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C H A P T E R 7 THE OPERATION OF THE NEW EXCHANGE RATE MECHANISM January–February 1984 By late January 1984, three months from the implementation of the new currency board in October 1983, the linked rate system for the HK$ had settled down and appeared to outsiders to be working tolerably well. The spot exchange rate was holding close to the official parity of HK$7.80, HK$ interest rates had fallen below those for US$, and renewed confidence in Hong Kong was shown by a resurgence in the demand for HK$denominated money supply. It was therefore appropriate to step back and examine more deeply how the new mechanisms were working, and to examine some possible scenarios for the longer-term adjustment of the Hong Kong economy under a currency board. Viewed from the perspective of the gold or silver standard, a currency board is a modern form of commodity standard that uses an external anchor currency instead of a commodity as its “standard”. This article uses that idea to explain how the re-introduced currency arrangements were working. Thus in the box on pp. 174–175 it adopts the terminology of “internal and external drains” from the gold standard era to discuss the kind of adjustments that the revised HK currency system might make in the wake of the currency stabilisation in 1983. In reality the free market exchange rate was being kept in line with the HK$7.80 official parity for Certificates of Indebtedness by judicious intervention from the Hong Kong authorities or by the Hongkong and Shanghai Bank as the manager of the clearing system. In retrospect the AMM article probably makes too much of the possibility for cash arbitrage (analogous with the shipment of gold between financial centres when exchange rates moved outside the so-called gold points under the gold standard), but has insights into how the wider aspects of the automatic adjustment mechanism operated. For example, the sections on interest rate determination, monetary growth and the behaviour of the economy under optimistic and pessimistic scenarios are all valid even without the core assumption that the exchange rate was being brought into line automatically. Once committed to a fixed exchange rate, it was important to understand how the Hong Kong economy would operate in the future. For example, the paragraph on the pessimistic scenario contains a plausible forecast (p. 180) of what might happen in Hong Kong after 1997. It was not until the Asian Financial Crisis of 1997–98 that the full extent of the problems of operating the new system was really exposed. 170 Hong Kong’s Link to the US Dollar A S I A N M O N E T A R Y M O N I T O R Vo l . 8 N o . 1 J a n u a r y – F e b r u a r y 1 9 8 4 When the new system for issuing Hong Kong dollar banknotes was implemented from Monday, October 17th 1983 there was a widespread lack of understanding about how the scheme would operate to stabilise the exchange rate for the Hong Kong currency, and consequently a high degree of scepticism that the new official exchange rate of HK$7.80 per US dollar could be maintained for very long. Also, because the HK$7.80 rate was considerably above the market rates of 8.30–40 that had been prevalent on Friday, October 14th, the implementation of the new scheme seemed to provide a heaven-sent opportunity to sell Hong Kong dollars and obtain US dollars while the new parity lasted. Now that the scheme has been in operation for several months and the sceptics who sold Hong Kong dollars in October have been confounded, it is appropriate to explain why the system is so resilient, and to examine the operation of the scheme with respect to (a) the behaviour of interest rates in the Hong Kong dollar money market, (b) the behaviour of the money supply since the implementation of the new scheme, and (c) the likely behaviour of the monetary and other nominal variables under alternative assumptions about the real economy. (A) THE BEHAVIOUR OF INTEREST RATES UNDER THE NEW MECHANISM The monetary arrangements set up in October 1983 established a fixed parity between the Certificates of Indebtedness issued to the note-issuing banks as cover for their banknote issue, and the US dollar. Effectively this...

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