Description
This is document describes about report on hong kong currency board
Hong Kong Currency Board
History, Functioning and Sustenance
What is a currency Board?
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.
Features of "orthodox" currency boards
The main qualities of an orthodox currency board are: ? A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins can convert them into the reserve currency (usually 110–115% of the monetary base M0). ? A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged (the anchor currency), at a fixed rate of exchange, with no restrictions on current-account or capital-account transactions. ? A currency board only earns profit from interests on foreign reserves (less the expense of note-issuing), and does not engage in forward-exchange transactions. These foreign reserves exist because: • • local notes have been issued in exchange, or Commercial banks must by reserve at the Currency Board. regulation deposit a minimum
? A currency board has no discretionary powers to effect monetary policy and does not lend to the government. Governments cannot print money, and can only tax or borrow to meet their spending commitments. ? A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements. ? A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.
Consequences of adopting a fixed exchange rate as prime target
The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit (or decided amount) of foreign currency it has in its vault (often a hard currency such as the U.S. dollar or
the euro). The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank.
A brief history of Hong Kong dollar exchange rate arrangements
Hong Kong has had a linked exchange rate regime of one kind or another for most of its history as a trading and financial centre. In 1863 the Hong Kong Government declared the silver dollar – then a kind of international currency – to be the legal tender for Hong Kong, and in 1866 began issuing a Hong Kong version of the silver dollar. The silver standard became the basis of Hong Kong’s monetary system until 1935, when, during a world silver crisis the Government announced that the Hong Kong dollar would be taken off the silver standard and linked to the pound sterling at the rate of HK$16 to the pound. Under the Currency Ordinance of 1935, banks were required to surrender to the Exchange Fund (which was invested in sterling assets) all silver bullion held by them against their banknote issues in exchange for Certificates of Indebtedness. These Certificates were the legal backing for the notes issued by the note-issuing banks under what became, in effect, a Currency Board system. The note-issuing banks were obliged to purchase the Certificates to back subsequent increases in their note issue with sterling. In June 1972, the British Government decided to float the pound sterling. The Hong Kong dollar was then linked briefly to the US dollar, first at the rate of HK$5.65 to the US dollar, and then, from February 1973, at HK$5.085. But, from June 1972, the note-issuing banks were allowed to purchase Certificates of Indebtedness with Hong Kong dollars. In November 1974, against a weakening US dollar, the Hong Kong dollar was allowed to float freely. Although the first two years went fairly well, the experience of a floating rate regime was not a comfortable one. The then prevailing monetary policy framework was too rudimentary to replace the external monetary anchor. There was no clear monetary policy objective, let alone the tools to pursue such objectives. As a result, this was a period of high volatility on almost all fronts. Real GDP growth dropped to 0.3% in 1975 and climbed to 16.2% in 1976. Inflation swung sharply from 2.7% in 1975 to 15.5% in 1980. The value of the Hong Kong dollar moved from HK$5.13 in 1981 to HK$9.60 to the US dollar in 1983. The depreciation of the Hong Kong dollar was made worse by speculative attacks and by the escalating crisis of confidence over the future of Hong Kong, which came to a head in 1983. The record low point of HK$9.60 in September 1983 was reached after a drop of 13% in just two days. Facing both a currency panic and nervousness about the soundness of a number of banks, the Government announced on 15 October 1983 a new policy to
stabilise the currency, which is now the basis of Hong Kong’s monetary system: the Link between the Hong Kong dollar and the US dollar at the fixed rate of HK$7.80 to one US dollar.
Why the Link is important to Hong Kong
The Linked Exchange Rate system suits the needs of a highly open economy such as Hong Kong’s. It is simple, consistent and well understood. It enables Hong Kong to adjust to shocks without the damage and volatility of a sudden currency collapse. The Link suits Hong Kong’s economic conditions. Hong Kong is a very externally oriented economy, with a completely open capital account and a large financial sector. The total value of the external trade in goods and services in a year is equivalent to well over three times the GDP. These factors leave HK heavily exposed to financial shocks stemming from
volatilities in external markets. The Link provides Hong Kong with a firm monetary anchor which, among other things, reduces the foreign exchange risk faced by importers, exporters and international investors. The choice of the US dollar as an anchor is logical, since it is the predominant foreign currency in which the external trade and financial transactions are denominated. The effectiveness of the Link is helped by a number of economic attributes enjoyed by Hong Kong: First, the structure of Hong Kong economy is flexible and responsive. Markets such as the labour market, property and retail markets respond quickly to changing circumstances: this flexibility facilitates adjustments in internal prices and costs, which in turn bring about adjustments to external competitiveness without the necessity of moving the exchange rate. Secondly, Hong Kong’s banking system is strong and solvent, and well able to cope with the fluctuations in interest rates which may arise under the Linked Exchange Rate system. Thirdly, the Hong Kong Government pursues a prudent fiscal policy, with large accumulated fiscal surpluses and a target of budgetary balance over the medium term. Thus there is no fear that the exchange rate system might be undermined by monetary financing of government expenditure. Fourthly, Hong Kong possesses ample foreign currency reserves for supporting the Link. These reserves, held in the Exchange Fund, amounted to US$122.8 billion at the end of September 2005. They are equivalent to over six times the currency in circulation – one of the highest levels in the world. Since the establishment of the Link in 1983, the Hong Kong dollar exchange rate has remained stable in the face of various shocks. It remained unaffected by the 1987 stock market crash, the Gulf War in 1990, the Exchange Rate Mechanism turmoil in Europe in 1992, the Mexican currency crisis of 1994/ 95, and the Asian financial crisis of 1997/98.
How the Link works
Hong Kong’s Linked Exchange Rate system is a currency board system, which requires both the stock and flow of the monetary base to be fully backed by foreign reserves. This means that any change in the monetary base is fully matched by a corresponding change in foreign reserves at a fixed exchange rate. In Hong Kong, the Monetary Base comprises: • Certificates of Indebtedness, which exactly back the banknotes issued by the note-issuing banks • Government-issued notes and coins in circulation • Aggregate Balance, which is the sum of the balances of the clearing accounts of banks kept with the HKMA • Exchange Fund Bills and Notes, which are issued by the HKMA on behalf of the Government. Most banknotes in Hong Kong are issued by three note-issuing banks. When the note-issuing banks issue banknotes, they are required by law to purchase Certificates of Indebtedness, which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund. The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are withdrawn from
circulation, Certificates of Indebtedness are redeemed and the note-issuing banks receive an equivalent amount of US dollars from the Exchange Fund. In the case of notes and coins issued by the Government through the HKMA, transactions between the HKMA and the agent bank responsible for storing and distributing the notes and coins to the public are also settled against US dollars at the rate of HK$7.80 to one US dollar. On 18 May 2005, the HKMA introduced a strong-side Convertibility Undertaking to buy US dollars from licensed banks at HK$7.75 to one US dollar, and announced the shifting of the existing weak-side Convertibility Undertaking from HK$7.80 to HK$7.85, so as to achieve symmetry around the Linked Rate of HK$7.80. Within the Convertibility Zone defined by the levels of the Convertibility Undertakings, the HKMA may choose to conduct market operations consistent with Currency Board principles with the aim of promoting the smooth functioning of the money and foreign exchange markets. The strong-side Convertibility Undertaking to buy US dollars removes the uncertainty about the extent to which the exchange rate may strengthen. This increases the sensitivity of the flow of funds into and out of the Hong Kong dollar to the interest rate differential between the Hong Kong dollar and the US dollar.
Under the Currency Board system, it is interest rates rather than the exchange rate which adjust to inflows or outflows of funds. The Monetary Base increases when the foreign currency (in Hong Kong’s case, the US dollar) to which the domestic currency is linked, is sold to the Currency Board for the domestic currency (capital inflow). It contracts when the foreign currency is bought from the Currency Board (capital outflow). The expansion or contraction in the Monetary Base causes interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital movement, while the exchange rate remains stable. This process is very much an automatic mechanism.
To reduce excessive interest rate volatility, a cushion of liquidity is provided by the Discount Window facility, through which banks can obtain overnight liquidity from the HKMA by arranging repurchase agreements using Exchange Fund paper and other eligible securities as collateral. The Base Rate of the Discount Window, which is the interest rate forming the foundation upon which the Discount Rates for repo transactions are computed, is set according to a pre-announced formula that takes into account the US Fed funds target rate and Hong Kong Interbank Offered Rates. The practice of backing Exchange Fund paper by foreign exchange reserves ensures that Hong Kong dollar liquidity created by this process is also automatically backed by foreign exchange reserves in accordance with Currency Board principles.
Limitations imposed by the Linked Exchange Rate system
The Link is the preferred option for Hong Kong, but, like any monetary policy, it has limitations as well as advantages. ? The Linked Exchange Rate system rules out the use of nominal exchange rate movements as a mechanism of adjustment. Thus, shocks to the economy triggered by external or domestic events, such as sharp depreciations of the currencies of Hong Kong’s competitors or recession in export markets, may necessitate more adjustments of the internal cost/price structure than would be needed if the exchange rate were free to adjust. While such internal adjustment is slower than rapid adjustment by the exchange rate, the process may be accompanied by more durable and necessary structural adjustments within the real economy. ? The Link ties Hong Kong to US monetary policy at times when the economic cycles of Hong Kong and the US may not necessarily be moving in tandem. A Linked Exchange Rate system leaves little scope for an autonomous interest rate policy to achieve the objectives of price stability or promotion of economic growth. If there is a misalignment between Hong Kong and US economic cycles, local interest rates, which closely track their US dollar counterparts, may not be best suited to the macroeconomic conditions of the domestic economy. For example, an increase in US interest rates to cool down an overheating economy might impede recovery from recession in Hong Kong. Nevertheless, the flexible economic structure in Hong Kong enables its economy to adapt quickly to changing circumstances. Hong Kong’s economic growth performance has been impressive under the Linked Exchange Rate system since 1983.
The South-East Asian Currency Crisis and how the peg was maintained
During the Asian financial turmoil over the 1997-1998, only the Hong Kong dollar peg escaped the wave of huge devaluations which hit Asian currencies. But speculative pressures did not spare the Hong Kong currency board. Indeed, several attacks were launched against the Hong Kong dollar and the expectations of devaluation fluctuated sharply over the period. Because Hong Kong did not suffer from bad fundamentals at least in 1997, which could have justified the attacks against its currency, one explanation to the observed speculative pressures rests on possible contagion effects stemming from the Asian crisis. To account for the propagation of shocks, three possible channels can be emphasized: a common cause stemming for example from the industrial countries and affecting the emerging economies in the same way (monsoonal or external effects), a crisis in one country entailing a modification of macroeconomic fundamentals in another (spill over effect), and the shift in market sentiment about the fundamentals of a country triggered by a crisis elsewhere, which is a pure contagion effect. This was triggered by this so-called”double play” on the following mechanism: Starting at the beginning of 1998, speculators pre-funded themselves by swapping US dollars for HK dollar in the debt market with multilateral institutions that had raised HK dollars through the issue of debt. Unlike the October 1997 speculation, the August crisis thus reflected a largely planned attack, the positions taken by speculators providing them partly against a huge increase in the domestic interest rate. The HKMA estimates that the hedge funds borrowed about HK$30 billion from January to August 1998. Then they borrowed shares at a relatively low cost and engaged in short-selling the stock index and HSI futures abruptly before shorting the Hong Kong dollar. The HK dollar sell-off waves were aimed at provoking a sharp interest rate increase, then forcing the stock exchange to plunge. The more the Hang Seng Index fell, the higher the profits of speculators due to the marking -to-market of their margin accounts on the Futures Exchange. The marking to market implies that the future contract is settled daily rather than at the end of its life, so that the gains of a seller of HSI futures are added to its margin account at the end of each day when the future prices decline. The HKMA has estimated that 80,000 HSI futures contracts were sold by hedge funds, which were conducive to a profit of HK$4 billion every thousand-point fall in the stock index. The gains have also stemmed from the continuous short sales of stocks, the speculators purchasing securities to meet their settlement obligations at a lower price they had short-sold them T+2 days before. Finally, by exercising HSI put at maturity, as the HIS had fallen relative to the strike price of the options, their holders might have benefited from further gains. Buying HSI put options could be a pure speculative position, only motivated by the expectations of a decline in the stock index or could be taken to cover a long position in the stock index (the result is a synthetic HSI call). In this context, all the bearish strategies were successful, as long as, coupled with
sales of HK dollar inducing an interest rate increase. These gains were then either converted into US dollars by foreign speculators, reinforcing the short HK dollar positions or reinvested in bearish speculative positions in the futures and options markets.
As a response to this double attack, between the 14th and 28th August 1998, the HKMA intervened via the Exchange Fund on the stock and futures markets. It acquired a portfolio of equities and HSI futures for an amount of about US$15 billion, which is 7% of the capitalisation and around 30% of the current Hang Seng Index value (IMF’s International Capital Markets Report, 1999). About 13% of its non monetary reserves, i.e. the reserves in excess that did not back the monetary base, were allocated to these interventions, inducing an important injection of liquidity into the money market. In attempting to increase the value of the HSI and HSI futures, the Monetary Authority sought to squeeze the speculators. They would have been constrained to close their short positions by purchasing stocks and futures contracts, before their expiration date at a higher price they had short sold them. But by acting so, the HKMA departed from freemarket principles, and introduced some doubt about its future willingness to obey the automatic mechanism of the currency board.
In a first stage, the HKMA considered high interest rates as a tool to defend the peg and to punish speculators. But, to work well, the automatic adjustment mechanism of the currency board should not suffer from a high risk premium, unless it becomes totally inefficient to induce new capital inflows. This premium is likely to be positive during speculative attacks, so that the normal operation of the interest rate arbitrage depends to a large extent on the confidence the markets place in the authorities’ monetary commitment. Because high interest rates were not effective and because its discretionary responses to speculative attacks appeared unsuccessful, the HKMA adopted a new strategy on 5th September 1998 to reduce interest rate volatility. A set of technical measures was announced to strengthen the currency board, grounding it on a more rulebased system. They respected the fundamental precept of the currency board and were aimed at conveying the firm determination of the HKMA to its commitment to the linked exchange rate system. First, the convertibility guarantee was extended from banknotes to include the aggregate balance. Before the reform, there was no clear convertibility undertaking to convert the aggregate balance or any definition of the domestic currency into foreign reserves at the fixed exchange rate of HK$7.8 to US$1. Second, the LAF was supplanted by a discount window, where banks can use the Exchange Fund bills as collateral to obtain overnight liquidity henceforward, without restrictions and without penalties for repeated use. The base rate, the interest rate of the discount window, is set according to a formula taking into account both an average of the Hong Kong interbank interest rates and the Fed fund rate.
These measures have basically two main implications on the operation of the Hong Kong currency board. The banks can increase liquidity in their clearing accounts by rediscounting their holdings of Exchange Fund bills at the discount window. The HK dollars so obtained have the convertibility guarantee because they are part of the aggregate balance. But, implicitly, the convertibility guarantee is indirectly extended to the outstanding of Exchange Fund papers held by banks: the part of the Exchange Fund bills held in excess with respect to those needed to manage intra-day liquidity is also covered. Consequently, the monetary base has almost been doubled. It now includes in addition to the coins in circulation, the certificates of indebtedness (CI) backing the banknotes, and the aggregate balance, the outstanding of Exchange Fund bills and Notes. Furthermore, to ensure that all new Exchange Fund papers are fully backed by foreign currency reserves, the measure stipulated that issue of new Exchange Fund papers is contingent to an inflow of US funds. In case of a currency attack, banks can thereby use their holding of Exchange Fund Bills to inject liquidity into the aggregate balance to avoid capital outflows exceeding the interbank liquidity. Because the size of the aggregate balance can potentially be increased from HK$2.5 billion to 81 when needed, this limits seriously the scope for further double play speculation, based on the high sensitivity of interest rate. Due to a greater inter-bank market depth, the interest rate movement in response of capital flows was thereby dampened. An interpretation of these Exchange Fund bills and notes is that they are equivalent to put options on the HK dollar. In fact, the first, legally binding measure guarantees that all the banks holding Exchange Funds Bills and Notes denominated in HK dollars would be covered in case of a HK dollar devaluation beyond 7.75. Furthermore, to avoid the renewal of future double game strategies, these measures were also accompanied by reforms of the operation of the securities and futures markets, aiming at increasing the cost of speculative activity and tightening the regulation.
doc_266284383.doc
This is document describes about report on hong kong currency board
Hong Kong Currency Board
History, Functioning and Sustenance
What is a currency Board?
A currency board is a monetary authority which is required to maintain a fixed exchange rate with a foreign currency. This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.
Features of "orthodox" currency boards
The main qualities of an orthodox currency board are: ? A currency board's foreign currency reserves must be sufficient to ensure that all holders of its notes and coins can convert them into the reserve currency (usually 110–115% of the monetary base M0). ? A currency board maintains absolute, unlimited convertibility between its notes and coins and the currency against which they are pegged (the anchor currency), at a fixed rate of exchange, with no restrictions on current-account or capital-account transactions. ? A currency board only earns profit from interests on foreign reserves (less the expense of note-issuing), and does not engage in forward-exchange transactions. These foreign reserves exist because: • • local notes have been issued in exchange, or Commercial banks must by reserve at the Currency Board. regulation deposit a minimum
? A currency board has no discretionary powers to effect monetary policy and does not lend to the government. Governments cannot print money, and can only tax or borrow to meet their spending commitments. ? A currency board does not act as a lender of last resort to commercial banks, and does not regulate reserve requirements. ? A currency board does not attempt to manipulate interest rates by establishing a discount rate like a central bank. The peg with the foreign currency tends to keep interest rates and inflation very closely aligned to those in the country against whose currency the peg is fixed.
Consequences of adopting a fixed exchange rate as prime target
The currency board in question will no longer issue fiat money but instead will only issue one unit of local currency for each unit (or decided amount) of foreign currency it has in its vault (often a hard currency such as the U.S. dollar or
the euro). The surplus on the balance of payments of that country is reflected by higher deposits local banks hold at the central bank as well as (initially) higher deposits of the (net) exporting firms at their local banks. The growth of the domestic money supply can now be coupled to the additional deposits of the banks at the central bank that equals additional hard foreign exchange reserves in the hands of the central bank.
A brief history of Hong Kong dollar exchange rate arrangements
Hong Kong has had a linked exchange rate regime of one kind or another for most of its history as a trading and financial centre. In 1863 the Hong Kong Government declared the silver dollar – then a kind of international currency – to be the legal tender for Hong Kong, and in 1866 began issuing a Hong Kong version of the silver dollar. The silver standard became the basis of Hong Kong’s monetary system until 1935, when, during a world silver crisis the Government announced that the Hong Kong dollar would be taken off the silver standard and linked to the pound sterling at the rate of HK$16 to the pound. Under the Currency Ordinance of 1935, banks were required to surrender to the Exchange Fund (which was invested in sterling assets) all silver bullion held by them against their banknote issues in exchange for Certificates of Indebtedness. These Certificates were the legal backing for the notes issued by the note-issuing banks under what became, in effect, a Currency Board system. The note-issuing banks were obliged to purchase the Certificates to back subsequent increases in their note issue with sterling. In June 1972, the British Government decided to float the pound sterling. The Hong Kong dollar was then linked briefly to the US dollar, first at the rate of HK$5.65 to the US dollar, and then, from February 1973, at HK$5.085. But, from June 1972, the note-issuing banks were allowed to purchase Certificates of Indebtedness with Hong Kong dollars. In November 1974, against a weakening US dollar, the Hong Kong dollar was allowed to float freely. Although the first two years went fairly well, the experience of a floating rate regime was not a comfortable one. The then prevailing monetary policy framework was too rudimentary to replace the external monetary anchor. There was no clear monetary policy objective, let alone the tools to pursue such objectives. As a result, this was a period of high volatility on almost all fronts. Real GDP growth dropped to 0.3% in 1975 and climbed to 16.2% in 1976. Inflation swung sharply from 2.7% in 1975 to 15.5% in 1980. The value of the Hong Kong dollar moved from HK$5.13 in 1981 to HK$9.60 to the US dollar in 1983. The depreciation of the Hong Kong dollar was made worse by speculative attacks and by the escalating crisis of confidence over the future of Hong Kong, which came to a head in 1983. The record low point of HK$9.60 in September 1983 was reached after a drop of 13% in just two days. Facing both a currency panic and nervousness about the soundness of a number of banks, the Government announced on 15 October 1983 a new policy to
stabilise the currency, which is now the basis of Hong Kong’s monetary system: the Link between the Hong Kong dollar and the US dollar at the fixed rate of HK$7.80 to one US dollar.
Why the Link is important to Hong Kong
The Linked Exchange Rate system suits the needs of a highly open economy such as Hong Kong’s. It is simple, consistent and well understood. It enables Hong Kong to adjust to shocks without the damage and volatility of a sudden currency collapse. The Link suits Hong Kong’s economic conditions. Hong Kong is a very externally oriented economy, with a completely open capital account and a large financial sector. The total value of the external trade in goods and services in a year is equivalent to well over three times the GDP. These factors leave HK heavily exposed to financial shocks stemming from
volatilities in external markets. The Link provides Hong Kong with a firm monetary anchor which, among other things, reduces the foreign exchange risk faced by importers, exporters and international investors. The choice of the US dollar as an anchor is logical, since it is the predominant foreign currency in which the external trade and financial transactions are denominated. The effectiveness of the Link is helped by a number of economic attributes enjoyed by Hong Kong: First, the structure of Hong Kong economy is flexible and responsive. Markets such as the labour market, property and retail markets respond quickly to changing circumstances: this flexibility facilitates adjustments in internal prices and costs, which in turn bring about adjustments to external competitiveness without the necessity of moving the exchange rate. Secondly, Hong Kong’s banking system is strong and solvent, and well able to cope with the fluctuations in interest rates which may arise under the Linked Exchange Rate system. Thirdly, the Hong Kong Government pursues a prudent fiscal policy, with large accumulated fiscal surpluses and a target of budgetary balance over the medium term. Thus there is no fear that the exchange rate system might be undermined by monetary financing of government expenditure. Fourthly, Hong Kong possesses ample foreign currency reserves for supporting the Link. These reserves, held in the Exchange Fund, amounted to US$122.8 billion at the end of September 2005. They are equivalent to over six times the currency in circulation – one of the highest levels in the world. Since the establishment of the Link in 1983, the Hong Kong dollar exchange rate has remained stable in the face of various shocks. It remained unaffected by the 1987 stock market crash, the Gulf War in 1990, the Exchange Rate Mechanism turmoil in Europe in 1992, the Mexican currency crisis of 1994/ 95, and the Asian financial crisis of 1997/98.
How the Link works
Hong Kong’s Linked Exchange Rate system is a currency board system, which requires both the stock and flow of the monetary base to be fully backed by foreign reserves. This means that any change in the monetary base is fully matched by a corresponding change in foreign reserves at a fixed exchange rate. In Hong Kong, the Monetary Base comprises: • Certificates of Indebtedness, which exactly back the banknotes issued by the note-issuing banks • Government-issued notes and coins in circulation • Aggregate Balance, which is the sum of the balances of the clearing accounts of banks kept with the HKMA • Exchange Fund Bills and Notes, which are issued by the HKMA on behalf of the Government. Most banknotes in Hong Kong are issued by three note-issuing banks. When the note-issuing banks issue banknotes, they are required by law to purchase Certificates of Indebtedness, which serve as backing for the banknotes issued, by submitting an equivalent amount of US dollars at the rate of HK$7.80 to one US dollar to the HKMA for the account of the Exchange Fund. The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. Conversely, when Hong Kong dollar banknotes are withdrawn from
circulation, Certificates of Indebtedness are redeemed and the note-issuing banks receive an equivalent amount of US dollars from the Exchange Fund. In the case of notes and coins issued by the Government through the HKMA, transactions between the HKMA and the agent bank responsible for storing and distributing the notes and coins to the public are also settled against US dollars at the rate of HK$7.80 to one US dollar. On 18 May 2005, the HKMA introduced a strong-side Convertibility Undertaking to buy US dollars from licensed banks at HK$7.75 to one US dollar, and announced the shifting of the existing weak-side Convertibility Undertaking from HK$7.80 to HK$7.85, so as to achieve symmetry around the Linked Rate of HK$7.80. Within the Convertibility Zone defined by the levels of the Convertibility Undertakings, the HKMA may choose to conduct market operations consistent with Currency Board principles with the aim of promoting the smooth functioning of the money and foreign exchange markets. The strong-side Convertibility Undertaking to buy US dollars removes the uncertainty about the extent to which the exchange rate may strengthen. This increases the sensitivity of the flow of funds into and out of the Hong Kong dollar to the interest rate differential between the Hong Kong dollar and the US dollar.
Under the Currency Board system, it is interest rates rather than the exchange rate which adjust to inflows or outflows of funds. The Monetary Base increases when the foreign currency (in Hong Kong’s case, the US dollar) to which the domestic currency is linked, is sold to the Currency Board for the domestic currency (capital inflow). It contracts when the foreign currency is bought from the Currency Board (capital outflow). The expansion or contraction in the Monetary Base causes interest rates for the domestic currency to fall or rise respectively, creating the monetary conditions that automatically counteract the original capital movement, while the exchange rate remains stable. This process is very much an automatic mechanism.
To reduce excessive interest rate volatility, a cushion of liquidity is provided by the Discount Window facility, through which banks can obtain overnight liquidity from the HKMA by arranging repurchase agreements using Exchange Fund paper and other eligible securities as collateral. The Base Rate of the Discount Window, which is the interest rate forming the foundation upon which the Discount Rates for repo transactions are computed, is set according to a pre-announced formula that takes into account the US Fed funds target rate and Hong Kong Interbank Offered Rates. The practice of backing Exchange Fund paper by foreign exchange reserves ensures that Hong Kong dollar liquidity created by this process is also automatically backed by foreign exchange reserves in accordance with Currency Board principles.
Limitations imposed by the Linked Exchange Rate system
The Link is the preferred option for Hong Kong, but, like any monetary policy, it has limitations as well as advantages. ? The Linked Exchange Rate system rules out the use of nominal exchange rate movements as a mechanism of adjustment. Thus, shocks to the economy triggered by external or domestic events, such as sharp depreciations of the currencies of Hong Kong’s competitors or recession in export markets, may necessitate more adjustments of the internal cost/price structure than would be needed if the exchange rate were free to adjust. While such internal adjustment is slower than rapid adjustment by the exchange rate, the process may be accompanied by more durable and necessary structural adjustments within the real economy. ? The Link ties Hong Kong to US monetary policy at times when the economic cycles of Hong Kong and the US may not necessarily be moving in tandem. A Linked Exchange Rate system leaves little scope for an autonomous interest rate policy to achieve the objectives of price stability or promotion of economic growth. If there is a misalignment between Hong Kong and US economic cycles, local interest rates, which closely track their US dollar counterparts, may not be best suited to the macroeconomic conditions of the domestic economy. For example, an increase in US interest rates to cool down an overheating economy might impede recovery from recession in Hong Kong. Nevertheless, the flexible economic structure in Hong Kong enables its economy to adapt quickly to changing circumstances. Hong Kong’s economic growth performance has been impressive under the Linked Exchange Rate system since 1983.
The South-East Asian Currency Crisis and how the peg was maintained
During the Asian financial turmoil over the 1997-1998, only the Hong Kong dollar peg escaped the wave of huge devaluations which hit Asian currencies. But speculative pressures did not spare the Hong Kong currency board. Indeed, several attacks were launched against the Hong Kong dollar and the expectations of devaluation fluctuated sharply over the period. Because Hong Kong did not suffer from bad fundamentals at least in 1997, which could have justified the attacks against its currency, one explanation to the observed speculative pressures rests on possible contagion effects stemming from the Asian crisis. To account for the propagation of shocks, three possible channels can be emphasized: a common cause stemming for example from the industrial countries and affecting the emerging economies in the same way (monsoonal or external effects), a crisis in one country entailing a modification of macroeconomic fundamentals in another (spill over effect), and the shift in market sentiment about the fundamentals of a country triggered by a crisis elsewhere, which is a pure contagion effect. This was triggered by this so-called”double play” on the following mechanism: Starting at the beginning of 1998, speculators pre-funded themselves by swapping US dollars for HK dollar in the debt market with multilateral institutions that had raised HK dollars through the issue of debt. Unlike the October 1997 speculation, the August crisis thus reflected a largely planned attack, the positions taken by speculators providing them partly against a huge increase in the domestic interest rate. The HKMA estimates that the hedge funds borrowed about HK$30 billion from January to August 1998. Then they borrowed shares at a relatively low cost and engaged in short-selling the stock index and HSI futures abruptly before shorting the Hong Kong dollar. The HK dollar sell-off waves were aimed at provoking a sharp interest rate increase, then forcing the stock exchange to plunge. The more the Hang Seng Index fell, the higher the profits of speculators due to the marking -to-market of their margin accounts on the Futures Exchange. The marking to market implies that the future contract is settled daily rather than at the end of its life, so that the gains of a seller of HSI futures are added to its margin account at the end of each day when the future prices decline. The HKMA has estimated that 80,000 HSI futures contracts were sold by hedge funds, which were conducive to a profit of HK$4 billion every thousand-point fall in the stock index. The gains have also stemmed from the continuous short sales of stocks, the speculators purchasing securities to meet their settlement obligations at a lower price they had short-sold them T+2 days before. Finally, by exercising HSI put at maturity, as the HIS had fallen relative to the strike price of the options, their holders might have benefited from further gains. Buying HSI put options could be a pure speculative position, only motivated by the expectations of a decline in the stock index or could be taken to cover a long position in the stock index (the result is a synthetic HSI call). In this context, all the bearish strategies were successful, as long as, coupled with
sales of HK dollar inducing an interest rate increase. These gains were then either converted into US dollars by foreign speculators, reinforcing the short HK dollar positions or reinvested in bearish speculative positions in the futures and options markets.
As a response to this double attack, between the 14th and 28th August 1998, the HKMA intervened via the Exchange Fund on the stock and futures markets. It acquired a portfolio of equities and HSI futures for an amount of about US$15 billion, which is 7% of the capitalisation and around 30% of the current Hang Seng Index value (IMF’s International Capital Markets Report, 1999). About 13% of its non monetary reserves, i.e. the reserves in excess that did not back the monetary base, were allocated to these interventions, inducing an important injection of liquidity into the money market. In attempting to increase the value of the HSI and HSI futures, the Monetary Authority sought to squeeze the speculators. They would have been constrained to close their short positions by purchasing stocks and futures contracts, before their expiration date at a higher price they had short sold them. But by acting so, the HKMA departed from freemarket principles, and introduced some doubt about its future willingness to obey the automatic mechanism of the currency board.
In a first stage, the HKMA considered high interest rates as a tool to defend the peg and to punish speculators. But, to work well, the automatic adjustment mechanism of the currency board should not suffer from a high risk premium, unless it becomes totally inefficient to induce new capital inflows. This premium is likely to be positive during speculative attacks, so that the normal operation of the interest rate arbitrage depends to a large extent on the confidence the markets place in the authorities’ monetary commitment. Because high interest rates were not effective and because its discretionary responses to speculative attacks appeared unsuccessful, the HKMA adopted a new strategy on 5th September 1998 to reduce interest rate volatility. A set of technical measures was announced to strengthen the currency board, grounding it on a more rulebased system. They respected the fundamental precept of the currency board and were aimed at conveying the firm determination of the HKMA to its commitment to the linked exchange rate system. First, the convertibility guarantee was extended from banknotes to include the aggregate balance. Before the reform, there was no clear convertibility undertaking to convert the aggregate balance or any definition of the domestic currency into foreign reserves at the fixed exchange rate of HK$7.8 to US$1. Second, the LAF was supplanted by a discount window, where banks can use the Exchange Fund bills as collateral to obtain overnight liquidity henceforward, without restrictions and without penalties for repeated use. The base rate, the interest rate of the discount window, is set according to a formula taking into account both an average of the Hong Kong interbank interest rates and the Fed fund rate.
These measures have basically two main implications on the operation of the Hong Kong currency board. The banks can increase liquidity in their clearing accounts by rediscounting their holdings of Exchange Fund bills at the discount window. The HK dollars so obtained have the convertibility guarantee because they are part of the aggregate balance. But, implicitly, the convertibility guarantee is indirectly extended to the outstanding of Exchange Fund papers held by banks: the part of the Exchange Fund bills held in excess with respect to those needed to manage intra-day liquidity is also covered. Consequently, the monetary base has almost been doubled. It now includes in addition to the coins in circulation, the certificates of indebtedness (CI) backing the banknotes, and the aggregate balance, the outstanding of Exchange Fund bills and Notes. Furthermore, to ensure that all new Exchange Fund papers are fully backed by foreign currency reserves, the measure stipulated that issue of new Exchange Fund papers is contingent to an inflow of US funds. In case of a currency attack, banks can thereby use their holding of Exchange Fund Bills to inject liquidity into the aggregate balance to avoid capital outflows exceeding the interbank liquidity. Because the size of the aggregate balance can potentially be increased from HK$2.5 billion to 81 when needed, this limits seriously the scope for further double play speculation, based on the high sensitivity of interest rate. Due to a greater inter-bank market depth, the interest rate movement in response of capital flows was thereby dampened. An interpretation of these Exchange Fund bills and notes is that they are equivalent to put options on the HK dollar. In fact, the first, legally binding measure guarantees that all the banks holding Exchange Funds Bills and Notes denominated in HK dollars would be covered in case of a HK dollar devaluation beyond 7.75. Furthermore, to avoid the renewal of future double game strategies, these measures were also accompanied by reforms of the operation of the securities and futures markets, aiming at increasing the cost of speculative activity and tightening the regulation.
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