Working Papers

HKSAR’s Dysfunctional Currency Board

There is a minority tendency in classical liberal circles that retains a fetish for fixed exchange rate regimes, inspired by various hard money doctrines, despite the terrible havoc these regimes have wrecked on emerging market economies in recent years.  Contrary to what Steve Hanke might have you believe, Hong Kong’s currency board is no exception.  Yeung Wai-Hong totes up the damage:

since the peg was put in place there have been repeated bouts of speculative runs on the Hong Kong dollar…In the name of defending the peg, the government ended up nationalizing more than a tenth of the blue chips traded on the stock market.

The hard earned reserves that the HKMA splurged on the foreign exchange and stock markets was not the only thing lost. By nationalizing privately held shares, Hong Kong also lost its long-held faith in the free market.

The peg withstood the financial storm, but a very much shaken Hong Kong suffered a sustained period of deflation that was the worst on record. In a misguided hope to revive the economy, the government took to industrial policy with a vengeance, pouring public funds into developing various “ports.” The most high-profile of these is Cyberport, a project aimed at spurring the growth of information technologies but which has turned out to be nothing more than a property project.

It is clear then the fallout from defending the peg has by no means been confined to the financial sector. Along the way, Hong Kong’s free market economy has taken on increasingly interventionist characteristics…

Currency boards are supposed to be automatic, self-adjusting mechanisms that operate without arbitrary interventions. Time and time again, this has turned out not to be the case.

Hong Kong might have a genuine need to raise local interest rates to let off some of the steam in the property market. The fact that the peg has failed to deliver the required interest rate rise testifies once again to the fact that the peg cannot, as promised, shield the economy from haphazard interventions, the raison d’etre to establish the peg in the first place.

A quarter of a century should be time enough to prove the validity of any theory. The verdict on the Hong Kong dollar peg is out: It has flunked. The need to defend the peg has led Hong Kong down an increasingly interventionist path that is incompatible with a free market economy.

posted on 26 May 2005 by skirchner in Economics

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I am no great fan of currency boards and have been highly critical of the HKMA from time to time. 

However, I think the critque cited above is a bit weak:

1.  HK does not run an “orthodox” currency board - reserves and backing of the money supply vary.  The HKMA gurantee had not included a “strong side” peg.  This has meant currency volatility, extreme sensitivity of interest rates to domestic liquidity in the overnight market and more financial risk than would be the case under “orthodox” arrangements. 

2.  It is not clear that the massive stock market intervention was required to support the peg in 1997-98.

3.  HK interventions by the government do not seem to me to revolve around the peg issue.  Whilst protracted economic weakness and deflation may have contributed to an urge for more activist government - I see many other institutional arrangements that bias in that direction (not least a British legacy public service much larger than that in Singapore).

It seems to me that the HKMA should in the first instance be criticised for:

1.  Running an occassionally very active monetary policy - such as in the last 18 months allowing ambiguity about “strong side” risks to keep interest rates unusually low.

2.  Excessive conservatism in bank prudential requirements that has hindered development of the mortgage market.

3.  A fixation with greating a domestic debt market and debt benchmark which has competed with banks for funding, led to the creation of the HK Mortgage Corporation (competing with banks and insurers on the asset side of the balance sheet) and probably reduced some of the fiscal pressures on the government.

The CEO of the HKMA is very explicit in his views that markets fail and the “guided” capitalism is necessary.  This is a widely held view in the HK administration and that view as much as the currency board contributes to the trends cited by the author above.  Similarly pressures for antitrust law and a consumption tax come from this very fashionable, but misguided view of what “modern” capitalism is about.

One saving grace of the HKMA’s current disposition - the trading band on the dollar leaves HK with a fairly active currency market and the transition to other currency arrangements would be relatively smooth.

Posted by .(JavaScript must be enabled to view this email address)  on  05/26  at  03:12 PM

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