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C H A P T E R 4 HONG KONG’S FINANCIAL CRISIS History, Analysis, Prescription (November–December 1982) In September 1982 Margaret Thatcher made her infamous visit to Beijing to discuss with Deng Xiao-ping and other Chinese leaders the future of Hong Kong after June 30th 1997, when the British government’s lease over Hong Kong’s New Territories was due to expire. From the viewpoint of the people of Hong Kong the visit went badly. Not only had Margaret Thatcher tripped and fallen on the steps of the Great Hall of the People in Tiananmen Square — an ill omen in Chinese eyes — but following these discussions Sir Geoffrey Howe, the British Foreign Secretary, had confirmed in Hong Kong that it would not be possible for Britain to maintain sovereignty in Hong Kong beyond June 1997. At this stage there was no official indication of the terms on which Hong Kong might be handed back, and therefore Hong Kong people were left to fear the worst — that there might be a complete transfer to communist rule. In this atmosphere a capital flight from Hong Kong started, causing the currency to tumble again. Between June and November 1982 it fell from an average of HK$5.86 per US$ to HK$6.67, a depreciation of 13.8%. Having made it clear by means of the T-form balance sheets (in Chapter 2) why the Hong Kong authorities could not stop the currency slide through intervention in the foreign exchange markets, and having been brushed aside by government officials in August 1981, the only course of action that seemed open to me was to offer a comprehensive restatement of the entire range of monetary problems facing Hong Kong. This was the role of this extended article (69 pages in the original AMM) in December 1982. The broad-brush argument — set out in sections 1 and 2 — was that the Hong Kong authorities had been treating the symptoms of the territory’s monetary and financial problems instead of dealing with the underlying causes. For example, the authorities treated bank and DTC insolvencies only by introducing increased regulation and supervision. Similarly, they dealt with stock market booms and slumps by tightening securities regulation, whereas in AMM’s view it was monetary instability that was causing both banking and DTC problems, as well as stock market and property market booms and busts. Furthermore the wide cyclical fluctuations in the economy, and a growing problem of inflation since 1974 were also evidence of underlying monetary problems. Because the Hong Kong government and banking circles at the time focused almost exclusively on 52 Hong Kong’s Link to the US Dollar “prudential” solutions to Hong Kong’s problems, the text necessarily spends much time critiquing these approaches, attempting to offer corrective analysis of the true nature of the problems facing Hong Kong. Indeed the original section 3, which has been edited down here to eliminate repetition, exhaustively presented the four major instruments of monetary policy (liquid assets, interest rates, a government borrowing scheme, and intervention in the foreign exchange market), and why each of them did not work. In this chapter only the first three are reproduced in full; the fourth is summarized. Section 4 (pp. 73–92) deals with the widespread misunderstanding in Hong Kong at the time of how the business cycle worked. One particular feature of business cycle analysis as presented in the government’s budgetary statements of this period was the complete separation of developments in the real economy from monetary developments. Whereas monetary economists view fluctuations in financial markets and in economic activity and inflation as part and parcel of the transmission process of monetary policy, Hong Kong government officials had developed a view of the business cycle that entirely omitted money and its impact on the economy. Some of the analysis may seem redundant today (e.g. the integration of the monetary and real sectors with inflation), but some of it remains very relevant (e.g. how a small open economy with a fixed exchange rate or with a currency board arrangement adjusts to external changes, and how its business cycle relates to the global or external business cycle). Sub-sections F and H (p. 83 and p. 86), dealing with Japan between 1949 and 1971, when Japan’s real GDP averaged 9.4% p.a. and the yen-dollar rate was pegged at 360 yen per US$, are especially relevant...

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