1. Huge Controversy

The Hong Kong government openly launched an intervention into the local stock and futures markets on 14 August 1998, to counter speculative "double market play" which threatened financial stability in the territory (Yam, 1998). That decision touched off a huge controversy. It has been the subject of severe criticism by the conservative media in the international community, and, of course, by major investment funds, which have had such fun in Hong Kong since last October.

I made known my support of the government's decision on 15 August. I still support it. All along, though, I have the following observations and reservations.

2. The Hong Kong CBA in Trouble: Dealing with Double Market Play

Hong Kong's currency board arrangement (CBA) is in some kind of trouble. Rejecting my recommendation of the AEL model that locks the spot exchange rate through effective currency arbitrage (Tsang, 1998a) as well as other insurance scheme proposals (FSB, 1998), the Hong Kong government is now dependent on an unreliable "specie flow" mechanism of interest rate adjustments, plus discretionary foreign exchange market intervention at unspecified levels close to the linked rate of HK$7.80/US$. Other than the presumed economic discipline of currency issue backed by 100% reserves, and the allegiance to a fixed exchange rate regime, the present CBA in Hong Kong is only a few steps away from central banking in the standard definition, albeit with unusually huge reserves (the third largest in the world, after Japan and Mainland China) (Tsang, 1998b).

That should not be a big problem in normal times, except for the ideological purists or linguistic perfectionists. However, the specie flow mechanism, now officially a passive one, has backfired because international speculators have manipulated it to push up interest rates and to short-sell in the local stock and futures markets.

Typically, speculators engineer an "attack" on the Hong Kong dollar by dumping it. Specie flow leads to a rise in interbank interest rates, which depresses stock prices and futures. If the Hong Kong Monetary Authority (HKMA) further reacts by buying Hong Kong dollars (selling US dollars), banking liquidity immediately dries up in the clearing balance under the RTGS (Real Time Gross Settlement) system. Interest rates move even higher. Speculators may "lose" in the foreign exchange market, but they gain handsomely in the stock and futures markets, where they have accumulated short positions. There does not seem to be any end to such "double market play" even as the stock market has fallen by 50% (Yam, 1998).

3. The AEL Model with a Deposit Reserve System: Not Adopted

To redress, the AEL model with a deposit reserve system will go a long way in alleviating the interest rate impact of a speculative currency attack. Given the turbulence that Hong Kong has been caught in, I would modify here my earlier argument that the deposit reserves could go down to zero in the ideal situation (Tsang, 1998a), for reasons spelt out in Tsang (1998c).

Firstly, there is no need for government intervention in the spot market as currency arbitrage through the electronic media prevents any bank from quoting a deviant rate. Forward speculation, on the other hand, will have much diffused impact on the RTGS system. Secondly, with a deposit reserve requirement, banks would typically keep "excess reserves". Even a modest 5% requirement with 1% or 2% excess reserves means that the normal banking balance with the HKMA will be close to HK$100 billion, instead of approaching zero as in the present case. Interest rate volatility will be reduced (Tsang, 1998c), and speculators will have much greater difficulties in engineering damaging "double market play" (Yam, 1998).

The government did not accept the AEL model in its April 1998 Review Report (FSB, 1998), for reasons that I found unconvincing (Tsang, 1998b). Theoretically, the clearing balance in the RTGS system, which is used only for settlement purposes, should approach zero, if there were perfect information and liquidity management efficiency on the part of banks were maximum. In reality, the clearing balance could be either positive or negative, and erring with a size of a few billions or a few tens of billions. This proves to be the Achilles' heel of the present version of Hong Kong's CBA, as international speculators can easily drive up interest rates by attacking the theoretically zero balance (Tsang, 1998c).

4. Sterilized Forex Intervention: Limited by Definitions

The Hong Kong government did try to make amends in July 1998 by sterilized foreign exchange market intervention. As Tsang (1998b) discusses, the April 1998 Review Report specified several conditions, under which the HKMA could recycle liquidity into the system, one of which is the management of fiscal reserves. Since the mid-1970s, cumulative fiscal reserves have been transferred to the Exchange Fund---where Hong Kong's foreign exchange reserves are kept---now managed by the HKMA. As a result of the government providing additional fiscal stimulus in June 1998, a deficit of HK$21.4 billion (instead of an originally budgeted surplus of HK$10.7 billion) was expected (Tsang, 1998d). Hence, there was a need for turning foreign reserves back to Hong Kong dollars, whose timing was however largely up to the HKMA.

It turned out the HKMA used the opportunity to carry out a sterilized intervention to ward off the speculative attack on the Hong Kong dollar in July 1998. The result was that the attack ended with less interest rate impact, to the agony of some speculators.

The problem is that sterilized foreign exchange intervention cannot last too long, unless the government is prepared to reverse the process since the mid-1970s: i.e., by converting its cumulative fiscal reserves into Hong Kong dollars again. That is not a wild card at all: a proper definition of Hong Kong's foreign exchange reserves should perhaps exclude funds of fiscal origins. The trouble is that it would mean a drastic re-classification of Hong Kong's reserves, and this is hardly the time to do so.

5. Stock Market Intervention: Prevention of a Credit Crisis

So when the speculators came again in August 1998, the Hong Kong government and the HKMA were caught in a dilemma. The "double market play" had generated an asset deflation whose speed was unprecedented in Hong Kong: 50% in ten months! Analysts often point that because of the fixed exchange rate in Hong Kong, the adjustment burden would fall largely on asset deflation. Yet, if we compare with the cases of Singapore and Taiwan, the total of their currency depreciation and asset deflation up to now is still slightly less than 50%! In other words, one cannot say that Hong Kong has refused to suffer the necessary pain.

Because of the unusual speed of asset deflation, moreover, a "credit crunch" has unfolded in Hong Kong (Tsang, 1998d). After reaching the peak of HK$1,793.4 billion in September 1997, the stock of total Hong Kong dollar loans and advances by all authorized institutions (licensed banks, restricted licensed banks, and deposit-taking companies) fell to HK$1,735.7 billion by June 1998. Within the same period, HK$ M3 declined from HK$1,728.5 billion to HK$1,696.2 billion.

As I argue in Tsang (1998d), the banking sector is under a double squeeze: a rapid fall in the value of their collateral, plus instability in the supply and the pricing of funds. Now the "double market play" of the international speculators actually aggravates both problems! In so far as share prices and property prices are highly correlated, there is a danger that the "credit crunch" may develop into a "credit crisis" if a downward spiral of asset deflation and loan contraction is formed against the backdrop of high and volatile interest rates.

This I think is the major reason behind the government's unprecedented decision to enter the stock market, although top government officials have not spelt out the argument in the way that I do here. That again is understandable: the government does not want to present the most serious side of the problem, in order not to appear alarmist.

6. Conclusion

If my interpretation of the situation is correct, the government must, along with the international speculators (who of course have no concern about Hong Kong's welfare at all), also take some blame for being unable to find a solution to strengthen the defense of the linked exchange rate system and to alleviate the interest rate impact of a speculative currency attack. That is the root of opportunities for speculators to carry out "double market play.

Now that the government has decided to use its huge reserves to counter speculation in the stock market, it should consider again establishing an effective arbitrage mechanism to defend the link that does not depend on 'discretionary intervention". In a dire time like the present, spending money in one market is obviously more economical than spending in two. With a firmer currency defense that is less susceptible to interest rate manipulation, the government may also afford an earlier retreat from the stock market. After all, it cannot stay there forever.

References

Financial Services Bureau (FSB) (1998) Report on Financial Market Review, Hong Kong Government.

Tsang Shu-ki (1998a) "Currency Board Complications: The AEL Model for Hong Kong?" article at web site: www.sktsang.com/ArchiveI/web982.html.

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

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) "Handling Credit Crunch under Hong Kong's Currency Board System," article at web site: www.sktsang.com/ArchiveI/web987.html.

Yam, Joseph (1998), "Why We Intervened", The Asian Wall Street Journal, 20 August.