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

C H A P T E R 13 EPILOGUE INTRODUCTION The selected AMM articles in chapters 1–7 showed how the fundamental flaws in Hong Kong’s monetary system in the 1970s and 1980s were identified, brought to the notice of academics, bankers, investors and the Hong Kong authorities, and eventually addressed after the dangerous run on the currency in September 1983. Chapters 8–12 traced some of the subsequent debate about why the automatic adjustment mechanism did not appear to be acting as efficiently as had been intended in keeping the free market rate for the HK$ at or close to the official parity of HK$7.80 per US$, and the initial steps the authorities took to correct these problems. In this final chapter, section 1 presents a summary and assessment of the initial reforms covered by AMM during the years 1983–89; section 2 reviews the period 1990–1998 including developments after coverage by AMM ceased publication; and section 3 covers the period 1998–2005 when the mechanism of the currency board was substantially amended following the Asian financial crisis, and subsequently fine-tuned. Each section is divided into two halves covering (a) the changes that were relevant to the monetary regime, and (b) an assessment of how the economy behaved under the currency board system in each phase. Section 4 attempts an overall assessment and a discussion of the appropriate monetary system for Hong Kong in the future. 1. SUMMARY OF MONETARY REFORMS, 1983–89 (A) Monetary Changes, 1983–89 (i) Problems with Convergence In the years from the re-adoption of the currency board system in October 1983 until 1989, my approach at AMM had been to focus on the deficiencies of the cash arbitrage 260 Hong Kong’s Link to the US Dollar process. It was preferable, in my judgment, that the system should operate automatically than that the authorities should be continuously intervening in the local money markets or in the foreign exchange market. The authorities, however, were in a better position to observe the limited extent of any such cash arbitrage, and had progressively moved to a position where, through interest rate management, they took responsibility for ensuring adequate albeit limited convergence between the official rate for banknotes and the open market exchange rate. In view of the shortcomings of cash arbitrage, and to maintain exchange rate stability, the authorities felt obliged “to influence interbank liquidity and thus short-term interbank interest rates, and [to engage in] direct intervention in the foreign exchange markets” (John Nugee, “A Brief History of the Exchange Fund”, HKMA Quarterly Bulletin, May 1995). According to this account, HSBC also collaborated with the authorities to carry the burden of any intervention costs. Since these ad hoc interventions were inherently unsatisfactory in bringing about full exchange rate convergence (see Chart 13.1), the authorities had to accept second best solutions. To ensure a more consistent and successful outcome for their intervention operations, they relied on three main instruments. First there was the money market borrowing scheme intended to tighten monetary conditions (see Ch 4, “The Exchange Fund’s Borrowing Scheme: A Twist on Operation Twist”, pp. 70–72). Second, to guard against exceptionally large and prolonged inflows the authorities had developed the negative interest rate scheme in December 1987. (Although this scheme was approved by an ordinance passed by the Legislative Council, it was never actually implemented). Third, a more decisive break with past practice was accomplished with the “Accounting Arrangements” in July 1988, which made the two previous schemes largely redundant. Chart 13.1 HK$/US$ Spot Rate, 1984–2006 (Source: Datastream, as of 20/3/2007) —— HK$/US$ Spot Rate 261 Epilogue 261 (ii) Abandonment of the Simple, Standard Model and the July 1988 Measures The new Account of HSBC at the Exchange Fund (EF) amounted to a reserve account for the system as a whole, and brought short-term money market interest rates (directly) and the free market exchange rate (indirectly) within the control of the authorities. In calm periods the system could be adequately maintained without assistance from the authorities, but in more disturbed times the system was dependent upon intermittent intervention operations by the authorities. However, as we shall see, these new arrangements only addressed one part of Hong Kong’s underlying monetary problems — achieving a modicum of convergence. At the same time they obscured...