30 years on, Hong Kong's dollar peg is still a star performer
John Tsang says given the important role that the linked exchange rate system has played - and continues to play - in Hong Kong's rise to international economic and financial prominence, there is no reason to change it. John Greenwood agrees, noting the lack of an alternative: a flexible rate system won't protect the economy from volatility, while the renminbi is far from ready as an international currency
Today marks the 30th anniversary of the linked exchange rate system. For 30 years, it been the cornerstone of Hong Kong's monetary and financial stability. The system has been tested through different economic cycles and financial crises, and has continued to work well for us. Today, it is an integral part of our daily life.
After all these years, some of us may have only vague memories of the anxiety in the community when the Hong Kong dollar depreciated sharply prior to the adoption of the linked exchange rate system. Let me take this opportunity to restate the system's benefits and its importance to Hong Kong.
In 1983, Hong Kong had a floating exchange rate system. The Sino-British negotiations on the future of Hong Kong were going on and there was a rapid deterioration in market confidence in the local economy. This sentiment led to a sharp depreciation of the Hong Kong dollar.
Worried Hong Kong people scrambled for groceries and food staples. Even toilet paper became a target of panic buying. I was then the assistant district officer in Sha Tin, having just joined the civil service. This experience left a deep impression.
It was against this background that the linked exchange rate system was introduced. The community calmed down after it was put in place and the Hong Kong dollar was effectively stabilised. This clearly showed how a stable exchange rate is closely related to our community's daily life.
The system has successfully maintained exchange rate stability and provided a stable monetary and financial environment that is crucial to our trade-dependent economy. Our import and export trade transactions are mostly denominated in US dollars. With the peg, it is much easier for businesses to estimate costs and determine pricing, since they need not worry about potential losses due to exchange rate fluctuations. They can also save costs for hedging against exchange rate volatility.
The stable exchange rate provided a favourable environment for Hong Kong to develop into an international trading hub. Our external trade increased from 190 per cent of gross domestic product in 1983 to the current 450 per cent and the number of employees in this sector has reached 30 per cent of the working population.
A stable exchange rate also provided a platform for our development as a financial centre. The US dollar is commonly used as an international currency and most international investors hold US dollars. Because of the stable exchange rate, most investors trading in Hong Kong equities need not hedge their currency exposure. In the past 30 years, the total assets of our banking sector and our stock market capitalisation have grown by 13 times and 152 times respectively, bringing growth to many service sectors.
The stable monetary environment has been crucial to supporting economic growth. Hong Kong's GDP has increased by nearly 10 times during this period.
With the upgrading of our credit rating to AAA in 2010, Hong Kong became one of the 14 economies in the world to have achieved that grade.
The linked exchange rate is a simple, clear, highly transparent and rule-based system. It is readily understood by the market and the public. Under it, Hong Kong has weathered a succession of crises and challenges. These include the 1987 stock market crisis, the 1990 Gulf war, the European Exchange Rate Mechanism crisis in 1992, the Asian financial crisis in 1997-98, the bursting of the dotcom bubble in 2000, the 2003 outbreak of the severe acute respiratory syndrome epidemic, the global financial crisis sparked in 2007-08, and the recent sovereign debt problems in Europe. The stability of the Hong Kong dollar during these times has firmly established the system's credibility.
No exchange rate regime is perfect. Some people think the linked exchange rate system is the main culprit in Hong Kong's recent asset price inflation brought about by US quantitative easing. It is important to note that jurisdictions with a flexible exchange rate are also not immune to such spillover effects. Hong Kong is no exception. But the linked exchange rate system has actually helped minimise the shocks.
After the start of US subprime mortgage crisis, emerging market economies generally faced fund outflow pressure. But Hong Kong has seen many investors parking their funds here, which contributed to the strengthening of the Hong Kong dollar in late 2008 to 2009.
Quantitative easing in the US and the Federal Reserve's recent remarks about its exit have caused big fluctuations in regional currencies. Some economies had no choice but to impose capital controls to defend against the volatile fund flows. The Hong Kong dollar, by contrast, has been stable, reflecting confidence in the linked exchange rate. The recent fall in foreign exchange turnover involving the Hong Kong dollar is also a sign of the low level of speculative activities.
Hong Kong is one of the few economies that has adopted a fixed exchange rate. It is also one of a few to have maintained exchange rate stability effectively over a long period. The success of the linked exchange rate system hinges on a number of important prerequisites.
First, we have a flexible economic structure in which internal prices, costs and wages can adjust to external changes, ensuring Hong Kong's competitiveness. Second, our banking system is robust, well capitalised and highly liquid, such that it can readily withstand external shocks. Third, under the government's prudent fiscal policies, the linked exchange rate is not affected by government debt or fiscal deficits. Fourth, our foreign reserves provide a strong backing for the linked exchange rate and financial stability.
Hong Kong still faces many external challenges. In particular, the exit from quantitative easing in major countries may result in volatile fund flows. We are upholding the linked exchange rate system not because we just want to maintain the status quo. More importantly, we are doing so because we strongly believe it is still the most appropriate monetary system for Hong Kong in light of the challenges ahead.
The government sees no need, and has no intention, to change it.
John Tsang Chun-wah is Hong Kong's financial secretary
The pegging of the Hong Kong dollar in October 1983 was a landmark event during the difficult Sino-British negotiations over the future of Hong Kong after 1997. The preceding collapse of the dollar from 5.50 to 8.60 per US dollar had resulted from waves of capital flight. Inflation rose above 15 per cent. Hong Kong people were acutely anxious and, in the febrile atmosphere, the mainland press was inclined to portray the currency weakness as a deliberate conspiracy by the British side.
However, what was not widely recognised at the time was that, at a deeper level, the underlying cause of the currency crisis was Hong Kong's unsatisfactory monetary framework, lacking either an internal or external anchor.
After the floating of the Hong Kong dollar in 1974, the Hong Kong authorities had no means of managing the internal quantity of money or inflation in Hong Kong because there was no central bank. Consequently, both the quantity and price of the Hong Kong dollar varied widely, bringing high inflation and wide swings in the exchange rate. The "linked" exchange rate system was designed to address these problems.
In broad terms, the system achieved its objectives by providing an external anchor. By December 1984, inflation had fallen below 5 per cent and interest rates converged with US rates. Even though at times inflation deviated from the US rate, the currency remained fairly stable around 7.80 per US dollar.
However, every monetary system has costs and benefits.
On the benefits side, the virtue of the 1983 currency peg was that it was simple, compatible with existing institutional arrangements (such as private bank note issues) and rule-based. It seldom required discretionary intervention by the monetary authorities. Moreover, a fixed exchange rate was ideally suited to a small, open economy with very large trade and capital flows.
But maintaining a successful peg required Hong Kong to fulfil a broader series of economic conditions.
For example, a fixed external exchange rate implies that domestic prices, wages and the economic structure must remain flexible. It also requires a free flow of goods, services and capital across international borders, strong financial supervision, fiscal prudence and care to ensure that households, businesses and banks do not become overleveraged. By and large, Hong Kong satisfied these conditions and therefore the linked exchange rate system has worked well. When external shocks have occurred, Hong Kong has adjusted rapidly. Undoubtedly, Hong Kong's peg to the US dollar has helped it to become the premier international capital market in Asia.
On the cost side, critics assert that loss of monetary independence has damaged economic performance. After the Asian crisis of 1997-98, for example, Hong Kong suffered several years of high unemployment and deflation. Conversely, US interest rates - which are transmitted to Hong Kong by the peg - are currently too low for its vibrant economy and this is threatening an asset bubble and inflation.
But the key question is: how much better would Hong Kong's economy perform under an alternative system?
Comparing the experience of other small, open economies in Asia such as Singapore or Taiwan, which allow their currencies to fluctuate against the US dollar, we find that those economies have not escaped the impact of global business cycle fluctuations.
For example, Singapore's gross domestic product has been much more volatile than Hong Kong's in recent years and its inflation higher than Hong Kong's. And in Taiwan, where the currency has appreciated 11 per cent against the US dollar since 2009, property prices have risen nearly as much in the past five years as in Hong Kong. Simply switching to a managed or floating exchange rate will not solve the asset price problem and could erode Hong Kong's role as an international financial centre.
Finally, what is the future for the Hong Kong dollar? Could it be pegged to another currency, or to a basket of currencies?
First, the US dollar is still the pre-eminent currency for denominating trade and capital transactions throughout Asia and is not likely to lose this position for many years. Also, current interest rates of the euro, British pound or Japanese yen are as low as US rates. It would therefore be of little benefit to peg to any of these or to a basket such as the special drawing rights (which is comprised of these three, plus the US dollar).
Second, the problem with the renminbi is that it is not convertible - that is, capital movements are restricted. Even though the renminbi circulates in a limited way in Hong Kong (accounting for 10.4 per cent of deposits in August), it is likely to be many years before China adopts full convertibility.
Third, the Basic Law specifies that the Hong Kong dollar will be the currency of Hong Kong until 2047.
Nevertheless, there is no doubt that China's economy will continue to grow rapidly over the next several decades and China will become a greater force in the global economy. Will it then make sense for Hong Kong to shift its US dollar peg to a renminbi peg?
In my view, the minimum conditions for the Hong Kong dollar to switch would include: full and irreversible convertibility of the renminbi on both current and capital account; the renminbi must achieve international reserve currency status, allowing foreign governments, banks, companies and individuals to freely buy, hold and sell renminbi deposits, securities and other property in China; and financial markets in China must develop to a point where interest rates become the primary tool of monetary policy. Only on this basis will Hong Kong's interest-rate-based financial markets integrate well with mainland markets.
Finally, Hong Kong would need to be confident that China will be the major driver of Hong Kong's business cycle. Currently, China's export-dependent economy is driven as much by the US as by domestic factors.
Only if these conditions are met will it make sense for Hong Kong even to contemplate drastic changes to a currency system that has served the territory well for 30 years.
John Greenwood is chief economist of Invesco and was the architect of Hong Kong's currency peg in 1983