[This paper was written in 1999 about Hong Kong's monetary system for a conference on currency boards sponsored by Hong Kong Baptist University. Bits of the paper are now outdated, and some things I expected to occur have not-in particular, I thought that sometime not too long after the East Asian currency crisis, China would take advantage of a period of calm to abandon its exchange rate peg to the U.S. dollar. However, I think the paper remains useful because it shows the gap between Hong Kong's existing monetary system and an orthodox currency board system. Few of the critics who claim that the speculative attacks on the Hong Kong dollar in 1997 and 1998 demonstrate the weakness of currency boards are aware of the details of how the Hong Kong system works, hence they are unaware of the extent to which the speculative attacks were caused by the unorthodox features of the system.]
Gwendolyn. On an occasion of this kind, it becomes more than a moral duty to speak one's mind. It becomes a pleasure. --Oscar Wilde, The Importance of Being Earnest, Act II
Until 1997, interest rates for borrowers of Hong Kong dollars were generally close to or even below corresponding rates in U.S. dollars, implying that perceived currency risk for Hong Kong dollar was virtually zero. Since 1997, borrowers in Hong Kong dollars have generally paid a premium compared to borrowers in U.S. dollars, and there have been a few spikes in short-term interest rates. Hong Kong's country risk may have increased somewhat as a result of no longer being a British colony, but most of the premium results from a perception of increased risk that the Hong Kong dollar will be devalued from its official rate of HK$7.80 per U.S. dollar.
The Hong Kong dollar withstood the Asian currency crisis where other currencies succumbed, but it remains vulnerable to speculative attacks because the Hong Kong Monetary Authority (HKMA) mixes currency board and central bank elements. Over time, Hong Kong has added central banking features to its original, fairly orthodox currency board system. The HKMA holds foreign reserves far exceeding 100 percent of the monetary base, but as currency speculators are aware, having the will to support the exchange rate is as important as having the means. Historically, orthodox currency boards have not devalued, because their institutional structure has insulated monetary policy from politics and because they have held foreign reserves equal to 100 percent or slightly more of the monetary base. Central banks typically have devalued, because they have been vulnerable on both points (Schuler 1999: 86).
Each of the HKMA's central banking features was added for reasons that seemed logical at the time. Cumulatively, though, they have moved Hong Kong's monetary system far from its currency board roots. Another speculative attack against the Hong Kong dollar seems likely when China devalues in the coming months. China devalued in 1994 without creating speculation that Hong Kong would devalue, but that was before Hong Kong reverted to China and before the HKMA extended its responsibilities from supporting the currency to supporting the stock market.
The problems that the Hong Kong dollar has experienced prompt a question: What if Hong Kong simply used the U.S. dollar? It is hard to see how fears about devaluation could have arisen. The extent to which fears do exist therefore indicates the extent to which the Hong Kong dollar is not a near-perfect substitute for the U.S. dollar because the HKMA is not fully credible as a currency board. The best way to increase credibility is to make Hong Kong's monetary system clearly an orthodox currency board and eliminate its elements of central banking. The HKMA seems to have understood this in a limited way, as shown by the measures it announced on 5 September 1998 (HKMA 1998), but it still seems to be torn between currency board and central banking principles. I will suggest how to make Hong Kong's currency board system orthodox, and by implication will offer generally applicable answers to the questions the organizers of this workshop have posed. (2)
The case for currency boards
Since Hong Kong's monetary system at present mixes currency board and central banking elements, the first task is to explain why an orthodox currency board is preferable to a mixed system or a full-fledged central bank. There are theoretical arguments for an orthodox currency board arising from debates about credibility and time consistency, rules versus discretion in monetary policy, fixed versus floating exchange rates, and so on (Hanke and others 1993: 21-40, 132-42). But the underlying debates have continued for decades, suggesting that if they are ever to be resolved, it will be by shifting them to a more empirical and practical focus.
The empirical case for currency boards is that on average they have performed much better than central banks. Think of all the former British colonies that have replaced their currency boards with central banks; how many have reliable currencies? Other than a few oil-rich sheikdoms and some Caribbean countries that rigidly link their currencies to the U.S. dollar, the list consists of Cyprus and Singapore. The pattern has been the same outside of former British colonies. Few people are aware of how badly central banks have performed, however, because until quite recently, nobody had compared the performance of central banking to the performance of other monetary systems in a thorough way. My study Should Developing Countries Have Central Banks? (Schuler 1996) was apparently the first attempt to make such a comparison. It examined all countries with more than 1 million people from 1950 to 1993. The study divided them into three groups: developed countries (all of which had central banking throughout the period), developing countries with central banks, and developing countries with other monetary systems such as currency boards. According to measures such as inflation, convertibility, freedom from currency confiscations, and avoidance of devaluations, developing countries with central banks had the worst performance of the three groups.
One study is not enough to settle such an important issue, but there have been a few others since that have yielded broadly similar results (Ghosh and others 1998, Hanke 1999, Hausmann and others 1999). Also, since May 1998 I have posted on my fairly well visited World Wide Web site an offer to pay up to US$1000 to anyone who can show that central banks have had better long-run monetary performance than currency boards by any important measure. So far, there have been no challengers. (3)
Historically, orthodox currency board systems have experienced fewer problems than unorthodox systems. (4) The speculative attacks that the Hong Kong dollar suffered in 1997-8 occurred at the point when the HKMA had accumulated and exercised to the fullest extent so far the capacity for an activist monetary policy.
The two main arguments for central banking in Hong Kong are that a full-fledged central bank would have greater capacity than the HKMA as a lender of last resort, which would make the financial system more stable; and that a floating exchange rate, which central banking would presumably involve, would enable the economy to adjust with less pain than a fixed rate. Neither argument has much empirical support. Evidently there has never been a thorough empirical investigation of whether having a central bank as a lender of last resort improves or reduces the stability of the banking system. A look at what evidence is available suggests that central banks reduce stability. Studies of banking crises since 1980 indicate that the biggest and costliest crises have occurred in central banking systems (for a summary, see Frydl 1999). Furthermore, in many countries, central banks themselves have been the main culprits in weakening the financial system because they have created high inflation and regulatory distortions that make it fragile (see Fry 1995: 373-449). The Asian currency crisis produced a spectacular example of this in Indonesia.
As for the desirability of a floating exchange rate, Singapore is the only country in all of Asia that has combined a floating exchange rate, albeit a heavily managed one, with unarguably good monetary performance over a long period. (Whether Japan also belongs on the list depends on your opinion of its monetary policy in the 1990s.) Even among countries that have been developed for decades, few central banks have maintained good monetary policy over long periods with floating exchange rates; for every Switzerland or United States there has been a (pre-euro) Italy or Spain. Learning how to operate a floating exchange rate in a responsible fashion can take a long time: after the United States definitively floated the dollar in 1973, the Federal Reserve took about a decade to develop effective operating procedures, and about another decade to refine its approach to such an extent that people were confident it would continue to keep inflation low over the long term. In the meantime, inflation and the fear of inflation produced wrenching changes in the U.S. economy.
The practical case for currency boards proceeds from the empirical observation that good central banks are rare. Theoretical debates among economists typically assume that the currency in question already has high quality and will continue to have it. They then argue about the comparatively small gains to be achieved from, say, returning to a gold standard in the United States versus continuing with a floating exchange rate that, by international standards, has performed exceptionally well. The most important practical problem of monetary policy, however, is how to achieve high currency quality in the first place. Hong Kong already has a good monetary policy through its link to the U.S. dollar, which although not perfect has had a long-run performance that few other currencies have matched. Critics of the currency board system need to explain why a floating Hong Kong dollar would succeed at outperforming the U.S. dollar over the long term where so many other currencies have failed.
It is not necessary to argue yet again the theoretical merits of fixed versus floating exchange rates to conclude that as a practical matter, the Hong Kong dollar should have a fixed exchange rate. In a currency board system, people can enjoy many of the benefits to be had from a floating exchange rate if people are not forced to use the currency board's currency. In Hong Kong, people are already free to use foreign currencies without restriction, including currencies that float against the Hong Kong dollar. Ideally, banks should also be allowed to issue notes and coins to compete with those of the currency board, as was the case in a few British colonial currency board systems, though not in Hong Kong. Unlike bank-issued notes in Hong Kong today, which are really HKMA notes printed with advertisements for the three note issuers, notes issued to compete with those of the currency board should face no special regulations and should be considered similar to deposit credits. If banks want to issue floating currencies, and it the public wants to use them, so be it. (5)
Competition in currency provides a practical solution to resolving many of the theoretical points economists have debated for decades. Ask an economist how many grocery store chains should exist and where individual stores should be located, and he will tell you that he doesn't know the particular solution, but he knows that competition allows it to emerge from the marketplace. Ask the same economist about monetary policy, though, and he will exhibit a kind of schizophrenia, assuming that he already knows what is best and is capable of running the monetary monopoly if asked.
Why couldn't a central bank maintaining a floating exchange rate be one of the competitors? It could, but that would be a first: there seem to be no cases where central banks have allowed competing domestic issuers of currency except in a vestigial sense, such as the three Scottish banks that continue to issue notes today under rules somewhat like those that apply in Hong Kong. Central banks have been loath to allow currency competition because the rationale of central banking is one of monopoly. Competition in currency faces fewer impediments when there is no central bank.
Currency board orthodoxy
The purpose of an orthodox currency board is to have a currency as good as the anchor currency, while capturing for the domestic government the seigniorage that under dollarization would accrue to the anchor country. Having a currency as good as the anchor currency implies foregoing policies that would call into question the fixed exchange rate and full convertibility into the anchor currency. To be orthodox, a currency board should follow three broad principles.
First, the currency board should have no discretion in monetary policy. It should maintain a truly fixed exchange rate, not a "fixed but adjustable" or pegged rate. The exchange rate should be a two-way commitment, both into and out of the anchor currency. In light of the ever-lower costs of undertaking financial transactions, the exchange rate should have a zero spread, at least for large transactions: the "central" rate should be the only rate at which the currency board effects transactions. Everyone, or at a minimum all banks, should have access to the currency board. Reserves should consist of true foreign obligations only, denominated in the anchor currency, and should not consist of obligations of the domestic government, whether or not denominated in foreign currency. The ratio of foreign reserves to the monetary base should be not less than 100 percent and not more than 115 percent, and the currency board should have no ability to use reserves in excess of 100 percent for lending or sterilization. The currency board should have no responsibility for measures of the money supply broader than the monetary base (which consists of its own notes, coins, and deposits). The currency board should be completely passive in the foreign-exchange market, responding only to the demands of the public. It should have no involvement in the domestic money market, and should not issue securities to be held by the public.
There has been some confusion about whether an orthodox currency board only issues notes and coins and does not participate directly in the clearing system, or whether it can also offer deposits and participate in the clearing system. An orthodox currency board can issue deposits if that improves convenience for its customers. Its deposits must be backed by foreign reserves in the same way as its notes. If the currency board participates in the clearing system as a custodian of funds for banks, it should not guarantee finality of payment for bank liabilities if the system is one of net settlement, nor should it defray the costs of the system. A number of past currency boards have issued deposits and participated in the clearing system: the East African Currency Board is an example. Other currency boards have left banks to operate the clearing system. Since most currency board systems have been dominated by international banks, particularly those from the anchor country, ultimate settlement could take place in the anchor currency through head offices. This procedure, plus open access to the fixed exchange rate of the currency board by all banks, produced results like those of what Tsang Shu-ki has called the "AEL model" (because it is practiced in Argentina, Estonia, and Lithuania).
Second, the currency board should be an independent entity. The currency board should not be under the same organizational roof as the ministry of finance, regulatory agencies for the financial system, or the deposit insurance fund. The currency board should not mix its foreign reserves with their funds nor should it share responsibility with them for any of their activities. It is desirable to give the currency board the highest degree of organizational independence and legal protection possible; that may mean incorporating it in a safe-haven country such as Switzerland, as is being considered for the proposed currency board in Montenegro. [Instead of establishing a currency board, Montenegro decided to make the German mark legal tender alongside the Yugsolav dinar. In practice the mark, being the better currency, crowded the dinar out of circulation.]
Third, financial regulation should be liberal and allow full integration with world financial markets. An orthodox currency board establishes currency integration through a fixed exchange rate with the anchor currency. Integration of the financial system with financial markets in the anchor country and the rest of the world complements currency integration. The most efficient way of accomplishing that is to allow foreign banks, particularly banks from the anchor country, to enter the market, establish branch networks, and buy local banks if they wish. The strongest financial system is the most open one. Exchange controls should be absent. Reserve requirements and liquidity requirements should be low or nonexistent. There should be no restrictions on interest rates or on currency mismatches with the anchor currency.
Although the rationale of the orthodox currency board system has rarely been articulated, the system is a coherent set of monetary and financial policies. In almost every respect it is the antithesis of the policies that animate a typical central banking system. Introducing unorthodox elements into a currency board system reduces its coherence by reducing confidence that the domestic currency is really as good as the anchor currency. Hence there is reason to distrust unorthodox features in the monetary systems of Hong and other currency board or currency board-like systems (Hanke and others 1993: 72-7, 188 n. 79).
Applying currency board orthodoxy to Hong Kong--general points
Hong Kong's currency board system faces two problems: concern that the Hong Kong dollar will be devalued in the long run, and deviations of the market exchange rate from the official rate of HK$7.80 per U.S. dollar in the short run. The long-run problem appears as a premium for the forward rate of the Hong Kong dollar against the U.S. dollar, while the short-run problem appears as a deviation of the spot rate from the official rate. Making Hong Kong's currency board system more orthodox requires addressing both problems. The general points here address mainly the long run-problem, while the more technical points in the next section address mainly the short-run problem.
The currency board should have a firm legal foundation. Neither the Basic Law nor statute law commits Hong Kong to any particular monetary system, anchor currency, or exchange rate. The Basic Law does not define what a Hong Kong dollar is, what type of exchange rate Hong Kong is to have, what assets are to be used to back the currency, or who may issue Hong Kong currency. The government implicitly has the power to decide all those questions as it pleases. (6)
Statute law is as elastic as the Basic Law. The Exchange Fund Ordinance originated with the Currency Ordinance, No. 54 of 1935. (7) When Hong Kong abandoned the currency board system in 1974 and readopted it in 1983, everything was done without changing a line of the Exchange Fund Ordinance. And that was under famously law-bound British colonial rule! Hong Kong's current political system is more potentially susceptible both to locally originating short-term political pressures and to pressure from the Chinese central government. The executive branch has the power to devalue the Hong Kong dollar and abandon the currency board system instantly by administrative decision, without public debate or the approval of the Legislative Council.
To preserve a currency board in Hong Kong, an explicit statute to entrench the system is more important today than ever. A statute could be changed, of course, but that would require the approval of the Legislative Council rather than a simple administrative decision. The experience of countries that have to some extent entrenched their currency board-like systems in statute law suggests that an explicit statute provides significant procedural protection that is currently lacking in Hong Kong. The Appendix specifies features that a currency board statute should have.
The next two changes can be effected by administrative decisions of the government and the HKMA, but would be more secure if embodied in statute law.
The currency board should be completely separate from fiscal and regulatory functions. A central bank combines monetary and fiscal functions. For example, the Bank of England, the central bank whose example has most influenced others, was founded expressly to finance the debt of the English government. In contrast, to prevent fiscal problems from contaminating the currency, an orthodox currency board has no fiscal functions.
The Exchange Fund, the predecessor to the HKMA, was generally a simple, orthodox currency board in its first incarnation (1935-1974). It performed no other tasks other than to exchange Hong Kong dollars for the anchor currency and to hold assets in the anchor currency equal to about 105 percent of notes issued. In its second incarnation (1983-1993) the Exchange Fund was less orthodox. In 1978 the government had deposited at the Exchange Fund its holdings of foreign currency, giving the Exchange Fund a potential tool of discretionary policy. The government deposits took on new importance in July 1988, when the government introduced changes that enabled the Exchange Fund to conduct open-market operations using those deposits. In March 1990 the Exchange Fund started issuing its own securities, Exchange Fund Bills (later supplemented by Exchange Fund Notes). The bills gave the Exchange Fund a more convenient instrument of monetary control than it had had. In 1992 the Exchange Fund established a liquidity adjustment facility to make short-term loans to banks, and on 1 April 1993 the government created the Hong Kong Monetary Authority by combining the Exchange Fund with the Monetary Affairs Branch of the Financial Secretariat and with the Office of the Commissioner of Banking (Nugée 1995).
The HKMA today looks more like a typical central bank than an orthodox currency board. It manages government funds; issues securities; lends to banks; supervises financial institutions; influences interest rates; intervenes in the foreign-exchange market; and in 1998 it even supported the stock market--none of which a simple, orthodox currency board does, and some of which many central banks do not even do. The varied activities that the HKMA undertakes in addition to supervising the issue of currency create confusion about whether Hong Kong still really has a currency board system. Because the HKMA has increasingly come to resemble a central bank, many speculators have expected it to act like a central bank and devalue.
To return to an orthodox currency board system, the HKMA should cease trying to actively influence interest rates and exchange rates. By doing so, it would reduce volatility in interest rates. Contrary to an opinion that has been expressed often in the Hong Kong press since 1997, interest-rate pain is not the price of an orthodox currency board system. Rather, after accounting for country risk, interest rates should remain close to the corresponding rates in the anchor country. Small changes in interest rates--a quarter or half a percentage point--should suffice to make the system work, as is the case for different regions within a country. The high interest rates that Hong Kong has at times suffered in the last two years have been unnecessary. They arise from unorthodox features that reduce confidence in the Hong Kong dollar. An orthodox currency board does not need to and in fact cannot "defend" the currency with high interest rates, intervention in the foreign-exchange market, or intervention in the stock market. An orthodox currency board system automatically maintains the fixed exchange rate with the anchor currency. When demand for the monetary base falls, an orthodox currency board automatically translates it into a fall in the supply of the monetary base. In Hong Kong, the currency board's participation in the foreign-exchange market should consist only in supplying Hong Kong dollars for U.S. dollars, or the reverse, on demand at the fixed exchange rate.
The HKMA's activities as the issuer of the monetary base should be separated from its fiscal and regulatory functions and spun off into a separate body, with a separate identity, status, and management. The new body, which could be called the Hong Kong Currency Board, should report directly to the Chief Executive and the Legislative Council, and should not be under the direction of the Financial Secretary. The Currency Board should become the custodian of the foreign reserves backing the monetary base, which should be separated from the other assets of the HKMA. At present, the HKMA publishes a separate balance sheet for its currency board activities. The new body would convert what is now merely a notionally separate balance sheet into an actually separate organization.
The monetary base as defined since the seven technical measures of 5 September 1998 has included Exchange Fund Bills and Notes. Previously, the HKMA sometimes used the bills and notes as instruments of sterilization, contrary to orthodox currency board practice, but under the current policy they are analogous to the deposits at the currency board that have existed in some other currency board system. The most effective way of preventing them from re-emerging as instruments of sterilization after another change of policy would be to cease issuing them. If thought necessary, Exchange Fund Notes and Bills held by banks could be replaced by deposits at the HKMA. The currency board might pay a rate of interest on the deposits tied to the rate it earns from its foreign assets; some other currency boards have done so. The deposits would be directly convertible into notes, so there would be no need to retain the HKMA's discount window as an intermediary to assure convertibility. As the next section explains, extending access to the convertibility undertaking and making it a two-way commitment with a zero band would greatly widen the pool of close substitutes for the Hong Kong dollar monetary base.
The currency board should have its own statute giving it a single mission: to exchange the Hong Kong dollar monetary base for U.S. dollars at HK$7.80 per U.S. dollar. Changes in the exchange rate or the reserve ratio should require a change in the statute. The new body should have a board of directors not overlapping with that of the HKMA. (8)
Because the HKMA combines multiple roles now, the separation between the monetary and fiscal spheres of Hong Kong's economy is not as distinct as it should be. Making the currency board a separate body would prevent future governments or managers of the HKMA from exhausting its foreign reserves, as has happened in so many central banking systems. In an orthodox currency board system, the government can for good or for ill use foreign reserves beyond those backing the monetary base to establish a deposit insurance fund, buy shares of stock, and so on, but those actions are clearly fiscal rather than being uncertain in classification, as they are now in Hong Kong.
The option of officially dollarizing should be part of the armory of the currency board. Since the purpose of an orthodox currency board is to have a currency as good as the anchor currency, Hong Kong should be prepared to officially replace the Hong Kong dollar with the U.S. dollar if the Hong Kong dollar cannot achieve enough credibility to make it a near-perfect substitute for the U.S. dollar. The government should make public a contingency plan explaining how dollarization at the official exchange rate of HK$7.80 per U.S. dollar would occur. Dollarization can be implemented almost as soon as the government decides on it. The government and the Exchange Fund Advisory Committee of the HKMA have claimed that dollarization would pose technical and legal difficulties, but have not explained in any detail what the difficulties are (Hong Kong 1998: 3.60-3.63; EFAC 1999). Careful analysis shows that dollarization at the official exchange rate would be little more complicated than changing the unit of account from pennies to dimes (Schuler 1998). (9)
The main difference between an orthodox currency board and official dollarization is that a currency board captures for the domestic government the seigniorage from issuing currency, whereas under dollarization the seigniorage typically accrues to the government of the anchor country. What a country loses in seigniorage, however, it may more than gain in lower interest rates if fears about devaluation create an interest rate premium in the domestic currency. Moreover, it may be possible for Hong Kong to receive a rebate of seigniorage from the United States if it uses the U.S. dollar. There has been interest in the United States recently about offering a rebate of seigniorage to officially dollarized countries (Mack 1999). (10)
An announcement that the government is prepared to dollarize, combined with a contingency plan explaining how it would be done, should be sufficiently convincing that the government would never actually have to use dollarization as an emergency measure. Dollarization could occur if the government wished, but it would occur in an atmosphere of calm. In Argentina, the mere announcement that the government was considering dollarization was sufficient to calm financial markets in 1995 and again in January 1999, even though there was apparently no definite plan. The model currency board statute of the Appendix contains provisions (5b and 14) that would permit dollarization.
Official dollarization at the official exchange rate of HK$7.80 per U.S. dollar is a better "exit option" than floating the Hong Kong dollar or devaluing and repegging it. (The option of joining a good monetary union is unavailable to Hong Kong. Asia has no regional counterpart to the euro, and monetary union with China would give Hong Kong a currency that is not fully convertible, violating Article 112 of the Basic Law.) Floating or repegging in response to a speculative attack would risk creating the generalized financial chaos suffered by Mexico in 1994-5 and East Asia in 1997. Banks and corporations with large liabilities in foreign currency might go broke as a result of the depreciation of the Hong Kong dollar. Even if the Hong Kong dollar were floated or repegged during a calm period, the experience of other countries suggests that over the long term Hong Kong would be highly unlikely to have a monetary policy as good as the one it has now through the link to the U.S. dollar.
In an orthodox currency board system there is really no need to worry about an exit strategy except in the unusual circumstance that the anchor currency becomes unstable or perhaps if, as in Lithuania, the initial choice of anchor currency was not the most appropriate one. For Hong Kong, neither is a problem. (11) The U.S. dollar is a stable currency and has good prospects for remaining so. Switching from the U.S. dollar to the yen as the anchor currency would not significantly reduce exchange-rate volatility for the Hong Kong dollar with respect to third currencies. In a world where the major currencies have floating exchange rates, any monetary policy will encounter exchange-rate volatility with respect to some currencies, and economies whose trade is not concentrated within a single currency zone must learn to live with that.
Most talk about the need for an exit strategy arises because people assume that the fixed exchange rate of a currency board will eventually become overvalued. There are two senses in which a currency can be overvalued. In the more precise sense, a currency is overvalued if at the existing exchange rate, demand to sell the currency exceeds the willingness of the monetary authority to buy, or would exceed it if exchange controls were absent. Overvaluation in this sense does not apply to a floating exchange rate because the central bank does not have to participate in the foreign-exchange market at all. Nor does it apply to an orthodox currency board, which never need worry about its foreign reserves being exhausted. To the extent that the HKMA acts in orthodox fashion, the Hong Kong dollar can no more be overvalued in relation to the U.S. dollar than a U.S. dollar in California can be overvalued in relation to a U.S. dollar in New York. The exchange rate is fixed just as the rate between a U.S. dollar in California and a U.S. dollar in New York is fixed. Overvaluation in the precise sense applies only to a peg, band, or target zone maintained by a central bank. A central bank operating a pegged rate typically holds foreign reserves less than 100 percent of the monetary base and engages in sterilized intervention, allowing the monetary base to increase even if foreign reserves are falling. When foreign reserves become sufficiently low they are vulnerable to exhaustion through a speculative attack, since most governments prefer devaluation to the measures necessary to defend a peg from a strong attack.
The other, looser sense in which a currency can be overvalued is that according to some statistical measure, the cost of living has increased more in Hong Kong than Bangkok over a given period. However, it is by now well known that floating exchange rates can deviate widely and for long periods from statistical estimates of their purchasing power parities. Such deviations do not imply any need for devaluation. To the extent that Hong Kong has followed an orthodox currency board policy, the Hong Kong dollar has shadowed the U.S. dollar. Therefore, to claim that the Hong Kong dollar should depreciate against the baht implies that the U.S. dollar should depreciate against the baht. Those who think the Hong Kong dollar is overvalued, however, envision the Hong Kong dollar depreciating against both the baht and the U.S. dollar. The logic of their argument is self-contradictory.
After making the current system orthodox, the government should stress that Hong Kong has an orthodox currency board and highlight the differences between a currency board and a central bank. One difference concerns the exchange rate. Economists usually fail to distinguish clearly between fixed and pegged exchange rates. To the extent that the currency board system is orthodox, the Hong Kong dollar has a fixed rate, not a pegged rate. With a fixed exchange rate, maintaining the exchange rate is the top priority of monetary policy (in an orthodox currency board system, the only priority). With a pegged rate, other objectives, such as interest rates, have equal status with the exchange rate as priorities of monetary policy. That sets up a conflict between priorities that usually ends in a devaluation, indicating that the exchange rate has been demoted in priority. Orthodox currency boards maintain fixed exchange rates and therefore have not needed to devalue; central banks that claim to maintain fixed rates in reality maintain pegged rates, which is why they have devalued repeatedly.
An orthodox currency board does not manage the supply of money, the balance of payments, or interest rates. They manage themselves, or more accurately, the decisions of millions of individuals in the market economy determine them. Therefore talk about the need for monetary management, such as the need to "defend" the currency, is nonsensical in an orthodox currency board system. If these changes suggested here are implemented, one hopes people would cease talking about monetary management and cease referring to the HKMA as Hong Kong's "de facto central bank." If not, the government should stress that Hong Kong does not have a de facto central bank; it has an orthodox currency board.
Applying currency board orthodoxy to Hong Kong--more technical points
The government of Hong Kong established the current official exchange rate of HK$7.80 per U.S. dollar on 15 October 1983, when it reintroduced the currency board system. Direct access to the convertibility undertaking was restricted to the note-issuing banks (then the Hong Kong and Shanghai Banking Corporation and the Standard Chartered Bank), and applied only to Hong Kong dollar notes. (12) The effect of the restriction, though complex in its details and changing somewhat over time, was that the pool of arbitragers was smaller than it would have been if all banks had been allowed access, and in consequence the spot exchange rate at times deviated by more than 1 percent from the convertibility undertaking. The deviations were larger and more persistent than in other existing currency board and currency board-like systems.
The development of the currency board system from 1983 to 1998 can be seen as a series of cumbersome, roundabout attempts to fix problems with the convertibility undertaking--problems that have not occurred in other currency board systems because they have not limited access as Hong Kong has. Rather than promoting arbitrage by giving all banks direct access to the convertibility undertaking, the government of Hong Kong tried to reduce fluctuations in the exchange rate against the U.S. dollar by roundabout methods that relied on monetary management. The culmination was the HKMA's purchase of HK$118 billion in shares of stock and stock-market futures contracts in August 1998. The seven technical measures of 5 September 1998 (HKMA 1998) reversed course and for the first time addressed some of the problems with the convertibility undertaking in a direct rather than a roundabout manner, and moved Hong Kong's currency board in a somewhat more orthodox direction. As a result, the spot exchange rate of the Hong Kong dollar with the U.S. dollar has been less variable than it was before.
Imperfections in arbitrage combined with certain regulations affecting banks erect barriers between the pool of Hong Kong dollar financial assets and the pool of U.S. dollar financial assets. Hence even though Hong Kong has the most open financial system in East Asia, it is not fully integrated into worldwide market for U.S. dollars. That works to Hong Kong's disadvantage during periods of uncertainty in financial markets because it prevents the liquidity available to borrowers in Hong Kong dollars from being as extensive as it could be at a given interest rate. Even small costs of conversion and small fluctuations in the exchange rate are sufficient to eliminate profits from converting U.S. dollars to make short-term loans in Hong Kong dollars when interest rates in Hong Kong dollars are higher.
There are several things the government and the HKMA can do to make the market for Hong Kong dollars fully integrated with the market for U.S. dollars. All can be done without changing existing law, because all are the result of administrative decisions by the government or the HKMA.
Consider extending access to the convertibility undertaking still further. The first of the seven technical measures of 5 September 1998 was to extend direct access to the convertibility undertaking to all banks. The HKMA should consider extending access to the convertibility undertaking still further, to other financial firms such as investment banks. That does not mean that everybody need have direct access to the Hong Kong clearinghouse, however. (Extending access to the public is possible, but experience indicates that it is not a detail of great practical importance for making the system work more efficiently.)
Once the market exchange rate reaches the official rate of HK$7.80 = US$1, make the convertibility undertaking a two-way commitment with a zero band, and avoid policies that promote a divergence between the two rates. The official exchange rate only applies to issues and redemptions of notes by the note-issuing banks. It is a two-way commitment. Since May 1992 the HKMA has used intervention to keep the market rate of the Hong Kong dollar on the "strong" side of the official exchange rate, although it has made no official commitment to do so. To eliminate the inconsistency of having a market exchange rate that differs persistently from the official rate, the HKMA stated on 5 September 1998 that as one of the seven technical measures, it intended to move the rate it offers on clearing balances to the official rate of HK$7.80, which it offers on Hong Kong dollar notes. Speculation developed that the move might occur soon in one step, so short-term interest rates in Hong Kong dollars increased. To end speculation, the HKMA announced on 14 September that it would leave the then-current clearing-balance rate of HK$7.75 per U.S. dollar unchanged for at least six months. Later it announced that it would move the clearing-balance rate to the official rate in steps of 1/100 of a Hong Kong cent per calendar day, starting on 1 April 1999. The movement is occurring now, and the clearing-balance rate will reach the official rate on 12 August 2000.
At present, the clearing-balance rate is only a one-way commitment: the HKMA allows banks to use it for converting Hong Kong dollars in their clearing accounts into U.S. dollars, but not for converting U.S. dollars into Hong Kong dollars. As a result of that barrier to arbitrage, the exchange rate in the interbank market fluctuates slightly around the creeping central rate offered by the HKMA, though the fluctuations are smaller than they were before the seven technical measures. Under current circumstances, limiting the commitment is necessary because a two-way commitment would expose the HKMA to losses from offering two different exchange rates. When the clearing-balance rate finally reaches the official rate, however, the commitment should become and remain a two-way commitment applying to the entire monetary base. The HKMA has announced that it does not intend to let the exchange rates diverge again, but the commitment would be more credible if embodied in law.
An orthodox currency board need not hold many or any notes of the anchor currency. Somebody who gathers HK$780 million in Hong Kong dollar notes should not expect to receive US$100 million in greenbacks; rather, he should expect a draft on a bank account in New York or something of that type. An orthodox currency board commits itself to exchange the domestic monetary base for specified foreign-currency assets on demand at a fixed exchange rate, but if the specified assets are not those that customers of the currency board most prefer, it is their job rather than that of the currency board to convert the assets into more preferred form.
Allow settlement of bank clearings in U.S. dollars at the official exchange rate. The clearinghouse settles interbank payments through transfers in the deposits banks have at the HKMA, which comprise part of the monetary base. Because Hong Kong has a real time gross settlement system, the clearing balances that banks need are small. Before the seven technical measures were announced, outflows of capital had the potential to create large interest-rate spikes because they could exceed the aggregate clearing balance of the banks, which is currently about HK$4 billion. Because of the divergence between the market rate and the official rate, the cheapest way to obtain foreign exchange could sometimes be to sell Hong Kong dollar clearing deposits at the HKMA for U.S. dollars, reducing the aggregate clearing balance and creating a liquidity squeeze for the system. The seven technical measures included changes that enable banks to sell Exchange Fund Bills and Notes to the HKMA at known, moderate rates of discount. By selling, banks enlarge their deposits at the HKMA, which they can use for interbank clearings. The Exchange Fund Bills and Notes outstanding of roughly HK$100 billion are now close substitutes for clearing balances because they are easily convertible into clearing balances through the HKMA's discount window. The amount of capital outflow needed to affect the aggregate clearing balance is now much larger, which has made short-term interbank interest rates in Hong Kong dollars less volatile.
A logical further step is to enlarge the pool of close substitutes much further, to include the U.S. dollar monetary base and even U.S. Treasury securities outstanding, which total not billions but trillions of Hong Kong dollars. Once the HKMA moves the clearing-balance rate to the official rate, the convertibility undertaking will be, or at least should be, a two-way commitment with a zero band. Federal funds, which banks use to settle their U.S. dollar clearings, will then become potentially as useful as Exchange Fund Bills and Notes as sources of liquidity. Since the U.S. Federal Reserve System operates a discount window to allow banks to sell Treasury securities for Federal funds, Treasury securities would in effect become potential supplements to the Hong Kong dollar monetary base. That would eliminate one rationale for issuing Exchange Fund Bills and Notes as money market instruments. (13)
Hong Kong could even settle clearings in U.S. dollars, as Argentina does, or at least allow settlement to be conducted either in Hong Kong dollars or U.S. dollars, as Argentina's clearinghouse allows. The Exchange Fund Advisory Committee commented on this possibility in its meeting of 22 July 1999 (EFAC 1999).
Offer "structured notes." Several Hong Kong academics, supported by Merton Miller of the University of Chicago, have developed the idea of offering insurance against a future devaluation of the Hong Kong dollar (Chen and Chan 1998; Cheng and others 1999b; Miller 1998). They have focused their attention on the idea of structured notes, a kind of put option for the exchange rate of the Hong Kong dollar against the U.S. dollar. They have proposed that the HKMA establish a separate entity to issue structured notes by setting aside HK$50 billion to HK$80 billion of its foreign reserves in excess of those that back the monetary base. The seven technical measures amount to adopting some of the ideas of the proposal for structured notes. In an orthodox currency board system, significant demand for structured notes is unlikely, but there is no harm in trying the proposal. If Hong Kong's system remains less than fully orthodox, demand for structured notes may be significant. If so, structured notes offered in sufficient quantity would reduce or eliminate the forward discount of the Hong Kong dollar against the U.S. dollar.
Refuse responsibility for guaranteeing the money supply beyond the monetary base. The convertibility undertaking should only extend to Hong Kong dollar notes in circulation, and deposits at the Currency Board. Just as an orthodox currency board strictly separates fiscal policy from monetary policy by not financing the domestic government, it strictly separates money (the monetary base) from credit (broader measures of the money supply) by not acting as a lender of last resort to banks. The issue is one of consistency and practicality. Unlike many central banks, an orthodox currency board does not siphon profits from commercial banks by requiring them to hold large noninterest-bearing reserves. Because the currency board does not share in the profits of banks, neither does it share in their losses. Banks have the responsibility of being sufficiently liquid. And more practically, an orthodox currency board lacks sufficient foreign reserves to back broader measures of the money supply.
An orthodox currency board system can have a limited domestic lender of last resort. A deposit insurance fund such as is now being studied in Hong Kong, lines of credit such as Argentina has secured, a system of cross guarantees, and funding bank rescues directly from the government budget are all possibilities (though not all equally good). But whereas a central bank whose currency is floating can in principle extend unlimited credit, lenders of last resort in an orthodox currency board system have limited resources and the fiscal implications of their activities are clear. More important, in an orthodox currency board system the fixed exchange rate with the anchor currency, combined with freedom for foreign banks to establish branch networks, enables the banking system to become well integrated with the world financial system. Global money markets are the main source of liquidity.
In Hong Kong, the main beneficiaries of the HKMA's willingness to be a lender of last resort are dozens of small banks that might not exist if not protected by the interest rate cartel and licensing requirements that restrict competition from foreign banks established since 1978. The note-issuing banks and the branches of foreign banks can borrow from their head offices or from international markets if they are short of liquidity (though they will also borrow from the HKMA if they can do so cheaply). The small banks may be unable to borrow other than from the HKMA. Rather than assuming that the HKMA must act as a lender of last resort, it is more appropriate to ask whether the small banks deserve what amount to special favors.
To repeat, experience suggests that on balance, a central bank as a lender of last resort weakens rather than strengthens the financial system. East Asia's recent banking disasters, from Japan to Indonesia, have all occurred in central banking systems. By acting as lenders of last resort, central banks have converted what should have been private losses from bank failures into large burdens on taxpayers. The disruptions that the central bank itself causes by creating extreme depreciations in exchange rates are absent in a currency board system. By nearly eliminating exchange risk with the anchor currency, a fixed exchange rate with a major international currency promotes greater access to liquidity in world markets than a pegged or floating rate maintained by a central bank.
This implies that the HKMA should eliminate certain banking regulations explained below and renounce the willingness it has stated to be a lender of last resort (HKMA 1999: Appendix 4). Moreover, the government of Hong Kong should emphasize that the Chinese government's statements of support for the currency board system are welcome, but that the currency board system does not require foreign reserves in addition to those held against the monetary base. The HKMA's huge foreign reserves in addition to the backing for the monetary base are irrelevant to an orthodox currency board system, as are the foreign reserves of the Chinese central bank. Currency boards elsewhere have not had and, especially where orthodox, have not needed huge excess foreign reserves.
It has been claimed that if people lose confidence in the exchange rate of the Hong Kong dollar and wish to convert their Hong Kong dollar deposits into foreign currency, even the HKMA's high level of excess foreign reserves is insufficient to prevent a panic (Cheng and others 1999b, p. 5). It is unclear why people would want to make such a conversion. A much more likely scenario is that they would switch from Hong Kong dollar deposits to U.S. dollar deposits within the Hong Kong banking system. In an orthodox currency board system, that would have virtually no effect; it would be little more than a change of unit of account. Even in the case of a mass conversion from Hong Kong dollar deposits into U.S. dollar notes, though, a central banking system with a floating exchange rate would not necessarily perform better. In principle, the central bank could print sufficient domestic currency for the public to convert all domestic-currency deposits into domestic-currency notes, but that would merely substitute a currency crash for a banking panic. Moreover, the central bank could not stop a panic affecting foreign-currency deposits.
Remove restrictions on the financial system. Hong Kong's financial system faces a number of restrictions that impair financial integration with the world market for U.S. dollars, thereby impeding arbitrage between financial assets in Hong Kong dollars and those in U.S. dollars. The oldest restriction is the interest-rate agreement imposed by the Hong Kong Association of Banks with the blessing of the government. The agreement limits the rates that banks can pay on time deposits of six days or less, current accounts, and savings accounts, which are in total about 30 percent of all Hong Kong dollar deposits. There never was any good reason for the interest-rate cartel, which simply transfers profits from small savers to banks, and perversely prevents small savers from taking full advantage of arbitrage opportunities by denying them interest rates as high as they should receive. A study of the agreement in 1990 estimated that it cost consumers HK$5.46 billion a year at the time (Kroszner 1990: 24). The HKMA has announced that it will phase out the interest rate agreement by mid 2001, provided that economic conditions are favorable (HKMA 1999: paragraphs 32-5).
Another restriction is the limit on branching by foreign banks that came to Hong Kong after 1978. Initially they were allowed only one branch; later they were been allowed to open a back office in a different location from the branch. The HKMA has announced its intention to increase from one to three the number of branches that new foreign banks can have and to consider further increases later (HKMA 1999: paragraphs 44-5). The effect of restrictions on entry is to protect existing banks--of which the smallest may be the most vulnerable--from new foreign competitors. There is little reason to expect that large international banks will fail as a result of making mistakes in Hong Kong; they have enormous resources and Hong Kong is only part of their business. If banks fail, they will be the comparatively small banks. Competition is the best way of weeding out the small banks that are sound enough to thrive from those that must close or merge with other banks.
Yet another restriction is that banks limit the extent of mismatches between Hong Kong dollar and U.S dollar liabilities. Unlike the case with other liabilities in other foreign currencies, where the HKMA sets limits, in the case of liabilities in U.S. dollars the banks are expected to have internal limits (HKMA 1997: section 6.4.7). In many central banking systems such limits make some sense, because mismatches between liabilities in foreign currency and assets in domestic currency have created trouble when the central bank has devalued the domestic currency. In an orthodox currency board system, though, the regulation would make no sense because it impedes arbitrage in interest rates without reducing currency risk.
If the restrictions are removed, my own preference is that Hong Kong not establish a compulsory, government-run deposit insurance fund. The big banks do not want one because they think that, as in many other countries, it will become a vehicle for subsidizing small banks at their expense by reducing the competitive advantages of stability that large size typically brings. Opening the banking system fully to foreign competition and not imposing measures such as compulsory deposit insurance to obscure differences in stability will both give people access to the most stable banks in the world and make them attentive to differences in stability. Openness and competition, rather than guarantees by the government and the HKMA, are the best ways to promote a stable financial system. Lest this view sound hopelessly old-fashioned, consider that, except for Singapore, every central banking system in East Asia has recently suffered or, in the case of China, seems likely to suffer a crisis that is will cost taxpayers large amounts of money. Hong Kong has been the exception not because the HKMA has been willing to act as a lender of last resort or because of regulation, but because Hong Kong has the most open financial system in the region and the HKMA has avoided the gross exchange-rate blunders of central banks in the region. (Hong Kong's rule of law also makes liquidation of bankrupt companies more efficient than elsewhere.) Making the currency board system more orthodox would reinforce those strengths. Banks would still be free to devise formal but voluntary cooperative measures to improve their liquidity if they wished.
Conclusion
Before closing, I should say something about the recession that Hong Kong is now recovering from. Both its causes and cures are largely outside of Hong Kong's control. Unlike the rest of China, Hong Kong is a highly open economy with a fully convertible currency. Hong Kong's openness has been one factor in its amazing long-run economic growth, but openness also means that Hong Kong cannot rely on a large internal market or on exchange controls to protect it from a region-wide East Asian recession. The economies that most influence the region are Japan, as a consumer and investor, and China, as a competitor in low-wage industries. Japan's stuttering pattern of economic growth in recent years and the danger of slow growth in China (despite what official statistics say) are well known. They would affect Hong Kong under any type of monetary system.
Bitter experience has taught many countries that chasing after short-term "flexibility" in monetary policy reduces the prospects for long-term growth. There are times when you must accept losses in the short term to make greater gains later. Hong Kong has one of the world's best long-term records of economic growth. The currency board system has contributed to it, by enabling Hong Kong to avoid the currency disasters that have beset its neighbors. If central banking is to be worthwhile for Hong Kong, monetary policy with a domestic central bank would have to be better than the policy Hong Kong imports from the U.S. Federal Reserve System. It is unlikely that Hong Kong would succeed where so many others have failed. The answer is rather to make the currency board system more orthodox so that the Hong Kong dollar becomes truly as good as the U.S. dollar, and enjoys the same level of credibility.
Appendix: A model statute for the Hong Kong Currency Board
The following model statute illustrates the level of legal protection that is desirable for the currency board system in Hong Kong.
1. a. The government of Hong Kong hereby creates the Hong Kong Currency Board.
b. The purpose of the Currency Board is to issue notes, coins, and deposits in Hong Kong dollars, and to maintain them fully convertible at a fixed exchange rate into a foreign anchor currency by holding a reserve fund of assets payable in the anchor currency that is at least equal to its liabilities.
c. The reserve fund shall be regarded as the property of holders of Currency Board liabilities, kept in trust by the Currency Board.
2. a. The Currency Board shall be governed by a board of five directors, appointed by the Chief Executive and confirmed by the Legislative Council. Directors shall be persons of recognized competence on the subject of currency boards.
b. A quorum shall consist of three members of the board of directors. Decisions shall be by majority vote, except as specified in paragraph 15.
c. The first set of directors shall be appointed for terms of one, two, three, four, and five years, respectively. Subsequent directors shall be appointed for terms of five years. Directors may be reappointed once. Should a director resign or die, a successor shall be appointed to complete the remainder of the term.
3. The board of directors shall have the power to hire and fire the Currency Board's staff, and to determine salaries for the staff. The bylaws of the Currency Board shall determine salaries for the directors.
4. a. The Currency Board shall issue note, coin, and deposit liabilities denominated in Hong Kong dollars. The liabilities of the Currency Board shall be fully convertible into the anchor currency.
b. The Currency Board's financial activities shall be limited to those necessary to maintain an orthodox currency board. In particular, it shall not attempt to target interest rates, act as a lender of last resort to financial institutions, lend to the government, or participate in the stock market.
c. Existing arrangements with regard to note issue by banks may be continued and extended to other banks.
5. a. The anchor currency is the foreign currency or the commodity with which the Hong Kong dollar has a fixed exchange rate. Initially, the anchor currency shall be the U.S. dollar and the exchange rate shall be 7.80 Hong Kong dollars per U.S. dollar. Subject to the conditions of paragraph 11, the exchange rate shall be considered a legally binding commitment for the government of Hong Kong.
b. The Currency Board may redenominate the Hong Kong dollar in terms of the anchor currency provided that the change is a simple change of accounting unit that does not affect values expressed in terms of the anchor currency.
c. Failure to maintain the fixed exchange rate with the anchor currency shall make the Currency Board subject to legal action for breach of contract. This provision does not apply to embezzled, mutilated, or counterfeited notes, coins, and deposits, or to changes of the anchor currency in accord with paragraph 13.
6. a. The Currency Board shall charge no commission for exchanging Hong Kong dollars for the anchor currency, or the reverse.
b. The Currency Board may establish a minimum size for transactions, not to exceed US$1 million. All licensed banks in Hong Kong shall be eligible to transact business directly with the Currency Board. The Currency Board may transact business with other persons at its option.
7. The Currency Board shall begin business with net foreign reserves equal to 105 per cent of its notes and coins in circulation and deposits with it. It shall hold its foreign reserves in securities or other forms payable only in the anchor currency. The Currency Board shall not hold securities issued by any level of government in the People's Republic of China, or by enterprises owned by those governments.
8. The Currency Board shall retain all net seigniorage (profits) into a reserve fund whenever its net unborrowed reserves fall below 105 per cent of its notes and coins in circulation plus its deposit liabilities. It shall remit to the government of Hong Kong all net seigniorage beyond that necessary to maintain 105 per cent reserves. The distribution of net seigniorage shall occur annually.
9. a. The Currency Board shall publish a detailed financial statement monthly. The statement shall appraise the Currency Board's holdings of securities at their market value.
b. The Currency Board shall publish every business day a simplified financial statement of its position at the close of the previous business day.
10. a. The Currency Board may issue notes and coins in such denominations as it judges to be appropriate.
b. The Currency Board may establish offices at such places as it judges to be appropriate.
11. Should the annual change in the consumer price index in the anchor country fall outside the range -5 per cent to 20 per cent for more than two years, or -10 per cent to 40 per cent for more than six months, within sixty days the Currency Board may:
a. Devalue (if the change in the index is negative) or revalue (if the change in the index is positive) the Currency Board currency in terms of the anchor currency by no more than the change in the index during the period just specified, or
b. Choose a new anchor currency and fix the exchange rate of the Currency Board currency to the new currency at the rate then prevailing between the new anchor currency and the former anchor currency.
12. If the Currency Board chooses a new anchor currency in accord with paragraph 11, within one year it must convert all its foreign reserves into assets payable in the new anchor currency.
13. The Currency Board may not be dissolved nor may its assets be transferred to a successor organization except by unanimous vote of the board of directors.
14. Hong Kong dollars shall be legal tender for paying taxes and settling debts in Hong Kong. However, they shall not be forced tender for contracts between private parties. The use of other currencies among consenting parties shall be legal.
15. Statues and regulations conflicting with this law are repealed.
16. This law takes effect immediately.
References
(This fairly extensive list of recent material in English excludes articles from Hong Kong Economic Papers and Pacific
Economic Review, which were not readily available to me.)
Asian Monetary Monitor (Hong Kong), various issues, 1977-1996.
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Chen, Nai-fu, and Alex Chan. 1998. "To Defend a Strong Currency in Times of Crisis." Working paper, Hong Kong University of Science and Technology, 19 January.
Cheng, Leonard K., Yum K. Kwan, and Francis T. Lui. 1999a. "Risk Premium, Currency Board, and Attacks on the Hong Kong Dollar." Working paper, Center for Economic Development, Hong Kong University of Science and Technology. Available online at <http://www.bm.ust.hk/~ced/main.htm>.
Cheng, Leonard K., Yum K. Kwan, and Francis T. Lui. 1999b. "An Alternative Approach to Defending the Hong Kong Dollar." Working paper, Center for Economic Development, Hong Kong University of Science and Technology, 8 May. Available online at <http://www.bm.ust.hk/~ced/main.htm>.
Culp, Christopher, and Steve H. Hanke. 1993. "The Hong Kong Linked Rate Mechanism: Monetary Lessons for Economic Development." Unpublished paper, Department of Economics, Johns Hopkins University (Baltimore), June.
EFAC. 1999. Hong Kong Monetary Authority. Exchange Fund Advisory Committee. "Record of Discussion of the Meeting of the Exchange Fund Advisory Committee Sub-Committee on Currency Board Operations Held on 2 July 1999." Available online at <http://www.info.gov.hk/hkma>.
Fry, Maxwell J. 1995. Money, Interest, and Banking in Economic Development, 2nd edition Baltimore: Johns Hopkins University Press.
Frydl, Edward J. 1999. "The Length and Cost of Banking Crises." International Monetary Fund Working Paper 99/30, March. Available online at <http://www.imf.org>.
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Greenwood, John G. 1991. "The Problem of CPI Inflation--Monetary or Structural?" Asian Monetary Monitor, v. 15, no. 3, May-June, pp. 1-14.
Greenwood, John G. [1994?]. "A Proposal to Solve the Cash Arbitrage Problem under the Linked Rate System for the Hong Kong Dollar." Unpublished paper.
Greenwood, John G. 1995. "The Debate on the Optimum Monetary System." Asian Monetary Monitor, v. 19, no. 2, March-April, pp. 1-5.
Greenwood, John G., and Daniel Gressel. 1988. "How to Tighten Up the Linked Rate Mechanism." Asian Monetary Monitor, v. 12, no. 1, January-February, pp. 2-13.
Hanke, Steve H. 1999. "Some Thoughts on Currency Boards." In Mario I. Blejer and Marko Skreb, editors, Balance of Payments, Exchange Rates and Competitiveness in Transition Economies. Norwell, Massachusetts: Kluwer Academic Publishers.
Hanke, Steve H., Lars Jonung, and Kurt Schuler. 1993. Russian Currency and Finance: A Currency Board Approach to Reform. London: Routledge.
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Henckel, Timo, Alain Ize, and Arto Kovanen. 1999. "Central Banking Without Central Bank Money." International Monetary Fund working paper, March.
HKMA. 1997. Hong Kong Monetary Authority. 1997. Prudential Supervision in Hong Kong. Hong Kong: Hong Kong Monetary Authority.
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HKMA. 1999. Hong Kong Monetary Authority. Hong Kong Banking into the New Millennium: Policy Response to the Banking Sector Consultancy Study. Hong Kong: Hong Kong Monetary Authority. Available online at <http://www.info.gov.hk/hkma>.
HKMA. Hong Kong Monetary Authority. Annual Report, various issues. Available online at <http://www.info.gov.hk/hkma>.
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Hong Kong. Financial Services Bureau. 1998. Report on the Financial Market Review. April. Available online at <http://www.info.gov.hk/fsb/finance>.
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Hong Kong Standard, Internet edition, <http://www.hkstandard.com> , various issues.
Jao, Y. C. 1999. "The Financial Sector in the Wake of the Recent Asian Crisis." in Wang Gungwa and John Wong, editors,Hong Kong in China: The Challenge of Transition, pp. 127-54. Singapore: Tunis Academic Press.
JEC. 1999a. United States. Congress. Joint Economic Committee. Office of the Chairman. "Encouraging Official Dollarization in Emerging Markets." Staff report, April.
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Kroszner, Randall S. 1990. "Banking in Hong Kong: Regulation, Stability, and the Role of Money Market Mutual Funds."Asian Monetary Monitor, v. 14, no. 4, July-August, pp. 16-36.
Kwan, Yum K. and Francis T. Lui. 1996. "Hong Kong's Currency Board and Changing Monetary Regimes." In Takatoshi Ito and Anne O. Krueger, editors, Changes in Exchange Rates in Rapidly Developing Countries. Chicago: University of Chicago Press.
Kwan, Yum K. and Francis T. Lui. 1999. "How Well Has the Currency Board Performed?" Evidence from Hong Kong." Working paper, Center for Economic Development, Hong Kong University of Science and Technology, March. Available online at <http://www.bm.ust.hk/~ced/main.htm>.
Kwan, Yum K., Francis T. Lui, and Leonard K. Cheng. 1999. "Credibility of Hong Kong's Currency Board: The Role of Institutional Arrangements." Working paper, Center for Economic Development, Hong Kong University of Science and Technology, 4 June. Available online at <http://www.bm.ust.hk/~ced/main.htm>.
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Notes
1. Senior Economist, Joint Economic Committee, U.S. Congress. Mailing address: Dirksen Senate Office Building Room G-01, Washington, DC 20510, USA. E-mail: <Kurt_Schuler@jec.senate.gov>. Paper prepared for Hong Kong Baptist University's International Workshop on Currency Boards, Hong Kong, 9 October 1999. This draft early September 1999. Comments welcome. The views here are my own alone, and not necessarily those of the Joint Economic Committee or the U.S. government.
2. The questions are: (1) What the convertibility undertaking of the currency board should cover. (2) Who should have access to the convertibility undertaking. (3) How the currency board should manage liquidity in the financial system. (4) How banks should manage liquidity to prepare for periods of stringency. (5) How to exit from a currency board system.
3. For details, see <http://users.erols.com/kurrency/bet.htm>.
4. For a survey of the history of currency boards to 1991, see Schuler 1992.
5. Hong Kong had competitive issue of bank notes from 1845 to 1935, but all notes were convertible at a fixed rate into an anchor currency--silver, which initially was the metal most widely used for Chinese and international trade (Schuler 1989). There was no apparent demand for notes convertible into copper or gold, nor for bank-issued fiat currencies. In part this reflects the network externalities of using a currency, which is why I said that people can enjoy "many" of the benefits of a floating currency if there is competition in currency.
6. Here are the relevant portions of the Basic Law:
Article 110. The monetary and financial systems of the Hong Kong Special Administrative Regions shall be prescribed by law.
The Government of the Hong Kong Special Administrative Region shall, on its own, formulate monetary and financial policies, safeguard the free operation of financial business and financial markets, and regulate and supervise them in accordance with law.
Article 111. The Hong Kong dollar, as the legal tender in the Hong Kong Special Administrative Region, shall continue to circulate.
The authority to issue Hong Kong currency shall be vested in Government of the Hong Kong Special Administrative Region. The issue of Hong Kong currency must be backed by a 100 percent reserve fund. The system regarding the issue of Hong Kong currency and the reserve fund system shall be prescribed by law.
The Government of the Hong Kong Special Administrative Region may authorize designated banks to issue or continue to issue Hong Kong currency under statutory authority, after satisfying itself that any issue of currency will be soundly based and that the arrangements for such issue are consistent with the object of maintaining the stability of the currency.
Article 112. No foreign exchange control policies shall be applied in the Hong Kong Special Administrative Region. The Hong Kong dollar shall be freely convertible....
Article 113. The Exchange Fund of the Hong Kong Special Administrative Region shall be managed and controlled by the government of the Region, primarily for regulating the exchange value of the Hong Kong dollar.
7. Here are the relevant parts of the Exchange Fund Ordinance as it now exists:
(1) There shall be established a fund to be called "the Exchange Fund"; which shall be under the control of the Financial Secretary and shall be used primarily for such purposes as the Financial Secretary thinks fit affecting, either directly or indirectly the exchange value of the currency of Hong Kong and for other purposes incidental thereto....
(1A) In addition to using the Fund for its primary purpose, the Financial Secretary may, with a view to maintaining Hong Kong as an international financial centre, use the Fund as he thinks fit to maintain the stability and the integrity of the monetary and financial systems of Hong Kong....
(2) The Fund, or any part of it, may be held in Hong Kong currency or in foreign exchange or in gold or silver or may be invested by the Financial Secretary in such securities or other assets as he, after having consulted the Exchange Fund Advisory Committee, considers appropriate; and the Financial Secretary may for the account of the Fund--
(a) buy or sell such currency, foreign exchange, gold, silver, securities or assets accordingly; and
(b) after having consulted the Exchange Fund Advisory Committee, enter into any financial arrangement that he considers appropriate for the prudent management of the Fund.
(3) ..., the Financial Secretary may borrow for the account of the Fund either in Hong Kong or elsewhere, on the security of the general revenue. (Laws of Hong Kong, chapter 66, section 3)
8. Singapore still has a Board of Commissioners of Currency, which issues notes and coins, but it has not had a currency board system since the Singapore dollar was floated in 1973. The Commissioners of Currency and the Monetary Authority of Singapore, which creates the deposit component of the monetary base, have identical boards of directors, assuring that the two bodies coordinate their actions as components of a central banking system.
9. If dollarization occurs before the rate the HKMA offers on clearing balances converges with the slightly "weaker" official rate it offers on Hong Kong dollar notes, the entire monetary base, and it alone, could be exchanged at the rate offered on clearing balances.
10. For more information on dollarization, see JEC 1999a, b; Stein 1999.
11. For ideas about what to do if the anchor currency becomes unstable, see Hanke and others (1993: 113-14). In the case of switching from one high-quality anchor currency to another that is more appropriate, the switch should be made without devaluing, by multiplying the exchange rate against the old anchor currency times the rate of the old anchor currency against the new anchor currency. For example, Lithuania now wishes to switch from the U.S. dollar to the euro as its anchor currency. If the Lithuanian litas switches from the U.S. dollar to the euro as the anchor currency on 1 January 2000, the old fixed exchange rate of 4 litai per dollar should be multiplied by the market rate of the dollar against the euro, say US$1.10 per euro, to yield 4.4 litai per euro as the new fixed rate. This is also the view of the IMF. In memoranda to the Lithuanian government in 1990 and 1991 and in a book in Lithuanian in early 1994, I suggested the German mark rather than the U.S. dollar as the most appropriate anchor for a Lithuanian currency board.
12. In the first incarnation of the currency board system, from 1935 to 1974, direct access had also been limited, but the note-issuing banks had agreed to buy or sell the anchor currency to other banks at a spread on either side about 0.2 percent wider than they faced at the Exchange Fund. The public faced a further spread of about 0.2 percent. Technically, the convertibility undertaking has always applied to Certificates of Indebtedness rather than to notes directly. The Certificates of Indebtedness are an anachronism that could be eliminated.
13. Therefore, contrary to Henckel and others (1999: 38-9), advances in payments technology that reduce the need of banks for reserves do not increase the volatility of interest rates in an orthodox currency board system and do not provide a rationale for central bank-type operations.