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54 Hong Kong’s Link to the US Dollar 5. The Official Case underlying the need for a 3-tier banking system is tenuous. Moreover, the official case against the kind of thorough-going reform previously set out in AMM is either unpublished or unconvincing. (See box in Chapter 2, pp. 26–28, “Central Bank or No Central Bank? A Critique of the Official Case”.) 6. The limited measures devised and implemented in 1979 and 1981 — namely the 100% liquid asset requirement placed on short term government deposits and the official scheme to borrow funds in the money market in order to affect interest rates — have been entirely unsuccessful in moderating the wide fluctuations of money and credit growth. While they may have occasionally been used to some effect in raising the interbank rate by a fraction or temporarily defending some particular exchange rate, there is no evidence to suggest they have been anything other than useless in countering the broader problem of the huge amplitude of fluctuations in money and credit growth to which the Hong Kong economy has been subjected. 7. The Business Cycle can probably never be eliminated entirely — least of all in a highly open economy such as Hong Kong — but there is much to be said in favour of moderating the fluctuations of the business cycle by instituting monetary policies which do not actually promote instability (in the way that Hong Kong’s peculiar system has done). Hong Kong would be better off with a mechanism which tended to restrain the economic upswing and moderate the downswing. In the belief that now is the time to be making plans for the longer term stability of Hong Kong’s economy, some proposals are again put forward here which would accomplish these ends. 2. BACKGROUND TO HONG KONG’S PRESENT BANKING LEGISLATION Thanks to the laudable reluctance of the Hong Kong government to intervene in the private sector, major pieces of banking legislation and other financial arrangements have usually been introduced to Hong Kong only in the aftermath of some crisis. — The 1964 Banking Ordinance was brought in as a direct response to the 1961 banking crisis. — The interest rate agreement was introduced in 1966 in the aftermath of the 1965 Banking Crisis. — The Office of Commissioner for Securities, the Securities Ordinance, and the Protection of Investors Ordinance were all introduced in 1974 in response to the stock market boom and crash of 1972–74. — The DTC Ordinances from 1976 onwards were brought in to regulate a part of the financial sector which was growing at such a pace that it posed a direct threat to the Licensed Banks and their interest rate agreement. — More recently a 3-tier banking system has been brought into being with the specific aim of protecting the Licensed Banks’ “interest rate agreement” which was rapidly 55 Hong Kong’s Financial Crisis — History, Analysis, Prescription 55 being eroded by the competitive, free market interest rates offered by the deposittaking companies (DTCs) for deposits in excess of HK$50,000 (about US$7,500). From an analytical standpoint, however, this type of “reactionary” legislation has inevitably produced a somewhat curious and makeshift banking structure. The peculiarities of the Hong Kong system have resulted in a system which, in our view, positively promotes monetary instability because the authorities are virtually powerless to affect the rate of monetary growth, while the banks are not restricted by any external constraint on the rate of credit and money creation and consequently they are free to alternate between phases of exuberant credit expansion and extreme cautiousness and timidity. This results in wide swings in money and credit growth. (The non-bank public is for the most part not responsible for these wide swings in money and credit growth, but from time to time there have been episodes involving large scale conversions of deposits into currency by the public — such as in 1965 and 1967 — precipitating a sudden monetary contraction.) In more orthodox banking systems the role of the authorities is to limit money and credit growth in the expansion phase of the business cycle by restricting the availability of bank reserves, a process which is usually reflected in rising interest rates as a symptom of tight money, while in the contraction phase the role of the authorities is to ensure that banks still have loanable funds by continuing to provide ample reserves, a process which is normally reflected in falling...

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