Should Hong Kong adopt a different exchange rate regime than its link to the US dollar? Ever since China’s opening, Hong Kong has become more integrated with the Chinese economy, a development likely to increase over time as the Chinese economy continues to grow faster than the advanced economies of the US, Japan and Europe. So is the Linked Exchange Rate system fit for purpose in this emerging global economic landscape?


This may seem an important question to ask, but it is the wrong question. Hong Kong must strive to achieve dual integration –– first with the global economy and second with the Mainland economy –– in order to provide continued support for China’s progressive integration into the global economy. I had previously discussed the question of dual integration in this newspaper (see On the Source of Deep Contradictions (Parts I and II) 25 April 2012 and 2 May 2012). Ideally, Hong Kong’s exchange rate regime should support its dual integration role and not simply its economic integration with the Mainland.


For a small open economy like Hong Kong which has extensive international transactions with almost all major countries, there is very limited choice when it comes to the currency of choice for a fixed exchange rate. Three factors figure prominently.


First, while the rate should ideally be linked to an economy with which the selecting country has increasingly closer economic integration, this may not hold true for Hong Kong. True, China is likely to become its major trading partner over time even though Hong Kong still trades heavily with the rest of the world, and Hong Kong’s business cycle will become more synchronized with that of China’s making China a potentially suitable anchor economy. However, synchronized fluctuation over the business cycle is only one relevant consideration when it comes to economic integration.


Renminbi Link Deflationary


Another equally important consideration is the implications of Chinese economic growth on the value of the Renminbi. China is a developing economy so the Renminbi is likely to appreciate as it develops, similar to Japan in the post-World War II era. Pressure for China to appreciate its currency will rise as its economy transforms from manufacturing towards services, and especially non-traded services. This will lead to structurally generated domestic inflation. Again this is a long on-going process given that China still has a sizable agricultural sector.


If the Hong Kong dollar were anchored with the Renminbi under such a scenario, then its exchange rate would have to appreciate against the rest of the world in tandem. Hong Kong would then be faced with the long-term prospect of importing deflationary pressures as China modernized.


Alternatively, keeping the currency fixed against the US dollar would import inflation as Hong Kong continues to integrate with China. This makes it in fact an easier choice. Economically and politically, deflationary pressures as would be seen with a link to the Renminbi are much more difficult to manage than inflationary pressures, as we have learned from the experience after the Asian Financial Crisis.


The second factor affecting Hong Kong’s choice of an anchor currency is the need for the monetary policy of the anchor economy to be well behaved. At present there are no obvious credible alternatives to the US Fed. The People’s Bank of China does not have a long enough track record for us to judge its behavior. In the best of circumstances, it will be focused on accommodating the needs of a modernizing economy and this may not fit the needs of a developed open city economy like Hong Kong. If the People’s Bank resists market forces in order to achieve other state-determined developmental goals, then its monetary policy will be subject to considerable policy uncertainties, and possibly undisclosed reversals. This would not be regarded as a well behaved monetary policy and would not meet Hong Kong’s needs for a stable reliable currency anchor.


The third factor would be the difficulty of linking Hong Kong’s currency to a currency with limited convertibility such as the Renminbi. Hong Kong’s role as an international financial center would be immediately jeopardized as demand for Hong Kong dollar denominated assets backed by Renminbi would suffer. The advantage of linking to an international reserve currency like the US dollar is its full convertibility. China’s economic reforms are facilitated by Hong Kong’s continued vibrancy as an international financial center. Hong Kong serves as a benchmark, a source of funds, a facilitator for institutional innovation and reform. Linking to the Renminbi before it becomes a stable and fully convertible currency would be neither in the interest of Hong Kong nor China.


Basket Link Subject to Manipulation


The only way for the Renminbi to become reliably stable and fully convertible is if China resolves the glaring internal and external imbalances of its economy. Unless China weans its economy off the addiction to investment driven growth and rebalances towards consumption, its economy will hit a wall in a few years. These imbalances cast a long shadow over the future course of monetary policy of the People’s Bank of China, whose sole policy consideration has to be the growth and stability of the Mainland economy.


Milton Friedman has often warned that a small economy should not abandon its monetary policy independence to another country if that country is expected to pursue a poorer monetary policy than the small economy would have done on its own. By the same token we should not abandon the link to the US dollar in favor of the Renminbi unless we can be reasonably certain that the monetary policy of the People’s Bank of China will be more reliable and favorable for Hong Kong than the US Fed’s policy. In choosing between currency anchors, Friedman places the greatest emphasis on this consideration.


Another option might be for Hong Kong to fix its currency against a basket of convertible currencies from countries that are our major trading partners, but not including the Renminbi. However, it is not clear what advantage this would have over the US dollar link as it is impossible to know if such a basket would appreciate faster than the US dollar. Moreover, calculating the effect of second by second changes in the value of the currency basket is not straightforward. The weights used in a currency basket in general change as the value of each currency in the basket changes. A rise in the value of a currency increases its weight in the basket, and vice versa. This is a highly undesirable property to have when currency volatilities are high.


If such a basket were not pre-announced and therefore not rule-based, we would have to hand over to the Hong Kong Monetary Authority the power to make discretionary decisions over the value of the exchange rate. In effect we would migrate from a fixed exchange rate system to a flaky rate. How would the Monetary Authority decide the exchange rate? Would its mandate be to stabilize domestic prices, maintain unemployment, nominal GDP, or all or some of the above? Would domestic price stability be limited to consumer prices, core consumer prices, producer prices, property prices or all or some of the above? None of these decisions can be reduced to a simple formula. There will be ambiguity about the mandate given to the Monetary Authority and there will be considerable scope for discretion. Worse, the public might suspect that there would even be scope for indiscretion.


Link Rate Still Preferred


Questions would also arise about the Monetary Authority itself. Would it act under the instructions of the Financial Secretary or be independent? Is there sufficient political authority for the government or the Monetary Authority to take the required discretionary decisions? I have always suspected that some of the things the Singapore Government can do are not within the reach of the Hong Kong Government. The Singapore Government after all rules with the political authority of the People’s Action Party. A party that has won every single election since the founding of the Republic of Singapore by an overwhelming majority can assume much greater authority. The Chief Executive of Hong Kong does not even have a political party to call upon.


The problems of an undisclosed basket of currencies are of course also present with a floating rate. A floating rate would allow the Monetary Authority to control its own monetary policy, which would have to be announced. If domestic stabilization were the goal then it would have to state that this was the rule which it intended to follow to conduct monetary policy. The rule could be price stability, full employment, stability in money growth, stability in nominal GDP growth, or some combination of the above. Experience from most countries has shown that hitting any one of these targets is not easy in part because they are not precise. Perhaps the greatest skepticism relates to whether Hong Kong’s small open economy would be able to meet any of these targets with capital flowing freely across borders.


I have included nominal GDP in the list of targets and this deserves an explanation. Targeting nominal GDP was first proposed by Professor James Meade (Nobel Laureate, 1977) but it has never been tried. Currently, though it is getting a popular revival among the Market Monetarist group of economists posting in the blogosphere led by Scott Sumner, a University of Chicago graduate, the idea has not been endorsed by economists currently associated with the Chicago School of Economics.  However, it does have the support of Keynesians like Paul Krugman, Brad DeLong,

Christina Romer, Jeffrey Frankel, and others. Indeed, The Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere. I have included a paragraph on this because I suspect it will become an important idea in getting the world out of is current doldrums.


Coming back to the original discussion, it is worth noting that Singapore, like Hong Kong, has also decided against a floating rate. Instead it chooses to fix the exchange rate under the pretext that it is pegged to an unannounced basket of currencies. Presumably its exchange rate adjustments aim to achieve some degree of domestic stability. However, the domestic stabilization rule is not explicitly stated, thus avoiding the need to bind the monetary authority to intervene in the foreign exchange market. Nevertheless, Singapore has from time to time imposed capital controls to achieve its domestic stability goal, including controls over the purchase of property in a bid to stem property price increases due to capital inflows.


Based on economic considerations alone, our discussion of floating, fixed and flaky exchange rates so far has not uncovered any compelling reasons as to why any of the alternatives that have been raised over the years, and also in Mr. Joseph Yam’s recent research paper, are preferred to the present Linked Exchange Rate, at least for the foreseeable future.


Both fixed and floating exchange rate regimes have inherent free market adjustment mechanisms that accommodate economic shocks (both domestic and external) to avert a balance of payments or currency crisis. The adjustments are market driven and do not require government intervention, yet governments everywhere have often chosen to intervene. As a consequence, real world exchange rates often end up becoming flaky exchange rate regimes by default, where governments adjust the exchange rate after promising to uphold a fixed rate or intervene in the foreign exchange market after promising to uphold a floating rate. Governments break commitments because of the political pressures they face, so the drift into flaky rates is therefore political and not economic. Once we recognize the unavoidable propensity of governments to accept political expediency, then the choice of exchange rate regime has to recognize the political consequences.


Weathering The Asian Crisis


Hong Kong’s Linked Exchange Rate system is one of the most robust fixed exchange rates in the world today. It has remained robust because the Hong Kong population realizes instinctively its intrinsic value to Hong Kong. Staying with the Linked Rate requires economic policy discipline in a number of areas to make it function well. When the exchange rate cannot be adjusted in the face of external shocks, then wages and prices must remain flexible to absorb the shock. A high degree of capital and labor mobility will make resource reallocation more responsive. The presence of a large private sector generally will make the economy more flexible and able to adjust rapidly to shocks. Fiscal discipline that avoids budget deficits and public debts keeps government small and also makes the Linked Rate stronger.


The robustness of Hong Kong’s Linked Exchange Rate was severely tested during the Asian Financial Crisis. All economies in East and Southeast Asia were affected. Every economy except Hong Kong and China devalued their currencies to soften the impact of the negative shock. 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, with its Linked Rate, 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 by 17.5% and nominal GDP 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 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 self-reliance. These attributes allowed Hong Kong to weather the economic crisis under the Linked Exchange Rate, an ordeal not conceivable in any other economy. The people of Hong Kong should be proud of what they achieved during the six years when their economy was ravaged.


Rise of Property Prices Divides Society


Since the Financial Tsunami of 2008, Hong Kong has had to endure a different adjustment process due to the weak US dollar and low interest rates. Inflation and especially asset price inflation has created a deep division within the community between those with property and those without. The widening economic gap in Hong Kong is not so much one of income but more of wealth. The latter gap is to a large degree the effect of external shocks on property prices over the past two decades, which were amplified by a fixed exchange rate regime. This consequence was not difficult to foresee even 20 years ago.


Fortunately for Hong Kong there is a simple solution to address the widening wealth gap. Half the population in Hong Kong lives in subsidized housing either as renters or pseudo homeowners (who do not own the value of the land under their homes). If the government were willing to sell these premises to the occupant at a price they can afford without having to repay an exorbitant land premium, then the wealth gap would be immediately narrowed. Every household in Hong Kong would possess an asset that could protect it from the shocks that arise under a fixed exchange rate. The problem of housing in Hong Kong is not primarily about having affordable shelter. It is about having an asset that can be hedged against inflation for wealth preservation and enhancement.


I believe the Linked Exchange Rate is a valuable arrangement that should be usefully continued for all of the reasons discussed above. Its more onerous effect on the widening wealth gap can be relatively easily and effectively ended. In 1997, just before the restoration of sovereignty over Hong Kong from Britain to China, I wrote in the South China Morning Post that “the territory’s inflationary housing issue has divided it into ‘haves’ and ‘have-nots’. It was time, then, to end it. Sadly, this has remained an unfinished task. Resolving this contradiction would remove one of the obstacles to dual integration.





Y C R Wong, “Time to Count the Social Cost of a Divided People United”, South China Morning Post, Monday, May 19, 1997



Hong Kong and Mainland Economic Integration Series (Part 5)

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