Discount window an alternative to panic

The best example of what the Hong Kong Monetary Authority (HKMA) is trying to achieve with its package of reform measures is the change to a discount window from the previous liquidity adjustment facility (LAF).

The LAF, which was introduced in 1992, was always criticised in some circles because, by classic currency-board rules, it appeared like tinkering with the system where tinkering is not allowed.

The classic rules say that a currency board issues HK dollars when it receives US dollars in exchange for them at HK$7.80 to US$1. When people want US dollars back, the board takes their HK dollars at that same exchange rate, then puts them out of circulation. This is all that a classic currency board is supposed to do.

It works because if no one wants HK dollars and they are exchanged in large quantities for US dollars, then soon there will be a shortage of HK dollars in the system as they are taken out of circulation.

Those people who then still need HK dollars will be forced to bid up interest rates to get them. Sooner or later the interest rates will go so high that the rewards of holding HK dollars will appear attractive again and the money will flow back.

In this scheme, the LAF superficially looked like a dodge to evade that temporary pain of high interest rates on which the system depends. It allowed banks to borrow money from the HKMA rather than bidding up interest rates in the market.

But the LAF was set up because there are simply times when banks run a little short of ready short-term funds for reasons that have nothing to do with whether people generally want HK dollars or not. Why cause interest rates to go up as if in a panic when there is no panic? Here is the crux of the matter, however. The HKMA was never required to make the LAF available to every bank that wanted to use it, and, back in October last year, it came to the view that some bankers were using the LAF to speculate against the currency.

Its solution was to close the LAF, and the immediate result was a panic rush to the market for HK dollars.

This temporarily sent interest rates sky high, as the chart below shows, and, ever since that time, bankers have been reluctant to rely on the facility.

The closure proved counter-productive. It induced speculative panic rather than quelling it.

The change to a discount window is essentially a firm statement from the HKMA that this will not happen again. Rather than tightening short-term availability of HK dollars in times of crisis, it has come to the conclusion that the best course is to make them readily available.

The rules still say that commercial banks must maintain clearing-account balances with the HKMA at a defined level. But they are no longer bad boys if they convert them to US dollars.

Where in the past they ran the risk of having to go scrambling to the market for HK dollars if they ran short as a result of selling them in binges of speculation, they now have the assurance that they can go to the discount window to raise the money and on a net basis bring everything back into balance again quickly.

It means that manipulators will find it much more difficult to create temporary shortages of HK dollars, and it will reduce manipulative pressure on interest rates.

But, of course, it also means that the normal currency-board pull and push won't come into effect as quickly as it did in the past.

We've taken one step further away from the old system.