Tsang Shu- ki
Department of Economics
Hong Kong Baptist University

The recent "currency attacks" in Southeast Asia have heightened concerns about the Hong Kong dollar (HK$), pegged to the US currency at the rate of 7.80 since 1983 under the "link". Will the HK$ face the same fate as the Thai baht or the Malaysian ringgit? 

Many have analyzed the "lessons" for Hong Kong. Unfortunately, neglecting the exact mechanism of the link, there is not much to learn. 

Officials and commentators point to sound economic fundamentals and huge reserves. Hong Kong's economic fundamentals cannot be that sound, lest Mr. Tung Chee Hwa would not be enjoining everyone to work for "a new era". And no reserves are sufficiently large to withstand an onslaught that erodes bank deposits substantially.

  An exchange rate cannot be pinned for long by sound fundamentals or sufficient reserves. It can however be fixed by arrangements that appeal to the self interest of market participants, thereby diverting pressures to other facets of the economy. This is the real lesson to learn.

  Strangely, Hong Kong officials choose not to emphasize the distinct nature of the link. While southeast Asian countries try to keep their exchange rates stable (but not fixed) through market intervention and administrative control, the link is fixed for totally different reasons.

  The link belongs to a genre called "currency board", first set up in Mauritius in the last century: to be exact 1849. Like the gold standard, it was an ingenious invention. Dozens of economies---many former colonies of Britain---have adopted the system. It has worked well in fixing exchange rates.

  Hong Kong actually used it between 1935 and 1972, tying the dollar to the British pound. There are now over ten countries and territories in the world employing it, but none in Southeast Asia except Hong Kong and Brunei. This fact should have been stressed.

  The idea is surprisingly simple. A "currency board" issues currency notes (paper money) with a 100 per cent foreign reserves backing at a fixed exchange rate. Any holder of paper money therefore rests assured that he can exchange his notes into foreign currency at the fixed rate.

  In a modern financial system, people hold much more than paper money. Bank deposits typically exceed currency notes by ten to twenty times. No currency boards can have reserves that fully match bank deposits. Hong Kong's foreign exchange reserves, huge as they are, are about one third of Hong Kong dollar deposits.

  How is the exchange rate of bank deposits fixed? Like the gold standard, it is through arbitrage. Since the exchange rate of paper money is fixed, the rate of bank deposit has to follow suit. Any rate differential gives rise to profitable activity that closes the gap.

  Take Hong Kong as an example. If the market rate of deposit weakens to say 8.00 against the US dollar. Anyone can withdraw cash from his HK dollar deposit account, surrender the paper money to the "currency board" (the Exchange Fund) and get US$ at the fixed but stronger rate of 7.80.

  With HK$ 7.8 million in cash, he will be given US$ 1 million. By selling the US$ 1 million in the market, he fetches HK$ 8 million. So he obtains a profit of HK$ 200,000. That is arbitrage, riskless. The selling pressure on the US dollar will push the market rate back to 7.80.

  Under the gold standard, gold bullion was shipped across countries to ensure that exchange rates converged to their gold parities. In a currency board system, people move currency notes to keep the market exchange rate in line. Both systems appeal to the self interest of the arbitrageur, and are distinct from regimes that "fix" the exchange rate through non-market means.

  Why are Hong Kong officials shy of highlighting the link as a currency board system? The truth is that Hong Kong has been a "black sheep" in the family. From the beginning (1935), there was no currency board. Because of colonial tradition, HK dollar notes were issued by designated banks. There are now three of them: the Hongkong Bank, the Standard Chartered Bank, and the Bank of China.

  When issuing currency notes, the note-issuing banks (NIBs) deposit an equivalent amount of US dollar with the Exchange Fund (EF) at the rate of 7.80. That follows the principle of the currency board. However, besides the NIBs, other banks, financial institutions and the depositors at large have no direct access to the EF to perform arbitrage. This is a crucial weakness of the link.

  In the 1980s, the market exchange rate was on the weak side of the official rate (i.e. above 7.80). In the 1990s, it swung to the strong side, staying below 7.80. Deviation so far averaged 1%. Such a price differential should have invoked arbitrage activities. But they have hardly been observed.

  A key reason is that banks do not like to have large amounts of their deposits converted into cash for the pursuit of arbitrage profit. A large-scale conversion will be equivalent to a bank run! The NIBs and indeed the whole financial sector are not interested in facilitating arbitrage. Hence, the market rate has persistently strayed from 7.80.

  Moving gold around annoys relatively few people, moving cash around is a different story. That is a minus for currency board vis-a-vis the gold standard. Because of the absence of a genuine currency board and the lack of universal access to it by market participants, Hong Kong's multi-layer system adds to the problems of the classical board. It has failed to fully enforce the fixed rate of 7.80.

  When the HK dollar is under pressure, Hong Kong's central bank, the Hong Kong Monetary Authority (HKMA), has to tighten liquidity and raise interest rates, on top of shouting at speculators and banks that accommodate them. This is not the way that a currency board is supposed to work. Doubts linger on the long-run viability of the link.

  In any case, there is a real lesson for Hong Kong to learn. Argentina, Estonia and Lithuania adopted the currency board system in 1991, 1992 and 1994 respectively. I have dubbed them as the AEL model. Though latecomers, all three AEL countries use an improved version of the system. It overcomes the problem of cash movements for arbitrage, with which Hong Kong is struggling.

  They have instituted a reserves system whereby each bank has an account with the central bank, in which the reserves for notes as well as the monetary reserves are kept. The central bank guarantees the full convertibility of all the reserves of each bank, at the fixed exchange rate. This ingenious setup bypasses the problem of moving cash around for arbitrage.

  Suppose Hong Kong adopted such a system, no banks would dare quote an exchange rate that deviated from 7.80. If Bank A quoted a rate of say 8.00, Bank B could immediately sell US$ 1 million to it, fetching HK$ 8 million, with an instruction that Bank A transferred the amount to its account with the central bank. The HKMA would convert HK$ 8 million into US$ 1.026 million for Bank B at the fixed rate of 7.80. A profit of US$ 26,000 then went to Bank B. Banks C and D etc. would be jumping at the arbitrage opportunity.

  Note that no cash movements were involved in all these transactions, as the central bank played the role of settling arbitrage activities between banks by providing the necessary foreign reserves.

  With this improved currency board system, Argentina, Estonia and Lithuania have been able to ensure 100 per cent stability in their exchange rates. In 1995, Argentina faced serious crises: 20 per cent of bank deposits were lost in less than three months; sixty banks folded up; economic growth rate was a negative 4.6%; and unemployment shot up to 16%. Yet the market exchange rate adhered strictly to the official rate (of 1 peso against 1 US$).

  The same "miracle" occurred in Lithuania. A banking crisis broke out in December 1995. The nation's two largest banks were closed. Deposits fell by 15% in the first quarter of 1996. Yet the official rate of 4 litas against 1 US dollar was not challenged at all.

  I visited Argentina in April 1996 and the Baltics in June 1996. The amazing robustness of their exchange rates drove me to only one conclusion: Hong Kong's currency board regime, having started earlier, has performed rather poorly.

  Hong Kong should eat the humble pie and learn the real lesson from the experience of the AEL countries---our "junior" members in the currency board camp. This is not a time for indulging in self congratulation over sound fundamentals and huge reserves.

There is already a central bank in Hong Kong, the HKMA. It is not a very big step to institute a direct banking reserves system. Hong Kong's foreign exchange reserves are much larger in relative size than those of the AEL countries. It is a shame that the territory cannot guarantee a 100 percent stability in the exchange rate, as they can. Why should Hong Kong be bothered about the fate of the Thai baht or the Malaysian ringgit? They are different animals!

*Tsang Shu-ki is a professor of economics at the Hong Kong Baptist University.

(This short piece was published in the Hong Kong Standard, a Hong Kong newspaper, on 31 October 1997.)