Hong Kong′s Currency Board System

by: Goeksen Iyikoey

Table of Contents

1 INTRODUCTION  1

2 CURRENCY BOARDS 2

2.1 Definition of a Currency Board and other Arrangements  2
2.2 Adopting a Currency Board Arrangement – Pros and Cons 5

2.2.1 Positive Aspects of Currency Board Arrangements 5
2.2.2 Negative Aspects of Currency Board Arrangements  6

2.3 Macroeconomics Effects in Currency Board Arrangements  8

2.3.1 Inflation Effects 8
2.3.2 Growth Effects  9
2.3.3 Unemployment 10

3 THE HONG KONG CURRENCY BOARD (HKCB)  11

3.1 Today’s Currency Board Regime in Hong Kong  11
3.2 Difficulties in HKCB Operations 13
3.3 The Predictability of US-Dollar Purchases 15
3.4 Analyzing the Performance of the HKCB  18

4 CONCLUSIONS  19

Appendices

References

1 Introduction

Currency Boards have attracted widespread attention recently. While it was a popular system in pre-world war (II) times, it was largely replaced by central banks after the war. In the 1980s and especially in the 1990s it resurged again.¹ Many countries around the world decided to operate under a CBA again or to re-adopt this system. Even in Europe some economies such as Bulgaria and the new European Union member states Lithuania and Estonia decided for this system which is still running today.

The Currency Board Arrangement (CBA) is an extension of the fixed Exchange Rate Regimes (ERR) in which the domestic currency is pegged to a foreign currency. That makes it a very simple system which can be implemented very quickly and keeping the required efforts on a low level. Restrictive possibilities for monetary and fiscal interventions allows for the Currency Board system to be easily managed also in the long-run. Especially countries with small economies which have little global influence tend to adopt a CBA.²

One issue which is vitally discussed in theoretical and practical researches is the operations of the Hong Kong Currency Board (HKCB). This case is interesting regarding the fact that Hong Kong was already operating under a CBA earlier in its history and decided to re-introduce it again. Hence, Hong Kong has been subject to several speculative attacks and crises in the past. Therefore, the Currency Board in Hong Kong offers several possibilities to analyze the performance of Currency Boards in practice and to learn lessons for future adoptions or other actual CBAs. This paper focuses on two main points. First, it will take a look at the constitution of CBAs in general. It will be explained what a Currency Board is and how it is operating. Several advantages and disadvantages coming along with the adoption of a CBA will be discussed as well as the macroeconomic impact under a CBA. Second, the case of Hong Kong in specific will be investigated. We will take a look at how the HKCB is operating and what its main functions are. Hence, an overview of historical events will be given and the way how Hong Kong coped with difficulties in operat- ing the Currency Board will be discussed. One issue which will be focused on is the behavior of the monetary authorities in terms of foreign currency purchases to cover its domestic money. Before summarizing the outcomes of the paper in the conclusion, we will also shortly analyze how well the HKCB has performed.

2 Currency Boards

2.1 Definition of a Currency Board and other Arrangements

Before explaining the details of a CBA it is useful to bring up a short, general definition of what it is. As Balino and Enoch (1997, p. 1) give a good definition a CBA in its simplest form can be described as “a monetary regime based on an explicit legislative commitment to exchange domestic currency for a foreign currency at a fixed exchange rate, combined with restriction on the issuing authority – the currency board – to ensure fulfillment of its legal obligation.” That means the money issued by a Currency Board is pegged to a foreign currency - called reserve currency - at a fixed exchange rate. It represents the strongest form of an exchange rate peg.³ The Currency Board is committed to supply and redeem its domestic money for the reserve currency at any time on the basis of the fixed exchanged rate. The task of exchanging domestic currency for reserve currency and vice versa is the only responsibility of a Currency Board in the classical view.⁴ To maintain this function at any time, it is required to have the issued domestic currency fully covered by the reserve currency which implies that the coverage has to be at least 100%. Even though most Currency Boards are required to possess 100% of the reserve currency, there are exceptions where a higher or lower coverage is deter- mined by law.⁵ The actual coverage usually exceeds the required minimum coverage to back a potential decrease in the reserve currency’s value.⁶

To classify a CBA it is helpful to explain the differences to other exchange rate arrangements. ⁷ A less strong form of exchange rate peg is the fixed ERR. Even though Currency Boards and fixed ERRs share many attributes, the later one has more freedom in executing monetary policy. While the exchange rate in Currency Board Regimes is set by law, a fixed ERR has the possibility to change the target for its constant exchange rate over time. Furthermore, there is no necessity of fully backing the reserve currency by at least 100%. Also the central bank plays a more important role. Although it cannot set own targets for domestic interest rates, it still can undertake limited open market operations and lend money to banks.

Contrary to the above mentioned regimes, the floating ERR is not pegged to any reserve currency. The central bank does not have to defend the value of its currency and consequently has no commitment to possess sufficient foreign exchange reserves for this purpose. The value of the currency is determined by demand. A floating ERR offers the highest independence and freedom among all ERRs.⁸ The difference between the terms Currency Board and dollarization should also be clarified. In a Currency Board, the money authorities establish an own currency by issuing money (banknotes and coins) to distribute it inside the country, and back the issued domestic money with a reserve currency. A dollarization means that the domestic currency is substituted by a foreign currency. In this case, the foreign currency is the official legal tender in the local economy and therefore no own domestic money is being issued.⁹

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1 cp. Hanke 2002, p. 87.

2 cp. Lui, Cheng, and Kwan 2000, p. 1.

3 as the IMF (2000, p. 8) describes it.

4 cp. Ho 2002, p. 10; in the course of this term paper it will be shown that in practical application of a Currency Board System, the tasks exceed this classical view, which reduces the responsibility to only the function of exchanging money.

5 cp. Kopcke 1999, p. 24; for example, the Eastern Caribbean Central Bank committed itself to just cover 60% of the base money whereas the Currency Board in Hong Kong has to be in possession of at least 105% of the reserve currency (cp. Ghosh, Gulde, and Wolf 1998, p. 9). One reason for a higher required coverage could be the higher confidence investors will have in the system what is essential for a Currency Board’s success. This issue will be discussed in the course of this paper.

6 What also offers the possibility to function as lender of last resort (LOLR) what will be explained later on.

7 Exchange rate regimes are explained in Kopcke 1999, p. 32-36 and Desquilbet/Nenovsky 2003, p. 8- 11.

8 Equivalent to floating ERR, in literature the term flexible ERR exists.

9 A detailed definition of dollarization can be found in HKMA 2000a, p. 20.