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SCMP Reporter

THE linked-rate system for the Hong Kong dollar is often hailed as a convenient ''political'' solution to the currency crisis of 1983, when the currency plummeted from HK$6.50 to almost $10 to the US dollar.

   But in reality, it was a highly technical response to a critical flaw in Hong Kong's prevailing monetary arrangements - the authorities' inability to control either the supply or the price of money (expressed in terms of the exchange rate).

   That the ''peg'' has worked and has since become an integral part of the rubric of ''stability and prosperity'' is comforting and important to the people of Hong Kong.

   But if alternatives are put forward, they must be considered on their technical merits first and their political consequences second.

    The monetary menu facing Hong Kong is the same now as in 1983.

   There are three broad options: a central bank to control the money supply; a central bank to manage the exchange rate; or the present linked-rate system or some variant of it.

   Each has advantages and disadvantages. It is not a choice between black and white.

  If a central bank was introduced to control the money supply, the single advantage would be that consumer price index (CPI) inflation could be reduced by about five per cent a year if Hong Kong dollar M3 money supply were cut from about 16 per cent a year (its average over the past three years) to, say, 11 per cent.

   However, there would be at least five disadvantages. First, it is not easy to prove that 11 per cent Hong Kong dollar M3 growth is appropriate for Hong Kong, nor would it be easy to hit that target: a huge part of demand is determined from outside, so money growth is affected by changing foreign demand.

    The corollary and second problem is that the exchange rate must be free to fluctuate and absorb the impact of changes in external demand - allowing the currency to appreciate when foreign demand is strong, and depreciate when it is weak.

   But anyone who remembers the terrifying consequences of having a free-floating rate at a time of political crisis will not willingly risk a repetition of 1983.

    Third, introducing a central bank would require extensive institutional changes, mainly involving a transfer of the clearing house to the central bank so that all banks could maintain an account there, and a complete revision of the note-issuing mechanism.

   Fourth, having a central bank is risky because it gives the authorities the power to print money.

  Finally, and perhaps most important, having a central bank essentially means shifting from a monetary rule (HK$7.80 equals US$1) to a discretionary system run by officials, who would be subject to political pressure.

   Recent experience in China of political pressures taking precedence over the economically desirable policy has not been encouraging.

  The second option is having a central bank to manage the exchange rate, which is the policy pursued by most of the Asian dragon economies.

   The main advantage would be that, like Singapore, Hong Kong could manage its exchange rate upwards by about five per cent a year to offset a large part of its CPI inflation. This would distribute the gains in living standards from the territory's overall increase in productivity more fairly, but it would not reduce the cost pressures that are causing structural changes in the economy.

   From a US dollar standpoint, 15 per cent inflation plus 35 per cent appreciation of the Singapore dollar over the past five years are identical to the five per cent inflation plus zero currency appreciation that Hong Kong has experienced over the same period.

   But this option suffers from some of the drawbacks of the first.

  Also a way must be found of managing the exchange rate. Most Asian economies that have managed the exchange rate upwards against the US currency have exchange controls, but these would violate the Basic Law - and would represent bad economics.

  Another possibility is to combine the two and options, but this would only give more discretionary powers to the administrators of the system with no compensating advantages.

  The third option - the linked rate system, or more properly, the currency board system - also has advantages and disadvantages.

    Pluses are that the system is rule-based, and largely non-discretionary; the authorities cannot print money; and for exporters, importers and tourists the exchange rate against the US dollar (the currency of Hong Kong's second-largest trading partner, the one to which the yuan is pegged, and the dominant one by volume in the foreign exchange markets) is conveniently stable.

   Moreover, the system has succeeded in stabilising Hong Kong's monetary growth compared with before 1983.

    Minuses are that CPI inflation, or non-traded goods-and-service price inflation, considerably exceeds that in the US. This will continue as long as Hong Kong's productivity growth in traded goods (which derives from upgrading low value-added jobs in manufacturing into areas of comparative advantage such as high value-added services) exceeds that in the US.

 However, as structural changes in the economy are completed and productivity growth slows, CPI inflation will converge towards the US inflation rate.

    Finally, banks' charges for deposits of more than $20,000 in Hong Kong dollar banknotes when the free market rate is at a premium to the parity anger large retail customers and create losses for those banks that regularly redeem a lot of notes, since they are obliged to sell Hong Kong dollar notes at 7.8 to the US dollar and buy back Hong Kong dollar funds at a higher price in the forex market.

  Modifications to the linked rate system are possible. But changing the 7.8 rate once would destroy confidence in what has been until now a permanently fixed parity. Resetting the rate at, say, 7.4, would trigger expectations of another upward revaluation, so the deviation between the free-market rate and the parity would grow.

   In short, changing the rate would undermine the mechanism.

    Linking the Hong Kong dollar to a basket of currencies, as some suggest, may look attractive but has four major problems.

   First, it means a continuously changing parity, so speculation about future changes would again lead to wider fluctuations of the free market rate around the parity.

   Second, as long as China has an unconvertible currency it is impractical for the yuan to be in that basket, despite China being by far the territory's largest trading partner.

   Third, the composition of the basket would be subject to the same bureaucratic or political discretion as the choice of money growth or the choice of exchange rate under a central bank.

   Fourth, my studies have shown that a basket peg would not have significantly cut CPI inflation in recent years.

     Hong Kong's dollar peg is basically a modern version of the old gold or silver standard, using the US dollar instead of a precious metal.

     As Sir William Purves said recently: ''Nothing is set in cement for ever.''    But under the true gold and silver standards of the 18th and 19th centuries, parities remained unchanged for many decades.

    I believe Hong Kong would be best served by keeping the 7.8 parity unchanged for at least another decade, and preferably for many more.



Pros and cons of the currency peg