HKMA Adviser Sees Lending Window As Key Change In System
(Dow Jones Newswires, 25 September 1998)

By James T. Areddy
Special Writer, Asian Economics

HONG KONG (Dow Jones)--The key technical change in Hong Kong's currency board mechanism earlier this month was related to the new discount window, not the official pledge to buy the currency from banks, according to an important adviser to the Hong Kong Monetary Authority.

The discount window operation has reduced the likelihood local interest rates will spike higher because of speculator pressure, said the HKMA adviser, Charles Goodhart, who is a London School of Economics professor and former Bank of England official.

"I think the situation is eased and the technical changes have made people become more confident in the currency board system," Goodhart told Dow Jones Newswires in an interview.

"I hope (the peg) will last for the next 50 years. It has served Hong Kong extremely well. It has taken Hong Kong through a lot of difficulties," he said. Goodhart said the current exchange rate of HK$7.8000 against the U.S. dollar remains appropriate.

When the seven technical measures to bolster the peg were announced on Sept. 5, Goodhart was specifically credited by HKMA Chief Executive Joseph Yam Chi-kwong as a guiding force behind the changes. It was similar to 1983, when Goodhart's name was invoked to support the peg's creation.

The latest measures - including a government promise to buy Hong Kong dollars from banks at a set exchange rate and the creation of a discount window for short-term bank borrowing - were part of a broad restructuring of the local currency system following a round of the government's vicious fight with speculators. The moves greatly cooled market pressure, and somewhat reduced the worldwide criticism lumped on Hong Kong for its outright buying of equities in the previous month.

Yam was apparently able to use Goodhart's name to endorse the changes after the professor changed his earlier views and backed the decision to do some tinkering with the peg system.

HKMA Adviser/Lending Window -2: Speculators May Return

Indeed, when Hong Kong was hit by its first waves of speculation from the Asian financial crisis in late 1997, Goodhart was partly responsible for shooting down initiatives similar to those adopted on Sept. 5.

In the interview, he conceded that he had altered his views and that the peg changes probably should have been made earlier. "Clearly if you think it was right now, why was it not right earlier?" Goodhart said.

In response to the question why the changes weren't made earlier, an HKMA spokesman read a statement that said in part: "the seven technical measures have both advantages and disadvantages....so any changes to the arrangements would therefore have to be weighed carefully."

But the HKMA spokesman declined to provide specific details of Goodhart's role. And in the interview, Goodhart himself expressed modesty about his overall role. "To say this is my idea, no. I approve of the idea," he said, declining to take credit for anything in particular.

Nevertheless, Goodhart has been an important voice since the dawn of Hong Kong's currency board system during the turmoil of 1983. He was the Bank of England's chief representative during the talks that established the peg system 15 years ago, offering credibility to the colonial government's decision. He has remained a regular visitor to Hong Kong and an adviser to monetary authorities, although only on an unofficial basis after he turned 60 last year, he said.

Goodhart even wears a watch resembling a Hong Kong dollar coin.

Although Goodhart said he supports the measures now, he expressed ambivalence during the interview about the importance of some of them and warned that speculators are likely to come up with new ways to attack the territory's financial system regardless.

"Markets are always developing. People are always learning new techniques, and authorities have to learn how to respond," Goodhart said. "There is a continuing need to review the situation, and they need to decide if there are any structural changes necessary."

HKMA Adviser/Lending Window -3: HK$ Pledge Less Important

The HKMA's seven adjustments are extremely technical.

The one most market practitioners focused on was the HKMA's promise to buy Hong Kong dollars from local banks at a set exchange rate, which was regarded as firming the government's promises not to abandon the peg system. Currently that purchasing rate is HK$7.7500, although the HKMA intends to move the so-called "clear undertaking" to make a market back to the peg level of HK$7.8000 at some later date.

But Goodhart said that promise isn't particularly significant because the HKMA had already been widely known to intervene and buy Hong Kong dollars whenever the currency moved to HK$7.7500. "In effect, it was always there. I think that was a change of presentation, more than a change of substance," he said.

"I think the change in substance is the shift of the monetary base," Goodhart said, referring to an aspect of the discount window creation and its effect on the money market balance.

Through the discount window, the HKMA promised to provide banks with liquidity when they need it and up to the amount of government bills and bonds in circulation. That expanded the interest-rate sensitive portion of the money market so substantially that speculators would have to take positions almost 17 times bigger than before in order to send interest rates soaring, according to the HKMA.

And curtailing interest rates spikes went to the heart of breaking down the "double-plays" that the government said speculators used to profit from short-positions in stocks whenever they drummed up currency selling.

Goodhart sidestepped questions about his view of the Hong Kong authorities' unprecedented decision to get in the middle of those double-plays by buying stocks, futures and the local currency in the latter half of August. The action absorbed billions of U.S. dollar reserves and was famously criticized last week by U.S. Federal Reserve Board Chairman Alan Greenspan as compromising Hong Kong's free-market tradition.

Despite his continuing support for the system itself, Goodhart was a late convert to the need to refine it and an important reason changes weren't made months earlier, according to a fellow academic, Tsang Shu-ki of Hong Kong Baptist University.

Tsang himself was peripherally involved in setting the Hong Kong dollar peg back in 1983 when he was with Standard Chartered Bank, and his research papers show he had been advocating for over a year the kind of currency purchase promise the HKMA undertook on Sept. 5.

Adviser/Lending Window -4: Learning From Others

Tsang said his proposal to the HKMA stemmed from visits he made to Argentina, Estonia and Lithuania in 1996 to study those countries' currency boards. But Goodhart, Tsang said, belittled the experiences of other economies, particularly smaller ones. "The idea that Hong Kong should learn from them is a little tough to swallow," said Tsang.

Indeed, Goodhart said in the interview that "Hong Kong is the grand-daddy of existing currency boards" and it doesn't have much to learn from the relative newcomers. But Goodhart also said that in initially rejecting the idea that the HKMA should make promises about intervention levels, there was a concern from within the HKMA that a too rigid currency board might kill off local currency foreign exchange trading altogether, undesirable for such a big money center. Further, Goodhart emphasized that his was just one of the voices in the debate, adding "I'm not a hired gun. I'm an academic."

Yet the HKMA clearly relied a lot on Goodhart's advice, according to a report published by the quasi central bank last April. The report served to publicly reject the need for changes in the local monetary system and dismisses ideas - among them Tsang Shu-ki's - by saying decisions were "supported by Professor Goodhart."

Tsang said he differs with Goodhart over the core theory that a currency board system is a reinforcing circle: that interest rates will go up if a currency is sold, and that those higher rates will attract investment back into the currency, therefore keeping it pegged. Tsang said the view is anachronistic because there is actually a lag time before confidence is revived through higher interest rates.

"The high interest rates could be seen as a sign of weakness, not a sign of strength," according to Tsang.

Tsang's view is that arbitrage is the key for strength of any linked exchange rate system and the HKMA's currency purchase undertaking allows the quasi central bank to play banks off of each other and make them unwilling to trade outside of particular ranges.

The HKMA's new system works, for example, because a bank would have no takers if it offers to sell U.S. dollars for less than HK$7.7500, because that's the point where the HKMA promises it will always sell U.S. dollars. Tsang, however, said the system would be sturdier still if the purchase-promise went the other way too, with an official pledge to buy U.S. dollars.

The gold standard worked in a similar way, harnessing market forces to keep the rates in check, according to Tsang. It kept currencies in line because the purchase of the yellow metal could be arbitraged between currencies if exchanges moved out of line. Nobody talked about interest rates under the gold standard, he said.

By James T. Areddy; jareddy@ap.org; 852.2802.7002; Adam S. Najberg contributed to the story.