Hands On or Hands Off?: The Nature and Process of Economic Policy in Hong Kong

5. Monetary Policy

5 Monetary Policy Introduction In the realm of monetary policy, Hong Kong's currency board is perhaps just about as 'hands-off an arrangement as an economy could possibly have. Nevertheless, there have been occasions when the system has been characterised by its critics as suppressing market-determined adjustment, or when accusations of disproportionate intervention in markets have been levelled at the authorities. This chapter first reviews Hong Kong's monetary system and then briefly discusses the circumstances which have given rise to some criticism. Hong Kong is different Hong Kong differs from most developed economies in that, in common with just a few other small jurisdictions (for example, Bosnia-Herzegovena, Bulgaria, Estonia and Lithuania), it operates a currency board. The Hong Kong Monetary Authority, which occupies the position of central bank, effectively abjures any influence over the money supply or interest rates, but instead aims single-mindedly to maintain a fixed exchange rate, and an important distinction between currency boards and other regimes where the authorities may be conmlitted to a fixed rate - accepts the consequences which that brings for interest rates, money supply, and hence for inflation and other aspects ofthe economy which may be considered to be influenced by monetary conditions. In other regimes which focus on a fixed rate, but without the discipline 74 Economic Policies and Their Application of a currency board, the central bank (or monetary authority) has some latitude to influence domestic monetary conditions over and above any impact from official operations in the foreign exchange market to sustain the exchange rate. In the case of Hong Kong, and other strict currency boards, the monetary authority is forbidden to seek to modifY the domestic monetary impact of foreign exchange transactions executed for the account of the currency board. History Why does Hong Kong choose to differ from the mainstream of modern economies in this way? Much ofthe answer is rooted in Hong Kong's history as a trading post for China and a British colony. Hong Kong's present-day economy has its origins in the colonisation of Hong Kong by Great Britain in the mid-nineteenth century, as a key trading link to China. Before the colony's administrators had had much time to think about monetary matters, the traders found it convenient, not unnaturally, to base their business on the monetary system which operated in China. That was the silver standard. When Hong Kong introduced its own currency, it was therefore based on silver - silver coinage, and banknotes which were exchangeable for silver. Broadly speaking, this was the system which prevailed through to 1935. At that point China abandoned the silver standard. Hong Kong followed suit, and shifted to what was described at the time as a managed currency. This emerged, in practice, as a currency board based on sterling.34 The currency board was already established as the norm for British colonies. It had been conceived as an administratively simple and financially efficient mechanism for ensuring an adequate supply oflocal currency notes and coins in a colony, solidly backed against sterling at a fixed rate. In that era, most banking transactions would anyway have been conducted in sterling, so there was seldom any very compelling need to develop financial markets in the local currency. If an increasing amount of local business and banking came to be denominated in the local currency, as it certainly did in Hong Kong over the years, there was a natural tendency for the exchange rate between the local currency and the anchor currency to hold close to the fixed rate which had been set for notes and coin. In other words, the whole economy was seen to function on that fixed rate. Monetary Policy 75 Indeed, in those times there was never the slightest doubt about the colony's currency remaining at its fixed rate to sterling. Having already established its separate currency denomination, albeit with a fixed rate, the colony would be enjoying the profit from currency issuance.35 There was no compelling need to move any further towards monetary independence. After an interruption associated with the Japanese occupation of Hong Kong during the Second W orld War, the sterling-based currency board continued. The success of a currency board arrangement, and its acceptability to local people and businesses, depend to a considerable extent on the anchor currency being reasonably stable. In this context Hong Kong was tied to the fortunes ofsterling...