1. Walking the tightrope after a financial crisis

If a financial crisis is not handled or self corrects quickly, the real economy will then get hit. In a modern economy, the "transmission mechanism" between turmoil in the currency, stock, and property markets on the one hand and a full-fledged recession on the other is the reactive behaviour of the banking system, and the "conditioning factor" is the policy of the government that affects the input-output and price-quantity mix of commercial banks (Tsang, 1998c; 1998d). A credit crunch, under which banks severely tighten lending for fear of asset deflation and/or instability in funding, will touch off or deepen an economic downturn. On the other hand, vested interests or parties that have made bad decisions will always want to be saved, instead of facing the consequence of their mistakes. This constitutes a problem of moral hazard, which needs to be objectively considered, particularly if it involves taxpayers' money.

Moreover, in the context of Hong Kong, disequilibria and imbalances were built up in the pre-1997 era, which could only be solved by an effective structural reform. Knee-jerk "rescue measures" that jeopardize the long-term future should be avoided (Tsang, 1997; 1998d).

It is a very thin line between undisciplined bailing out and disciplinarian insensitivity. As Hong Kong is operating under a currency board arrangement (CBA), which is the most stringent form of fixed exchange rate regimes now practiced in the world, how best to walk the tightrope is a question that must be very carefully addressed. It actually opens up a host of issues about currency board economics.

2. Emerging credit crunch: Hong Kong's CBA under stress

The Hong Kong dollar was attacked in October 1997 as the second stage of the East Asian currency crisis unfolded. The financial bubble that had actually peaked then burst. Share and property prices collapsed, as interest rates showed huge volatility and stayed on average at uncomfortably high levels in the midst of uncertainty about the robustness of the HK$/US$ link of 7.80. Banks in Hong Kong started to tighten their credit.

The economy registered a negative real growth of minus 2.8% in the first three months of 1998. The last time a real quarter fall was recorded was in 1985. Bankruptcy and lay-off now surface regularly, and an increasing number of economists is forecasting negative growth for the whole year of 1998 (which will be a historical "first" since reliable GDP statistics became available). A few is booking the same for 1999. In fact, three sets of forces have been operating on the Hong Kong economy: (1) the still evolving external crisis, starting with the East Asian financial turmoil to the recent Japanese yen "crisis"; (2) the process of "Manhattanization" and the problem of structural imbalance in the Hong Kong economy (Tsang, 1994; 1998b); and (3) the cyclical downturn that became inevitable after the stock and property bubble of 1996-1997 (Tsang, 1998d).

While pains for at least two years seem likely, the financial plunge could in theory facilitate the badly needed re-adjustment process. As the exchange rate is fixed for political as well economic reasons, other sectors in the economy have to yield to the hard fact of over-pricing and non- competitiveness. Hong Kong's property prices and rentals before the turmoil were among the highest in the world. Given the plunge in the exchange rates as well as deep asset deflation in Hong Kong's neighbours, it was almost inevitable for the local financial bubble to burst, and for the property prices and rentals to come down significantly. These developments should actually be welcome, provided that they do not generate undue adverse impacts on the banking system and hence on the whole economy.

Of course, vested interests in Hong Kong might use the October 1997 turbulence and the unfolding hardship as a pretext for slowing down the structural adjustment needed for the long-run health of the economy. They may exercise their marker power or political influence by resisting any policy initiatives that reduced their benefits, or by passing the pains to other social strata. In the first half of 1998, some top property developers did pressurize the SAR government to back track on its target of providing 85,000 residential units per year to the market (whose purpose was to stabilize property prices in Hong Kong) (Tsang, 1998d).

In any case, more than market power has been at work. Credit contraction has emerged as a trend. After reaching the peak of HK$1,609 billion in September 1997, the stock of total Hong Kong dollar loans and advances by licensed banks then fell and stagnated around the level of HK$1,550 billion in the first four months of 1998. Some purchasers of residential property units before the bubble burst are painfully crying, as banks mark their asset value down by half and the interest rate charged turn double-digit, while others simply fail to find any willing bank creditor. A "credit crunch" becomes a danger in Hong Kong, which if unchecked may push the economy into a deep recession.

3. The dilemma facing banks in Hong Kong

The key to prevent the "crunch" is to alleviate through suitable measures the input-output difficulties felt by the banking system. Nonetheless, how to do it under a currency board system is a tricky question. Currency board purists would object to any facility of the lender of last resort by the government, not to say liquidity management by a central bank to relieve a tightening of credit.

Financial institutions in Hong Kong are facing two problems. First, the value of the collateral for their loans (mainly property units and to a lesser extent stock shares) have fallen by 40% to 50% on average from the peak in 1997, and may decline further. I must emphasize that their dependence on property as the major collateral is quite lamentable, and it reflects the structural imbalance in Hong Kong's economy (Tsang, 1994; 1997; 1998b).

In any case, given the speed of asset deflation, it is not surprising that banks are very sensitive about the health of their own balance sheet, and have become wary of extending new loans without securing dependable assets. Second, because of the persistent concern about the link (Tsang, 1998a), instability exists in their sources of funds: (1) quantity-wise, supplies of funds from the interbank market and customers are not readily forthcoming and could dry up with little notice; (2) price-wise, interbank interest rates have fluctuated widely around high levels, whereas competition for consumer deposits cuts deep into profit margin.

4. Fiscal and land policies

To alleviate the difficulties surrounding the banking system, a two-pronged approach is obviously needed. The arrest of the downward spiral of asset deflation, which may throw the balance-sheet health of some banks into question, requires some fiscal initiatives in terms of increasing public expenditure and reducing taxes. The Hong Kong government announced a package of measures on 22 June 1998, which included some cuts in taxes. But the most important one was the suspension of land sales for nine months (until March 1999). It was intended to shore up the collateral value of the banking system, so as to reduce its anxiety about asset deflation.

With the package of measures, the fiscal balance for 1998-99 would be turned from an originally budgeted surplus of HK$10.7 billion to a deficit of HK$21.4 billion. That amount of deficit however pales into insignificance compared with the cumulative fiscal surplus of HK$450 billion recorded in March 1998, which equaled to two average years of government expenditure! A deficit of HK$21.4 billion is only about 1.5% of Hong Kong's GDP and less than 5% of total budgeted revenue and expenditure in the fiscal year 1998-99, and it looks very humble against revised surplus of HK$80.9 billion for 1997-98. While the Financial Secretary Donald Tsang emphasized that the deficit "required to give a much needed relief to the economy shaken by unforeseen circumstances cannot be regarded as Government loosening its fiscal position or undermining its prudential financial management"(Donald Tsang, 1998), one could argue that the government can and should have been more aggressive. The fiscal reserves are supposed to serve Hong Kong in "rainy days". The territory is suffering from the economic aftermath of a financial storm.

5. "Monetary" polices given excess reserves in a CBA

To reduce the probability of a credit crunch, it is also necessary to stabilize the quantity and the price of fund supplies to the banking system. Theoretically, under a fixed exchange rate regime, there is no such thing as a "monetary policy" under which the authority can affect the monetary base, bank credit and hence total money supply, as well as their marginal value. This is particularly so for a strongly disciplined system like a currency board arrangement (CBA).

However, as I have argued elsewhere, Hong Kong's CBA is an atypical one (Tsang, 1998a). Most of the foreign exchange reserves, which stood at US$96.1 billion on 30 April 1998, representing 8.2 times of the total amount of currency in circulation and 45.2% of HK$ M3, did not originate from any CBA requirements. A large chunk of it has been cumulative fiscal reserves transferred from the government to the Exchange Fund (where Hong Kong's foreign exchange reserves were and are kept). Such a practice was started in the mid-1970s, when the Hong Kong dollar was floating, and was intended to give the monetary authority more firepower to shore up the local currency. It was not changed when Hong Kong shifted back to a currency board system in 1983. Nor was it discontinued when the Hong Kong Monetary Authority (HKMA), the territory's central bank, came into being in 1993.

In other words, Hong Kong has over-fulfilled the most stringent requirements of any currency board. Even if the government adopts the AEL model (of Argentina, Estonia, and Lithuania) and applies a deposit reserve ratio of as high as 20%, Hong Kong's foreign exchange reserves will still represent about 200% of the expanded monetary base (currency in circulation plus bank reserve deposits at the HKMA). There is only a liquidity requirement (25% of assets in specified liquid forms against total deposit liabilities) but no deposit reserve requirement in the territory, and banks need to have only a clearing balance with the HKMA that can cover their interbank settlements. If they run out of funds, the HKMA's HK$ LAF (liquidity adjustment facility), which serves as the role of the lender of last resort, is there to help.

No one would sensibly recommend the HKMA to impose a 20% deposit reserve requirement on banks. Even Malaysia, which did not adopt a CBA, reduced its requirement from 10% to 8% in mid-1998 in a bid to ease the liquidity problem of the banking system. An irony is that without a reserve requirement, Hong Kong is unable to reduce it to relieve the credit crunch, as other CBAs including Argentina and Lithuania have been able to do so (Santiprabhob, 1997, p.20). Moreover, since the only money that banks deposit with the HKMA is the clearing balance, which should theoretically approach zero if there is perfect information and maximum efficiency in liquidity management, large interbank HK$/US$ transactions would have amplified and significant effects on the clearing balance and therefore interest rates. A deposit reserves system (including most likely excess reserves voluntarily deposited by banks) would be a better cushion. But that is another story that I have analyzed elsewhere (Tsang, 1998c).

In any case, with the huge "excess reserves", the Hong Kong CBA could afford a few tricks of "monetary policies" that inject liquidity into the banking system and alleviate the danger of credit crunch. A simple way of doing so is to "play with the yield curve": the HKMA can borrow short and lend long in the interbank market, thus providing banks with some fund stability one, three or six months down the road. The HKMA would of course earn some profit in the case of a positively sloped yield curve, but bear extraordinary losses in case of a currency attack, when overnight rates might go to breathtaking levels.

The second choice is that of open market operations, through which the HKMA buys Exchange Fund bills and notes in the interbank market and then credit the selling bank's account with it with Hong Kong dollars. The limitation of such an exercise is that the total stock of outstanding bills and notes is just about HK$100 billion (most of which should be in the hands of banks), and they count as part of the liquid assets under the liquidity requirement.

Other than these marginal operations, there are two more "drastic" options: (1) the repatriation of foreign exchange reserves placed overseas; and (2) direct creation of base money by the Exchange Fund through the HKMA.

6. Repatriation of foreign reserves

The first option, repatriation of foreign reserves, has a large following locally. The issue is however rather complicated. Much of the Exchange Fund money has been invested by the HKMA in foreign currency instruments, including a large amount of US government bonds and bills. For ease of analysis, suppose the HKMA wants to recall money from its US$ deposits with Bank A in New York. It can ask Bank A to transfer say US$10 billion to Bank B in Hong Kong. Receiving that amount of US$, would Bank B then create new HK$ loans? The answer is: it depends because a problem of "currency match" and exchange rate risk is involved. If Bank B does not have full confidence about the robustness of the link of HK$7.80/US$, it would not dare to extend loans of HK$78 billion against the liability of US$10 billion (even assuming that it already has more than enough liquid assets to fulfill the liquidity requirement). A devaluation of the Hong Kong dollar would spell disaster for it.

In the worst case, Bank B would be so nervous that it simply re- lends the US$10 billion to Bank A in New York. Things are then back to square one: the HKMA simply fails to "repatriate" the territory's foreign exchange reserves!

Of course, the actual situation is unlikely to be so comical. Some Hong Kong enterprises need to borrow US$ to import, and banks can use the US$ funds placed with them to extend the required loans. Less frightened local banks may be willing to take up the currency risk and make HK$ loans. Finally, portions of the US$ reserves repatriated should end up (or start up) in the hands of the three Notes Issuing Banks (NIBs), which may issue some new bank notes (by transferring the US$ deposit back to the Exchange Fund through HKMA).

The three NIBs have been bearing the exchange rate "risk" of issuing HK$ notes against US$ reserves all the time anyway: the probability of the Exchange Fund defaulting on them by violating the contract of 7.80 is virtually zero. Even in the case of a formal devaluation, the Exchange Fund will no doubt compensate the NIBs for the exchange loss appropriately. The Hong Kong government did compensate not only the NIBs but also other banks with unhedged sterling assets after the revaluation of the Hong Kong dollar against pound sterling in November 1967, to which it was then pegged under a previous CBA that spanned from 1935 to 1972 (Nugée, 1995). However, bank notes now account for only 5% of total HK$ money supply; and their issuance is largely demand driven. It is not clear whether a deliberate creation of bank notes would add much, if at all, to the liquidity of the system.

A more direct, and indeed more effective way, for the Hong Kong government to repatriate its foreign exchange reserves is through the fiscal route. Remember what we said above: much of the Exchange Fund had a fiscal origin. Just increase government expenditure and import more! The US$10 billion can be spent, without worrying about the hesitation of the banking system. Nevertheless, since we are talking about preventing a full-scale credit crunch, the question is then whether the fiscal multiplier effect would be significant for the banks, in terms of stability in their fund supplies.

7. Direct creation of money by a CBA

The second option of injecting liquidity represents a patent violation of classical currency board principles: the direct creation of new money by the monetary authority, out of the blue. The HKMA simply lends money to banks in Hong Kong, without asking for any HK$ or US$ collateral. It is just like the printing of money by a typical central bank in the West. Despite all the monetarist dressing down and self criticism, central banks are still doing that, albeit much more carefully and constrained by all sorts of monetary targets.

The justification for this option is that Hong Kong has excess reserves, by any standard of CBAs, as discussed above.

8. Balancing short-run and long-run considerations for Hong Kong's CBA

Given a cumulative fiscal reserves that represented two years of government expenditure and a foreign exchange reserve that must be the envy of all currency board arrangements, the Hong Kong SAR is actually in a strong position to handle the aftermath of the East Asian financial turmoil and the bursting of its own stock and property market bubble. However, how to handle the structural reforms that are needed to launch the economy onto a more balanced development path, consistent with the "one country, two systems" framework is a rather different story. If not carefully handled, short-term rescue measures could derail long-term strategies.

A clear example is the suspension of land sales for nine months announced on 22 June 1998. The withholding might jeopardize the SAR government's declared plan of supplying 85,000 residential units per year to the market, as 39,000 units would be taken out from supply (Donald Tsang, 1998). Moreover, it has the consequence of shutting out medium and small-size property developers from bidding lands exactly when they became cheaper. Some of these developers, who have not over-committed like the big ones did in the heat of the euphoria, have loudly complained, and a journalist made a strong criticism that the government was unwittingly playing into the hands of the property tycoons (van der Kamp, 1998).

Ideally, given the importance of real estate in a high-density metropolis like Hong Kong, as well as the time lag involved in the production of usable property, sales of land by the government should be "cycle- neutral", instead of "pro-cyclical" or "anti- cyclical". The government should keep to a transparent supply rule and let the market adjust to it, rather than reacting to the market in a knee-jerk manner. To be more flexible, the authority can announce a "rolling" five-year plan of land disposal. While the SAR government finally realized such wisdom, its plan was strained by the need to carry out counter-cyclical policy to alleviate a recession. It is important for the government to map out and then announce a trajectory of returning to a cycle-neutral path of land supply rule, if the credibility of its longer-term structural reform strategy is not to be seriously compromised. At stake would also another property boom- and-bust cycle several years down the road.

As I have analyzed elsewhere (Tsang, 1998d), the economic strategy that the SAR government under the leadership of Chief Executive Tung Chee Hwa has adopted appears to be half-baked and insufficiently backed up by his staff with adequate resource allocations. One factor that is adding to the gloom of Hong Kong in 1998 is simply the following sets of questions: How would the economy grow after this crisis? How is the SAR going to remain or become more competitive? What kind of economic structure should be developed?

In the previous two crises that Hong Kong experienced, namely the 1974-75 oil crisis and the 1982-85 political crisis, what eventually pulled the economy out from the abyss was exports. Real export growth was 28.8% in 1976 and 33.5% in 1987, staggering performance! Few would nurture the same prospect for Hong Kong in the year 1999 or 2000, given the drastic devaluation around us. What will then be the economic "locomotive"?

In his speech at the ceremony marking the first anniversary of the establishment of the Hong Kong SAR on 1 July 1998, Mr. Tung Chee Hwa gave the impression that he was well aware of the contradictions between the long-term need to help the Hong Kong economy to move onto a more viable developmental path and the painful necessity of short-term rescue measures. It is useful to quote him in detail here:

"The SAR government has drawn up long-term plans to enhance Hong Kong's competitiveness and maintain its economic vitality. The Asian financial turmoil has exposed the weaknesses of our rather narrow economic structure. Therefore, while we are committed to the strengthening and reinforcing of major economic pillars, such as finance, property development, tourism, shipping and trade, we have to promote actively the growth of our economy by strengthening and developing further our cooperation with the mainland,.... developing high value-added and high technology industries; and developing such new and integrated industries as information technology, telecommunication, filming and television.

..... The biggest challenge we have now is how to integrate the development for our bright future with our efforts in relieving the people's hardship."

One can only wait and see whether Hong Kong can make the best of and minimize the worst of the unfolding economic crisis. At the same time, how Hong Kong handles the danger of a credit crunch will certainly be instructive for students of currency board economics.

REFERENCES

Nugée, John (1995) "A Brief History of the Exchange Fund," Quarterly Bulletin, Hong Kong Monetary Authority, May, pp.1-17.

Santiprabhob, Veerathai (1997) "Bank Soundness and Currency Board Arrangements: Issues and Experience", IMF Papers on Policy Analysis and Assessment, PPAA/97/11.

Tsang, Donald (1998) "Speech by Financial Secretary", 22 June, The Hong Kong Government Information Office.

Tsang, Shu-ki (1994) "The Economy", in The Other Hong Kong Report 1994, Hong Kong: The Chinese University Press, pp.125-148.

Tsang Shu-ki (1997) "Structural Imbalances Must be Rectified," Ming Pao, Hong Kong, 19 June (in Chinese).

Tsang Shu-ki (1998a) "The Hong Kong Government's Financial Market Review Report: An Interpretation and A Response," article placed on web: www.sktsang.com/ArchiveI/web985.htm.

Tsang Shu-ki (1998b) "Is a Currency Board System Optimal for Hong Kong?" article placed on web: www.sktsang.com/ArchiveI/web986.html.

Tsang Shu-ki (1998c) "The Unfinished Story: Analyzing the Options of Defending the Exchange Rate and Reducing Interest Rates in the Midst of a Crisis," Ming Pao, Hong Kong, 19 June (in Chinese).

Tsang Shu-ki (1998d) "The Hong Kong Economy: Opportunities out of the Crisis," Journal of Contemporary China, forthcoming.

van der Kamp, Jake (1998), 'Land Premium Game Takes Inevitable Course', Business Post, p.16, South China Morning Post, Hong Kong, 11 July.