Hong Kong's Link to the US Dollar: Origins and Evolution

CHAPTER 7 THE OPERATION OF THE NEW EXCHANGE RATE MECHANISM

59 Hong Kong’s Financial Crisis — History, Analysis, Prescription 59 3. HONG KONG’S MONETARY INSTRUMENTS AND WHY THEY DON’T WORK (A) Liquid Assets — Their Shortcomings as an Instrument of Monetary Control Liquid assets were intended as a prudential device but in Hong Kong they have come to be used as a monetary instrument. As a prudential device liquid assets are inferior to other methods of protecting depositors; as a tool for regulating monetary growth they do not work. Liquidity ratios were first introduced to the British banking scene in 1955 when the clearing banks were required to observe a 30 per cent minimum ratio of liquid assets to deposits. In 1964 the ratio was reduced to 28 per cent. From 1946 to 1971 there was also a narrower cash ratio of 8 per cent applicable to London clearing banks. In 1971 both ratios were replaced with a so-called reserve asset ratio of 12.5% of eligible liabilities, though this excluded assets which were also liabilities of the Bank of England such as vault cash. The importance of these British practices for Hong Kong was that in the period following the run on the Liu Chong Hing Bank in 1961, recommendations were made for Hong Kong by Mr. H.T. Tomkins of the Bank of England which relied heavily on British practice, and in particular on the intellectual framework adopted by the Report of the Radcliffe Committee on the Working of the (British) Monetary System (1959). These recommendations were enshrined in the Banking Ordinance of 1964 which under Section 18 imposed on Hong Kong’s licensed banks the obligation to hold certain specified liquid assets equal to at least 25% of their Hong Kong dollar deposits. The 25% ratio was divided into two categories, 15% was required to be held in certain “superliquid ” assets and the remaining 10% could be held in assets deemed to be slightly less marketable. Over the years there have been some changes in the definition of liquid assets, but they have remained unaltered in principle. As a prudential device to protect depositors the ratios were dramatically put to the test by the banking crisis of 1965, the year following their introduction. Evidently they did not stop bank runs, and their definition was therefore tightened up so as to permit only net balances with other banks in Hong Kong to qualify as a part of the extensive amendments to the Banking Ordinance in 1967. The problem with liquid asset ratios as a prudential device is that while they may ensure that at least a proportion of bank deposits is matched by readily marketable assets, they cannot protect depositors to any greater extent than the liquid assets themselves if other bank assets or bank capital are not available due to illiquidity or insolvency. In this respect they are inherently inferior to deposit insurance as a means of protecting depositors. 60 Hong Kong’s Link to the US Dollar Chart 4.3 The UK Secondary Banking Crisis and Hong Kong’s DTC Crisis: A Striking Parallel Year-to-year % change Hong Kong 1978–82 Domestic credit HK$M3 * (est.) *Linked data series Year-to-year % change M3 Domestic credit UK 1970–76 61 Hong Kong’s Financial Crisis — History, Analysis, Prescription 61 THE BRITISH SECONDARY BANKING CRISIS OF 1973–74 AND THE HONG KONG DTC CRISIS OF 1982–83: SOME STRIKING PARALLELS 1. With the accession of Edward Heath’s conservative government in June 1970 and following the publication of “Competition and Credit Control” in 1971 by the Bank of England loan ceilings on the larger banks and finance houses were scrapped, money and credit growth exploded, a variety of quasi-banks authorised under section 123 of the 1967 Companies Act flourished, and the property market took off. In Hong Kong finance companies which had grown up outside the licensed banks’ interest rate agreement started to be regulated by the Deposit-Taking Companies Ordinance of April 1976, though no effective restrictions were placed on their growth, so that by April 1981 (when registrations were suspended) there were no less than 350 registered DTCs. Meanwhile money and credit growth had soared, and the property market was booming. By the end of 1981 DTCs had captured one third of the deposit market. 2. As a part of the financial U-turn away from the “Dash for Growth” the Heath government imposed a general...