Hong Kong's Currency Board System - an analysis

II

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  IV

  References  IX

1

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-

¹ cp.Hanke 2002, p. 87.

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

2

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 currencycalled 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-

³ asthe 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.

3 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

Coming back to the Currency Board, we will take a closer look on how a Currency Board functions. The constitution of the interest rate is an interesting topic as the

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. 811.

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.

4

possibilities for monetary operations are limited under a CBA. That leads to the question on what is influencing the development of the interest rate in CBAs. Generally, it can be said that the interest rate is set in close relation to the monetary condition in the reserve country and determined by local market adjustments to those conditions prevailing in the reserve country. Additionally, there is a risk premium build into the domestic interest rate to back potential negative developments within the CBA. According to Balino and Enoch (1997, p. 4) the reasons for this risk premium can be seen in the possibility that a) the CBA can be changed, b) the convertibility of deposits cannot be assured, and c) the fact that Currency Boards tend to get under speculative attack on a non-regular basis which generally leads to a sharp rise in interest rates. 10

Another key issue is the function as a lender of last resort (LOLR). The LOLR is “an institution, normally a central bank that stands ready to accommodate demands for funds in times of crisis or liquidity shortage” ¹¹ . In theory, this function is not been given in CBAs. ¹² Even though the absence of the LOLR function should result in a sounder banking system on the one hand, it is also leading to serious concerns on the other as the Currency Board has no option to help domestic banks in case they need money supply due to external shocks or other critical situations. Balino and Enoch therefore suggest that proper prudential regulations and supervisory arrangements can reduce the need for LOLR support by “strong bank supervision, proper accounting standards, loan valuation rules, stringent disclosure requirements, and risk management arrangements in the payment systems”. 13

In practice, the LOLR problem is not as strong as in the theoretical view. As previously explained, most Currency Boards exceed the required minimum coverage of the domestic currency by reserve currency. ¹⁴ The deviation between minimum requirement and actual stock of reserve currency represents the scope a Currency Board has to react on monetary requests. Therefore, a Currency Board holding ex-

¹⁰ ashappened in the case of Argentina in 1995; cp. Balino and Enoch 1997, p. 4.

¹¹ HKMA 2000a, p. 36.

¹² cp. Ho 2002, p. 15.

¹³ cp. Balino and Enoch 1997, p. 21.

¹⁴ For example, Estonia had an actual coverage in 1997 of 118 percent of M0 even though only 100 percent is required. Hence, there was 18% “space” to potentially use it for LOLR matters.

5

ceeded foreign reserves is able to act as LOLR without breaching the stock back rule. 15

2.2 Adopting a Currency Board Arrangement – Pros and Cons

Choosing a Currency Board as ERR can be a useful decision in certain situations. There are pros and cons offering chances and risks, which have to be balanced. Especially in difficult situations ¹⁶ , the implementation of a CBA can help to get out of critical circumstances. In most recent cases in which a CBA was introduced, the main reason for the establishment was the goal of “maintaining the long-term stability of the currency” ¹⁷ . The question if adopting a CBA is helpful for a specific country or not is based on intensively analyzing the country’s actual situation. It highly depends on how a country is able to utilize advantages of CBA and control the unavoidable disadvantages. Only if the CBA is performing well in the long-run, it can create credibility – which is the most critical factor for trust into the system and therefore for its entire success. ¹⁸ In this part the main advantages and disadvantages coming along with a CBA will be presented. 19

2.2.1 Positive Aspects of Currency Board Arrangements

CBAs are operating with an extreme simplicity and transparency. Balino and Enoch (1997, p. 6) suggest that this fact leads to a broad contribution to enhance credibility and to a simplification in central bank functions. Clear operating rules, a pegged exchange rate, and the reduction of tasks (like central banks under a flexible ERR have) lowers the requirements for administrative efforts. Therefore, staff, financial expenses, and bookkeeping can be kept on a reduced level. The simplicity also allows

¹⁵ cp. Ho 2002, p. 16.

¹⁶ One example is high inflation (cp. 2.3.1) ¹⁷ cp. Balino and Enoch 1997, p. 7.

¹⁸ For example, Gerlach (2005, p. 13f.) shows that credibility is one main reason for smooth development of a Currency Board. In his researches on the exchange rate development after 1998 he suggested that the decline of the very high exchange rate of the Hong Kong Dollar (HKD) compared to US-Dollar (USD) derived from an increased credibility of the Currency Board after 1998. Further-more, a higher credibility of the Currency Board reduced the need to purchase reserve currency; in 2.3.1 it is statistically shown that the better inflation performance of Currency Boards compared to other ERRs derives mainly from a so-called confidence effect which indicates the credibility brought to an ERR; also cp. 2.2.1 and Chan 1999, p. 18 et seq.

¹⁹ At this point it would also be interesting to investigate deeper under which circumstances the adoption of a CBA could be helpful for a country. Anyway, to not exceed the contents of this term paper, this discussion will be left out. In some explanations in this term paper there will be examples why and when Currency Boards established CBAs. This allows getting a clue under which circumstances countries see CBAs as helpful.

6 for a country to profit from seigniorage ²⁰ benefits immediately after the adoption of a CBA.

Operating with sound monetary and fiscal policies is a main attribution to Currency Boards as they eliminate or strictly limit the operational possibilities of the monetary authorities. ²¹ This is strengthening the CBA credibility which is supported by clear policy intentions of the authorities and ensured monetary independence from the government. Furthermore, the circumstances lower the basis for inflation biases what for CBAs represent a very attractive ERR for countries following exchange ratebased disinflation policies. 22

As another advantage, Balino and Enoch mention that Currency Board-running countries could experience an important contribution to stabilization programs as a CBA is securing monetary discipline. In many cases the interest costs declined and resulting from that, large capital inflows were attracted. Regarding the development of the inflation rate, Balino and Enoch could not see constant improvements in all of the major CBAs. The development of the inflation rate in CBAs has been investigated by Ghosh, Gulde, and Wolf (1998) and will be discussed later. 23

All mentioned advantages together help to enhance the total credibility of a CBA in the public and on financial markets. Williamson (1995, p.13; 18 et seq.) assumes that a high credibility promotes trade, investment, and growth. Furthermore, the lower risk of devaluation at highly credible arrangements leads to a relatively immunity to speculative attacks. 24

2.2.2 Negative Aspects of Currency Board Arrangements

Like every existing system, also a CBA does not only bring positive aspects along. Taking a look at the nominal exchange rate rigidity, there might be negative impacts on the arrangement. Exchange rate misalignment can increase the fear of devaluation or even the entire abandonment of the arrangement. This leads to serious concerns about the credibility. Attempts to correct those misalignments can lead to tight li-

²⁰ “Seigniorageis the profits accruing to the monetary authorities from its right to issue legal tender currency.” (Salvatore, Dean, and Willett 2003, p. 84).

²¹ cp. Balino and Enoch 1997, p. 6.

²² as for example, in the cases of Argentina, Estonia, and Lithuania; cp. Balino and Enoch 1997, p. 6. ²³ cp. 2.3.1.

²⁴ Speculative Attacks are not rare in CBAs as can be seen in the case of Hong Kong later in chapter 3.