The Hong Kong Dollar Linked Exchange Rate System. Ernest CHU Oct 2014

Transcription

1 The Hong Kong Dollar Linked Exchange Rate System Oct Whenever the economy of Hong Kong is experiencing setbacks or turmoil, the Hong Kong Dollar Linked Exchange Rate System (LERS) is usually the first to come under scrutiny. Understandably, the LERS is an important monetary instrument which has far-reaching consequences, both positive and negative (Hong Kong Monetary Authority [HKMA], 2005). In recent years, there is no shortage of criticisms of the LERS being the culprit behind high inflation and high housing prices (Cookson, 2011; Li, 2013). The distorted economy of Hong Kong, thus, calls for a review of the LERS. This paper aims to shed some light on this matter and evaluate the LERS; alternatives to the LERS will not be the focus of this paper. The paper is structured as follows: firstly, some brief background information regarding the LERS, followed by an introduction to the framework used for the analysis. Then, the analysis of the LERS, where the benefits and costs will be weighed against each other. Finally, some brief comments on the alternatives to the LERS before some concluding remarks. I) Background Information Before the LERS, Hong Kong has undergone many changes to its exchange rate regime. According to HKMA (2005), Hong Kong followed the silver standard from 1863 to 1935, when a world silver crisis compelled the Hong Kong dollar (HKD) to be pegged the British pound for HK$16 per pound. But by June 1972, the British pound was made freely floating, thus the HKD changed its anchor to the US dollar (USD), first at HK$5.65 per USD, then at HK$5.085 in This peg did not last long, however, as the USD was weakening, and by November 1974, the HKD was made freely floating. Unfortunately, due to the lack of robust monetary policy framework, the economy of Hong Kong experienced high volatilities in its GDP growth, inflation and exchange 1

2 rate. Finally, in October 1983, the LERS we know of today has been established, at HK$7.8 per USD. The most notable challenge to the LERS has been the 1997 Asian financial crisis. Due to a contagion effect following the Taiwan dollar being made freely floating, many speculators believed that the HKD was overvalued and held short positions. The interbank interest rates rose in defence of the LERS, which caused stock prices to fall. In an attempt to salvage both the LERS and the stock market, the Hong Kong government bought up almost HK$120 billion worth of shares. (Wong et al., 2001; Sheng, 2009). II) Theoretical Framework The nature of the LERS is, in fact, part of a larger scope of monetary economics. This is embodied by what is known as the Impossible Trinity. The Impossible Trinity is essentially a trade-off between three desirable macroeconomic objectives: stable exchange rates, free capital flows and sovereign monetary policies (Obstfeld, Shambaugh, & Taylor, 2004). Figure 1: The Impossible Trinity Free capital flows Fixed exchange rates Sovereign monetary policies 2

3 For example, since the HKD is fixed to the USD and there are unrestricted capital flows in and out of Hong Kong, it is impossible for the HKMA to set interest rates. If the HKMA sets an interest rate higher than that of the Federal Reserve, US dollars will be sold for Hong Kong dollars and put downward pressure on the Hong Kong interest rate until it balances with the USD, and vice-versa, ceteris paribus. Hence, according to the above framework, maintaining the LERS consequently forces Hong Kong policymakers to forsake one of the other two objectives. Alternatively, policymakers could forsake the LERS to achieve the other two objectives. Subsequently, most of the forthcoming analysis will be focussed on this aspect. III) Analysis A) The Case for Fixed Exchange Rate The advantages of fixed exchange rates are well-documented. The primary benefit is the minimisation of exchange rate risk for transnational business transactions. The LERS is important to Hong Kong, as it is a small, open economy with high levels of imports and exports (Census and Statistics Department [Censtatd], 2014a). Employment statistics also show that the majority of Hong Kong s labour force is engaged in the import/export business (Censtatd, 2014d). Thus, stabilising the exchange rate to encourage international trade in Hong Kong is vital to Hong Kong s continued economic health. As regards speculative attacks, a legitimate concern, the LERS, which is a currency board system, is different to a conventional peg (HKMA, 2005). The HKD is fully backed by HKMA s foreign reserves in USD. In other words, for every HK$7.8 outstanding, there is US$1 in HKMA s foreign reserves. Thus, the HKMA needs not resort to intervention in the foreign exchange market and manipulation of supply in order to maintain the peg. Furthermore, the Hong Kong government is fiscally prudent, as demonstrated by its consistent surpluses year-on-year (HKSAR Government, 3

4 2014), which means that there is no need to rely on monetary financing to pursue its fiscal policies, contributing to the stability of the LERS. Why, however, should the HKD be specifically linked to the USD? Firstly, in terms of trade, the US is Hong Kong s second-largest trading partner (see figure 2 below). Figure 2: External merchandise trade (HK$ Million) (Censtatd, 2014c) Mainland China USA Japan Taiwan ,444, , , , ,698, , , , ,891, , , ,253 Looking at the above data, one could reasonably suggest linking the HKD to the Chinese Renmenbi, as Mainland China is by far Hong Kong s largest trading partner. However, due to practical constraints, this is at the moment impossible. Secondly, and more significantly, the USD plays a significant role in foreign investments in and out of Hong Kong. Consider figures 3 and 4 below: Figure 3: FDI inflow to Hong Kong by investor country in 2012 (Censtatd, 2014b) 4

5 USD millions The Hong Kong Dollar Linked Exchange Rate System Figure 4: Hong Kong top 5 FPI partners in 2013 (IMF, 2014) 400, , , , , , , , ,000 50, ,965 83,551 65,877 0 China Cayman Islands Bermuda USA UK Despite China being the top FDI and FPI partner of Hong Kong, observe that the other significant investment partners of Hong Kong the British Virgin Islands, Bermuda, Cayman Islands and the US either use the USD as their domestic currency, or their domestic currencies are pegged to the USD. Thus the LERS, integrating HKD with USD, facilitates these significant investment flows in and out of Hong Kong. Finally, in a world operating on fiat money, it is crucial to consider the status of the USD as a hard currency. Fiat money has no intrinsic value, and thus its usefulness highly depends on the confidence which people have in its issuer. For that, the USD has no parallel. Firstly, the USD is the most widely-used currency in international transactions. Secondly, the USD is free convertibility. Thirdly, the USD is the most-held foreign reserve currency, mainly due to its history being the world s reserve currency since the Bretton Woods agreement. The above combination of worldwide recognition and use makes the USD still the most-trusted world currency, even in the aftermath of the global financial crisis. (Goldberg, 2010). 5

6 Hence, the LERS has been and still is an integral part of Hong Kong s economic stability and the USD is still the most appropriate currency to be linked to. The shortcomings of LERS, perceived mainly as Hong Kong s high inflation rates, will be discussed in a later section. B) Maintaining Free Capital Flows Some believe that having some form of capital control is a good macroprudential policy, especially in light of the global financial crises. Some consider capital control as a responsibility to correct negative externalities caused by investors who do not internalise the costs of financial instability when making investment decisions (Korinek, 2011). Furthermore, there is evidence to suggest that having financial controls can substantially lower risk by lowering debt components in financial portfolios and limit credit booms (Ostry, Ghosh, Chamon, & Qureshi, 2012). However, the liberalisation of capital flows could also be beneficial to the economy, by allowing free access to capital markets and thus the more efficient use of capital (savers and borrowers have access to the best risk-return portfolios). Furthermore, free capital flows is associated with higher foreign direct and foreign portfolio investments. Subsequently, some research suggests that free capital flows have positive impacts on economic growth (Levine, 2002; Aizenman, Jinjarak, & Park, 2011). Specifically in the case of Hong Kong, it would be unwise to restrict capital flows. Aside from reaping the aforementioned benefits of free capital flows, Hong Kong has very few natural resources, and the manufacturing sector has moved to China (Carroll, 2007), meaning that the economy of Hong Kong is focussed on the services sector. Figure 5: Percentage share of value added of the Four Key Industries in Hong Kong GDP (Censtatd, 2014e) Financial services Tourism Trading and logistics Professional services and other producer services

7 Figure 5 above shows that financial services and trading and logistics are two of the most economically significant industries of Hong Kong responsible for over 30% of Hong Kong s GDP. One could infer from the statistics that Hong Kong is highly competitive in these industries, partially due to free capital flows allowing foreigners easier access to these services provided by Hong Kong. Furthermore, Hong Kong remains an important access point to China, due to the Hong Kong s liberalised capital flow (especially compared with China s strict capital controls) (Yue & He, 2008). Thus, implementing capital control, despite its merits, may not be well-suited for Hong Kong, which is dependent on capital flows to create value and contribute to economic growth. C) Inflation and Monetary Policies Critics of LERS have been unrelenting in blaming the LERS for persistently high inflation in Hong Kong. Inflation in Hong Kong has averaged at around 4% per year since 2009, especially housing rents, which have increased by 30% between 2009 and 2014 (Censtatd, 2014d). There are two ways in which the LERS could contribute to the inflation: firstly, the weakening USD has also lowered the value of the HKD, causing imports to become more expensive. Also, the US s expansionary monetary policies (quantitative easing and low interest rates), aiming to stimulate a weak US economy, are inappropriate for Hong Kong s relatively robust economy, and may cause it to overheat. However, it is uncertain whether the abolishment of LERS may resolve such issues. One could take Singapore as an example. Proponents of the LERS will be quick to address that, despite Singapore s monitoring band regime (not a strict peg), inflation in Singapore has been higher than Hong Kong because being a small and open economy, it is inevitable that both Singapore and Hong Kong will be affected by the global economy (Holland, 2012; HKMA, 2013). Although there may be some truth in such arguments, the inflation rates of Hong Kong and Singapore may be affected by different factors. Therefore, without proper analysis of the sources of inflation in 7

8 both areas, it cannot be concluded that the LERS has little or no impact on inflation in Hong Kong simply by comparisons with Singapore. Figure 6: HKD/CNY exchange rate (XE.com, 2014) Nevertheless, it would be inappropriate to dismiss the effect of LERS on Hong Kong s domestic prices. Hong Kong s consumption goods are mostly imported from China (Censtatd, 2014c). Meanwhile, the value of the HKD compared to CNY has depreciated by more than 10% since 2009 (figure 6 above). What remains true is that there may be alternatives in alleviating inflation in Hong Kong without the need to abolish the LERS. Wong (2014), for example, attests that outdated land policies are to blame for Hong Kong s high housing prices. Specifically, the supply of housing is unable to meet the demand not due to the lack of land on which to build, but due to poor government policies in making land available to developers. Furthermore, for critics who concern themselves with the mismatch of Hong Kong s economy and the US s monetary policies, it should be reminded that the Federal Reserve is expect to commence the tapering of its expansionary monetary policies, stopping the quantitative easing and increasing the interest rates. If this becomes the future trend, then it would be less convincing to argue for the abolishment of LERS from the perspective of monetary policies. 8

9 Therefore, whilst abolishing the LERS may help ease inflationary pressure and allow Hong Kong to pursue monetary policies that reflect the current Hong Kong economy, there are alternatives which may help alleviate these problems that should be considered. IV) Alternatives to LERS Given the rise of China and its increasing role in the economy of Hong Kong, some people believe that it is appropriate to consider linking the HKD with CNY. Proponents of such a peg will not hesitate to refer to the data in figures 2, 3 and 4, which clearly shows China s significance in Hong Kong s trade and investments. Unfortunately, using the CNY as an anchor suffers from two technical setbacks. Firstly, CNY is not freely convertible. Secondly, according to HKMA Chief Executive Norman Chan, there is an insufficient amount of offshore CNY to establish a HKD- CNY LERS almost 2 trillion yuan would be required (as cited in Chatterjee, 2013). Thus a peg to the CNY is technically impossible at present. There are also other currencies that could be considered, such as the British pound, the Euro or even a basket of currencies. Another alternative is to let the HKD freely float. Hong Kong s economic fundamentals are strong and people generally have confidence in Hong Kong as a world-class financial centre. Aside from an appreciation of HKD which some predict, this would also allow the HKMA to dictate monetary policies. However, as aforementioned, Hong Kong s attribute as a small, open economy means that having a currency anchor to provide economic stability is also important. There are many merits and demerits to all these alternatives, but have been addressed too hastily above due to the constrained scope of this paper. I implore others to explore these issues in greater depth for a more fruitful discussion. 9

10 V) Summary of Analysis and Conclusion Based on the above analysis, the author is compelled to recommend the status quo for the short term. Out of the three macroeconomic objectives in the Impossible Trinity framework, choosing to maintain free capital flows makes the most sense. As for the choice of fixed exchange rates over sovereign monetary policies, it seems that the lack of sovereign monetary policies can be overcome in the short term. Indeed, the author s position is deliberately cautious. In light of the recent financial crises, from which the world has yet to recover from, it would be inappropriate to introduce more uncertainty to the economy. However, the author must concede that there are better alternatives for the future, but more research would be required to construct some semblance of a conclusion for this. In conclusion, whilst this paper cannot unabashedly claim that the LERS is the ideal exchange rate regime for Hong Kong, there is evidence that the LERS has its merits. As regards its demerits, the paper has also suggested some alternative methods to mitigate some of the ill-effects of LERS. Hence, at least in the short term (during the world s recovery), the LERS should remain as the exchange rate regime of Hong Kong. 10

11 References Aizenman, J., Jinjarak, Y., & Park, D. (2004). Capital flows and economic growth in the era of financial integration and crisis, (NBER Working Paper 17502). Cambridge, MA: National Bureau of Economic Research. Retrieved from Carroll, J. M. (2007). A concise history of Hong Kong. Hong Kong: Hong Kong University Press. Census and Statistics Department. (2014a) Gross Domestic Product. Hong Kong: Census and Statistics Department. Retrieved from Census and Statistics Department. (2014b). External direct investment statistics of Hong Kong Hong Kong: Census and Statistics Department. Retrieved from Census and Statistics Department. (2014c). Hong Kong external merchandise trade. Hong Kong: Census and Statistics Department. Retrieved from Census and Statistics Department. (2014d). Hong Kong monthly digest of statistics: October Hong Kong: Census and Statistics Department. Retrieved from Census and Statistics Department. (2014e). Table 188: Value added of the Four Key Industries [Data file]. Hong Kong: Census and Statistics Department. Retrieved from Chatterjee, S. (2013, October 14). Too early to consider yuan as Hong Kong dollar peg HKMA chief. Reuters. Retrieved from Cookson, R. (2011, September 8). Hong Kong faces dollar peg inflation dilemma. Financial Times. Retrieved from Goldberg, L. S. (2010). Is the international role of the Dollar changing? Federal Bank of New York: Current issues in economics and finance, 16(1). Retrieved from HKSAR Government. (2014). The Budget. Hong Kong: HKSAR Government. Holland, T. (2012, June 18). Don t blame the peg: Singapore s no better off than HK. South China Morning Post. Retrieved from Hong Kong Monetary Authority. (2005). HKMA background brief no. 1: Hong Kong s Linked Exchange Rate System. Hong Kong: Hong Kong Monetary Authority. Retrieved from Hong Kong Monetary Authority. (2013). Frequently asked questions on the Linked Exchange Rate System (LERS). Hong Kong: Hong Kong Monetary Authority. Retrieved from International Monetary Fund. (2014). Co-ordinated portfolio investment survey [Data file]. Retrieved from Korinek, A. (2011). The new economics of prudential capital controls: A research agenda. IMF Economic Review, 59, Levine, R. (2002). International financial liberalization and economic growth. Review of International Economics, 9(4), Li, S. (2013, October 14). Hong Kong peg to US dollar blamed for city's soaring property prices. South China Morning Post. Retrieved October 20, 2014, from Obstfeld, M., Shambaugh, J. C., & Taylor, A. M. (2004). The trilemma in history: Tradeoffs among exchange rates, monetary policies and capital mobility (NBER Working Paper 10396). Cambridge, MA: National Bureau of Economic Research. Retrieved from Ostry, J. D., Ghosh, A. R., Chamon, M., & Qureshi, M. S. (2012). Tools for managing financial-stability risks from capital inflows. Journal of International Economics, 88(2), Sheng, A. (2009). From Asian to global financial crisis: An Asian regulator s view of unfettered finance in the 1990s and 2000s. Cambridge, UK: Cambridge University Press. Wong, R. Y. C. (2014, March 14). Why is housing so expensive? [Web log comment]. Retrieved from Wong, R. Y. C., Chang, E. C., Siu, A. K. F., Luk, Y. F., Rao, P. S., & Kwan, W. C. (2001). Asian financial crisis: Causes and development. Hong Kong: Hong Kong Institute of Economics and Business Strategy, the University of Hong Kong. XE.com. (2014). XE currency charts (CNY/HKD) [Data file]. Retrieved from Yue, E., & He, D. (2008). The future of the Renminbi and its impact on the Hong Kong dollar. Cato Journal, 28(2),