations in Guangdong grew, the total income of Hong Kong residents rose significantly higher and faster than domestic income. This translated into an even faster increase in consumption spending.
The structural transformation of Hong Kong’s economy therefore created a substantial excess demand for domestically oriented consumer services (the non-traded sector), so much so that measured inflation rates in Hong Kong reached double digit levels. For a small open economy like Hong Kong, the price of output from the traded sector is fixed in the world market. The enormous pressure on domestic resources caused prices in the non-traded sector to rise relative to the traded sector. Labour and property markets, which are much less mobile and tradable resources than capital, came under enormous pressure, wages rose, consumer prices increased, and property prices soared.
The inflationary pressures that started with China’s opening lasted until the onset of the Asian Financial Crisis in 1997. The situation was worsened by the linked exchange rate regime because throughout that period the value of the US Dollar was also weakening on the world market. Real interest rates (as measured by the Best Lending Rate of HIBOR) were also negative during most of this period. China’s opening was a positive shock for the Hong Kong economy, but it happened at a time when the US Dollar was weakening and US interest rates were low, thereby exacerbating the shock.
The Asian Financial Crisis
When the structural transformation was largely completed, the Hong Kong economy was shaken by the Asian Financial Crisis in 1997 with disastrous results. All East Asian and Southeast Asian economies were affected. China was relatively insulated because its international capital markets were relatively closed. Every economy except Hong Kong and China devalued their currencies to soften the impact of the negative shock that ravaged their economies and financial markets. During 1997-98, Japan devalued by 7.4%, South Korea by 32.0%, Taiwan by 14.2%, Singapore by 11.3%, Thailand by 24.8%, Malaysia by 28.2%, Indonesia by 71%, the Philippines by 27.9%, and Vietnam by 11.9%.
Hong Kong stayed with the linked exchange rate; perhaps the restoration of sovereignty from Britain to China in 1997 created enough political uncertainty that the authorities were unwilling to tamper with an important monetary institution even in the face of one of those most terrible economic times since the Great Depression. Let me put on record that at that time I too supported keeping the linked rate.
The people of Hong Kong had to endure a period of intense deflationary pressure. Between 1997 and 2003, the cumulative consumer price fell by 11.6%, the cumulative GDP deflator fell by 17.5%, nominal GDP fell by 9.5%, and unemployment reached a peak level of 8.8%. Real interest rates reached their highest levels since World War II: the real Best Lending Rate hit 12.9% and real HIBOR hit 9.8%.
It is useful to compare these numbers with US figures during the Great Depression of 1929-39. The cumulative consumer price fell by 18.7%, the cumulative GDP deflator fell by 19%, nominal GDP fell by 11%, and unemployment reached a peak level of 24.9 %. Deflation and economic output decline were comparable between Hong Kong and the US during these two episodes, although the unemployment impact was far less severe in Hong Kong.
The economic downturn and the consequences of the Asian Financial Crisis would have been worst had it not been for an impeccable record of fiscal prudence, stellar sovereign credit ratings, flexible labor and product markets, a robust banking system, and an ethic of individual self reliance. These attributes allowed Hong Kong to weather the economic crisis without descending into chaos like Argentina in the 1990s or Greece today. Still, half a million people in Hong Kong marched on the streets on 1 July 2003 to express their economic and other frustrations. In the following year, Mr. C H Tung had to step down as Hong Kong’s Chief Executive.
The Global Financial Tsunami
The Global Financial Tsunami first struck in the US in August 2008. Turmoil in the banking and financial markets has since abated, but a lingering unresolved crisis in the Eurozone area remains. The world’s largest industrialized economies are all struggling with around double digit unemployment rates and trying to stave off the threat of recession. Yet Hong Kong is miraculously experiencing an unemployment rate of 3.3%, and since 2009 cumulative nominal GDP has risen by 12.83%, cumulative GDP deflator by 3.2%, and cumulative consumer price inflation by 8.2%. Property prices are once again soaring from both internal and external demand.
The prospect of a prolonged period of low interest rates in the global economy has fueled asset price increases in Hong Kong once again. Real interest rates have turned negative: the real Best Lending Rate is -0.3% and real HIBOR is -5.0%. The government is strenuously trying to dampen property price increases through regulatory and fiscal measures, and more recently through measures to increase housing supply, but at the same time desperately trying to avoid triggering an accidental property crash.
Hong Kong is not the only economy in Asia and among the emerging market economies to be in this predicament. But the inability to adjust its exchange rate has automatically removed the only available policy tool for softening the impact of external shock on the domestic economy. Regulatory and fiscal measures are at best only temporarily effective at choking off demand; particularly as their impacts are usually limited to those who can least afford to make a purchase. They also create huge distortions in the market.
The Exchange Rate and the Value of Rules
In the period 1974-83 when the HK Dollar floated, it first appreciated against the US Dollar then gradually depreciated. This was the period when Fed Chairman Paul Volcker tightened monetary policy and raised interest rates in order to break inflationary expectations. The gradual depreciation of the HK Dollar raised domestic prices in Hong Kong and probably softened the austerity impacts of the Volcker measures on the local economy. But this was an exceptional period in Hong Kong’s monetary history.
Under the linked exchange rate, the key tools for monetary management are no longer available to Hong Kong authorities. Both the exchange rate and the nominal interest rate are tied to those of the US. It is easy to blame the bad state of the economy on the loss of policy tools. What is often ignored is that cyclical fluctuations are seldom permanent. The goal of a stabilization policy is to encourage supply and discourage demand during an economic boom and vice versa. The question is whether discretion or rules should guide macroeconomic stabilization policy.
Under an exchange rate arrangement, the authorities must make a choice between two main macroeconomic objectives: internal price stability or external price stability. In the face of a temporary positive shock, the demand for internal price stability can be met by reducing inflationary pressures through an appreciation of the currency. A flexible exchange rate arrangement can potentially help engineer a deflationary effect, and will empower the monetary authority with considerably more discretionary power.
Whether the monetary authority will “do” the right thing, “say” the right things, and “act” at the right time in applying this power is of course uncertain. The markets will respond to the increased uncertainty accordingly. They are prone to indulge in speculative endeavors to out-guess the monetary authority’s actions.
If the monetary authority has to be made accountable for its additional powers in a highly politicized manner, then the power of discretion becomes its vulnerability. Uncertainty will be heightened if the stabilization policy is held hostage to the whims of politicians and the lobbying of interest groups. Worse, it exposes monetary and higher officials to enormous risks of being corrupted or blackmailed.
By contrast, the linked rate, whose aim is to achieve external price stability, has a higher degree of certainty because it is tied down by rules. The longer the rules have been in place and survived the test of time, the greater their credibility. There are obvious tradeoffs between alternative exchange rate arrangements. But highly credible rules are invaluable and should not be abandoned lightly; and certainly not for temporary short term gains and to appease special interests.
Are there options for keeping the linked rate regime and continuing with 100% US Dollar backing, but allowing the rate to be set by a transparent formulaic rule that would automatically appreciate the HK Dollar at regular specified intervals when there is inflationary pressure and vice versa? This is an almost impossible task for two reasons.
First, no one is able to devise a formula that predicts future events over a long horizon and outperforms the US Dollar. Second, it is difficult to see how any formula could be immune to manipulation. A popular alternative candidate is a weighted basket of currencies, but it also fails on both counts. It is impossible to specify the correct basket of currencies and their appropriate weights for the future and the basket would be vulnerable to statistical manipulation as long as it contained more than one currency.
The only alternative is to adjust the rate periodically with the value of the RMB, but still retain the US Dollar backing. This solves the manipulation problem, but it does not resolve the question of whether it will be the correct rate for Hong Kong. And we would have replaced the uncertainties of Fed policy with that of the People’s Bank of China.
Policies to Facilitate Market Adjustments
If Hong Kong has to live with the linked exchange rate regime then it is useful to consider how life can be made less onerous. Maintaining a balanced budget and holding down public expenditure in the face of rising political demands will be the single most important task. All one has to do is to look at the enormous public debt burdens of industrialized economies today. In the post-Depression era these governments created expensive social welfare policies that have finally come to roost. If Hong Kong follows this path as our politicians implore us to do, then it could not continue to keep its economy open and its external prices stable.
The government can contribute most by reducing artificial impediments to the proper operation of market forces. Avoid legislation that reduces labour market mobility. Labor market interventions in Hong Kong are quite modest by comparison with other countries and they should remain so because the structure of our economy demands a great degree of flexibility. If our labor markets were any less flexible it is doubtful our unemployment rate during the Asian Financial Crisis would have peaked at only 8.8%.
Property price inflation is an outcome of the adjustment process. The rising cost of housing in the property market is politically divisive and socially alarming. The solution is to increase the supply of housing. This can be achieved by increasing land supply, raising plot ratios, facilitating the redevelopment of urban areas, and altering frozen land uses. Selling the existing public housing stock to occupants at giveaway prices will help to alleviate the consequences of property price inflation and reduce the unequal distribution of wealth. This will provide almost half the population with a good hedge against inflation and greatly increase housing market efficiency. Building more public rental and homeownership scheme units would not achieve these goals, and would be another burden on government spending.
No monetary authority can be completely insulated from political pressures. Events outside the monetary area will inevitably conflict with the goal of maintaining external price stability. The monetary authority cannot afford to ignore these non-monetary issues that are beyond its control. However, it is just as suicidal for the authority to involve itself in politics because this would compromise its autonomy and independence.