Mr. Joseph Yam, former Chief Executive of the Hong Kong Monetary Authority, last week published an academic research paper calling on the Hong Kong authorities to review whether our present Linked Exchange Rate system is still fit for purpose. Economic conditions in the world have changed since the original arrangement was first introduced almost 30 years ago. Mr. Yam delineates a number of different monetary and exchange rate arrangements that could be considered as alternatives to the present linked rate. Insofar as I can detect, he does not seem to express a strong preference for any specific arrangement at this stage.


Exchange rates exist because people in different nations wish to conduct transactions with each other using fiat money issued by their governments. Fiat money is money declared by a government to be legal tender. It has no intrinsic value and is neither convertible by law into any other commodity nor fixed in value in terms of some commodity. Historically, gold, silver and copper were the most commonly used commodity moneys. In a world with commodity money, exchange rates between nations would not exist.


Fixed Rate as Monetary Union


Gold and silver were the preferred choice of money in most parts of the pre-modern world. The widespread adoption of fiat money in modern times reflects the growing competence and trustworthiness of governments, which is sufficient enough that the public are willing to hold and use fiat money. It is also a sign that governments have gained enormous power.


Fiat money embodies an important contractual relationship between a government and its people. This conceptualization brings out the fundamental cause of exchange rate or currency crises: the loss of confidence and faith in a government by the peoples of the world. Because fiat money has no intrinsic value, unlike commodity money, there is the possibility that the value it represents can totally evaporate.


Nations have adopted different rules for the determining the exchange rates of their fiat currencies. There are conceptually three distinct types of exchange-rate regimes: floating, fixed, and flaky, each with different characteristics and different results. At one end of the spectrum is the completely freely floating exchange rate in which the central bank never intervenes to offset market pressures on that rate; at the other end is the firmly fixed exchange rate with no fluctuations allowed. These two extremes often do not apply to exchange rate regimes in practice.


The three main currencies, the US dollar, the Japanese yen and the European euro, float freely against each other –– as do a number of smaller currencies, such as the Canadian dollar, Swedish krona, British pound, Korean won and New Zealand dollar. However, the de jure commitments to freely float exchange rates have not prevented the central banks of these nations from intervening actively in foreign exchange markets from time to time.


An example of a fully fixed exchange rate, which in principle is the same as a monetary union, is the Hong Kong dollar. The Hong Kong Monetary Authority is obliged at all times to exchange US dollars for a fixed amount of Hong Kong dollars (HK$7.8 Hong Kong per US$1). This means in essence that Hong Kong is in a monetary union with the USA –– the only difference being that Hong Kong issues its own banknotes. A second example of a fixed exchange rate is the European Monetary Union, where all members have given up monetary independence and left monetary policy decisions to the European Central Bank.


Although floating and fixed rates appear to be dissimilar, they have one common attribute that is not fully appreciated and seldom recognized explicitly in most economic discussions. Both regimes adopt a free market mechanism to balance payments in international transactions. The adjustments do not require any form of government intervention.


Monetary Competence Determines Choice of Floating or Fixed Rate


With a floating rate, the monetary authority sets monetary policy but has no exchange rate policy. The exchange rate automatically adjusts to equilibrate demand and supply in the foreign exchange market and achieve external balance or balance in the balance of payments. The internal balance or price level stability is attained through control of the monetary base by the monetary authority. If Hong Kong had a floating rate, it would gain control over its own monetary policy and the monetary authority would be responsible for achieving domestic price level stability.


With a fixed rate, the monetary authority sets the exchange rate, but has no monetary policy. Monetary policy becomes the passive outcome of excess demand or excess supply in the foreign exchange market: it is determined by the imbalance in the balance of payments. When a country’s official net foreign reserves increase, its monetary base increases and vice versa. This determines the rise and fall of the domestic price level. Again the adjustments do not require any form of government intervention.


Since both of these are free-market exchange rate mechanisms, there cannot be conflicts between exchange rate and monetary policies and consequently, balance of payment crises cannot occur. Indeed, under floating and fixed rate regimes, free market forces act to automatically rebalance financial flows and avert such crises. The Table below gives a summary description of the exchange rate regimes based on Milton Friedman’s foreign exchange trichotomy, and also summarizes our discussion of the floating and fixed exchange rate regimes.


Table: Friedman’s Foreign Exchange Trichotomy


Type of Regime Central Bank Exchange Rate Policy Monetary Policy Source of Monetary Base Conflicts between Exchange Rate and Monetary Policy Balance of Payments Crisis Exchange Controls
Floating Yes No Yes Domestic No No No
Fixed No Yes No Foreign No No No
Flaky: adjustable peg and dirty floating Yes Yes Yes Domestic and Foreign Yes Yes Yes


Contrary to popular perception, Friedman did not favor floating exchange rates over fixed exchange rates. In fact he favored both, depending on the circumstances. He preferred floating rates for countries with strong monetary authorities, which are usually found in developed economies. Floating rates allow a country the independence in choosing a monetary policy to suit its domestic situation. Countries with floating rates do not have to worry about whether business cycles across interconnected economies are synchronous or asynchronous.


However, Friedman favored fixed exchange rates for countries with weak monetary authorities, which are mostly found in developing economies. Their authorities are more vulnerable to economic mismanagement and political misconduct. Economists have articulated six criteria that a small economy should consider in deciding whether to fix its exchange rate to an “anchor country”. Hong Kong’s “anchor country” over the past 30 years has been the US. The six criteria are:


1.     How important is foreign trade to the small economy?

2.     How flexible are wages and prices in the small economy?

3.     How mobile is labor across borders?

4.     How mobile is capital?

5.     How good is monetary policy in the small economy compared with the “anchor country”?

6.     How good are political relations between the small economy and the “anchor country”?


Luck Matters


These six criteria define conditions for an optimal currency area. If there are close trade ties, high wage and price flexibility, and high capital and labor mobility between the small economy and the “anchor country”, then the two economies can beneficially form a monetary union with a common currency. One of the most obvious benefits is that the small economy does not have to assume the burden of having an independent monetary policy and the economic uncertainties associated with it. Hong Kong’s Linked Exchange Rate system is close to a monetary union.


Friedman stresses, however, 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. He places the greatest emphasis on this criterion. Friedman argues that floating exchange rates do not perform well in developing economies and this has been empirically supported by evidence of their weak monetary authorities and histories of monetary instability. He therefore advises these economies to form a monetary union with an “anchor country” whose monetary policy is reliably well conducted.


The choice between fixed and floating rates is difficult and countries have achieved both good and bad results with them. For example, in 1985 Israel successfully implemented a fixed exchange rate policy against the dollar that helped cut inflation without causing any negative long-term economic repercussions.


Chile also implemented a fixed exchange rate policy against the dollar in 1976. Results were good for the first year, but when US monetary policy was severely tightened between 1980 and 1982, causing the dollar to surge, monetary policy in Chile also had to be tightened. This caused Chile to suffer a serious economic setback and in 1982 it abandoned its fixed exchange rate policy.


These two cases underline how identical exchange rate policies can lead to different results. The outcome of the fixed exchange rate policy depends on how “lucky” one is with regard to the monetary policy in the “anchor country”. Israel was fortunate to introduce a fixed exchange rate policy at a time when monetary policy was relatively accommodative in the US; while Chile was unlucky to fix it just before US monetary policy had to be vigorously tightened. Friedman has warned, “Never underestimate the role of luck in the fate of individuals or of nations”.


Coming back to Hong Kong, the Linked Exchange Rate has worked very well in the past 30 years despite quite pronounced spells of “bad luck”. When China opened up in the 1980s, Hong Kong’s economy boomed as manufacturing moved across the border, precipitating the city’s rapid transformation into a high value-added service economy. Inflation reached double digit levels as a result of supply bottlenecks. Unfortunately, the US was heading into a period of low interest rates with a weak currency. Hong Kong’s link to the US dollar in this instance meant a decade of inflation and escalating property prices as the business cycles of Hong Kong and the US were out of phase.


The opposite happened during the Asian Financial Crisis of 1997. At that time, the US economy and dollar were strengthening. When the property price bubble went bust in Hong Kong at the time, deflationary pressures were reinforced. Hong Kong went into a deep recession and did not recover until 2003 when the US dollar softened.


An even stranger story occurred with the Financial Tsunami of 2008. As the rich economies went into recession, Hong Kong’s economy remained robust because China successfully executed a huge fiscal stimulus package that helped to keep the emerging economies going. Hong Kong was faced with a weak US dollar and low interest rates, but a full employment economy –– a lethal combination that prompted many to go after properties, sending prices soaring.


One could simply conclude that Hong Kong is not very lucky, but what is really worth noting is that Hong Kong was able to stay with the fixed rate because it possessed one of the world’s most flexible economies in terms of wages and prices, a robust banking system, and a sound fiscal policy. These helped Hong Kong to weather the shocks better than most other economies, although they did not save both Chief Executives from being the targets of massive public protests.


Friedman regarded a system of fixed but adjustable exchange rates as the worst of all worlds. This system is also known as the adjustable peg which, together with “dirty” floating rates (which I explain below), has been called the flaky exchange rate system by Professor Andrew Rose. An example of an adjustable peg is the European Monetary System (EMS) 1979-1998. Members of the EMS pursued a mutual fixed exchange rate policy, with exchange rates allowed to float within a narrow band and the various central banks obliged to ensure that they remained there (for example, via changes in interest rates or intervention in the foreign exchange market).


A country with an adjustable peg in principle abandons the option of an independent exchange rate policy. However, at times of pressing domestic need, governments may be willing to succumb to irresistible political pressure and adjust exchange rates (devalue or revalue), or completely abandon the fixed exchange rate policy. In addition, they can introduce various means to “control” prices and impose capital control measures. The system sows uncertainty in the foreign exchange market about just how “fixed” the policy is in reality. In so doing it becomes a potential “target” for speculative attack whenever threats appear that could lead to a balance of payments problem.


Hong Kong’s Role in Dual Integration


The “dirty” floating rate suffers from the same problem. Many countries that claim they float actually intervene a lot to smooth out the exchange rate, a phenomenon known as “fear of floating”. Some countries that officially claim to float their currencies adhere to a monetary policy that explicitly targets either inflation, unemployment, monetary growth, or some combination of the above. Others have what can be referred to as an opaque monetary policy; for example, why is it that the Bank of Japan targets have never been spelled out? The uncertainty arising from “dirty” floating rates is just as bad as the system of adjustable pegs.


The adjustable peg and the “dirty” float are different only on paper. In practice they are often indistinguishable. In regimes the Central Bank conducts both exchange rate and monetary policy, which breeds uncertainty and causes instability, and the source of the monetary base is a mixture of domestic and foreign assets. In these respects they are totally different from both the fixed and the floating regimes.


Adjustments occur in the foreign exchange market as a result of government interventions and market forces –– a mixture of politically driven and market driven factors that creates conflict between exchange rate and monetary policy. Under both the adjustable peg and the “dirty” float, the market knows but cannot tell exactly when the government will act, and so from time to time will second guess government behavior. The “speculation” that results precipitates crises in the balance of payments and the currency.


Fortunately, Hong Kong’s Linked Exchange Rate system is not a flaky system even though the Hong Kong Monetary Authority has given itself some powers to intervene in the foreign exchange market. But the scope for such intervention has been narrowly prescribed within a tight band of buying US dollars at 7.75 and selling at 7.85, known as the Convertibility Undertakings. It is worth pointing out that according to estimates by Klein and Shambaugh (2010) even such a tight band means it takes almost eight months before an increase in interest rates in the “anchor country” (the US) causes Hong Kong to adjust its own interest rates even half-way. The ability of countries with an adjustable peg or dirty float to prevent adjustment would no doubt be even more potent. Such delays put pressure on the balance of payments and build up currency crises in those countries.


Ever since China’s opening, Hong Kong has taken on the task of attaining dual integration –– first with the global economy and second with the Mainland economy. What role should Hong Kong’s exchange rate system play in this process? I shall discuss this in the next article. I shall also be taking a break from writing to prepare for my new teaching assignments in the new academic year after next week and will resume writing in September.





M Klein and J Shambaugh, Exchange Rate Regimes in the Modern Era, 2010.


A Rose, “Exchange Rate Regimes in the Modern Era: Fixed, Floating, and Flaky”, Journal of Economic Literature, September 2011



Hong Kong and Mainland Economic Integration Series (Part 4)

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