HONG KONG

While other Asian currencies were allowed to depreciate, to whatever degree, Hong Kong did not have that luxury, having adopted a currency board in October 1983 when the peg - for want of a better word, since it is not strictly speaking a currency “peg” - was fixed at
7.80 Hong Kong dollars to the U.S. dollar. What the Hong Kong authorities themselves call a linked exchange rate regime (i.e, a currency board) is designed to allow Hong Kong interest rates to adjust automatically to currency pressures via changes in domestic money supply, whereby the selling of Hong Kong dollars results in an equal reduction in the Hong Kong dollar money supply, thus causing interest rates to rise. Eventually, as the logic of the currency board system goes, domestic Hong Kong interest rates reach a level which attracts renewed investor interest in the Hong Kong dollar, causing purchases of that currency and subsequently an equal and opposite increase in the supply of Hong Kong dollars to the system, thus causing interest rates to fall back once more. In theory, the system is beautifully and elegantly simple. However, the practice of financial markets can be somewhat more violent. The date of October 23, 1997 was the first of several to be etched in the minds of those who watched the Hong Kong markets during the crisis. That day, the benchmark Hang Seng stock market index lost a stunning 1,211.47 points, at the time its largest one-day drop in history as speculators attacked both the currency and asset markets at the height of the first wave of the Asian crisis. As the Hong Kong dollar came under increasing attack, increasingly large amounts of Hong Kong dollars had to be withdrawn from the domestic money supply as required by the rules of the currency board. The Hong Kong Monetary Authority sat back and watched as the overnight borrowing rate skyrocketed to 3000o. The combination of soaring interest rates and heavy foreign exchange intervention caused USD-HKD to hit an intraday low of 7.4800, compared to usual trading levels at the time of around
7.7450, as the Hong Kong dollar screamed higher against the U.S. dollar in the wake of panicked speculators desperately trying to get out of their short Hong Kong dollar positions. October 23, 1997 was a day of high drama, a day when investors throughout the territory gazed up at public stock market screens in horror as the Hang Seng was smashed, a day when the speculators thought they were winning and ended up very badly burned as sky-high interest rates caused their funding costs to soar, a day the HKMA was tested and not found wanting. It was not to be the last time that the HKMA was tested however, far from it, though the bruising which the speculators took on that day caused many to take quite some time before they returned to have another go.
Basically, the options open to the Hong Kong authorities came down to two: hold the peg or let it go. The authorities chose to hold it at all costs, in the face of significant criticism from financial and economic commentators (mostly outside Hong Kong, and who were thus not exposed to the result of a de-peggingO and rightly so. As I argued at the time, a dc-pegging or an adjustment/devaluation of the Hong Kong dollar would have been catastrophic for Hong Kong. Many at the time said that Hong Kong needed to devalue in order for it to regain trade competitiveness lost to its major competitors in the wake of the ASEAN and North Asian currency devaluations during the Asian currency crisis. This logic is deeply flawed. Returning to the strict definition of the exchange rate regime in Hong Kong, the Hong Kong dollar is not pegged as several ASEAN currencies were pegged to the dollar at the time (only for those pegs to be blown apart), but is instead linked to the U.S. dollar via a currency board, whereby the HKMA, the monetary authority of Hong Kong in lieu of a standard central bank, guarantees to sell dollars at a rate of 7.80 Hong Kong dollars to the market, backing that guarantee with its own foreign exchange reserves from the Exchange Fund.
The currency board survived its test in October 1997, just as it had many before that (and subsequently), and by the end of the first quarter slightly more favourable liquidity conditions had allowed a relaxation in domestic Hong Kong interest rates, causing the spread between the 3-month HIBOR rate and the Fed funds’ target rate to finally dip back below pre-crisis levels. This was to be a temporary relief however for the Hong Kong markets and for the exchange rate system, which started to come under renewed attack in June and July of 1998. Local interest rates were forced sharply higher, while the stock market turned South, falling to a 1998 low of 6,544.79 from above 16,000 in 1997. At the time, speculators had discovered a way of “manipulating” the local markets as the HKMA would later charge, selling the Hang Seng futures, borrowing Hong Kong dollars and selling them short against the U.S. dollar, thus forcing interest rates higher. What they lost on their Hong Kong dollar borrowing, they more than made up for on their short Hang Seng futures’ and short Hong Kong dollar positions, seemingly free money. A large scale attack on the Hong Kong dollar and Hong Kong asset markets took place in early August of 1998. The Hong Kong authorities, not surprisingly took exception to this given that the economy remained mired in deep recession and higher interest rates would exacerbate that. Trading in Hang Seng stock index futures exploded in early August, with gross open interest in the front end contract rising to 92,000 contracts from 70,000 in June. Eventually, the Hong Kong authorities decided to do something about this, with the Financial Secretary and the HKMA Chief Executive Joseph Yam giving approval for the HKMA desk to intervene in the stock market with the specific aim of eliminating the speculative presence. From August 14-28, the HKMA bought cash stocks and Hang Seng futures, with a total worth of around HKD11O bin, causing the Hang Seng to rebound back above the 10,000 level. Incredibly, the HKMA had taken on the markets and won - again - but this did not come without a deluge of criticism, both from within Hong Kong this time and externally that the authorities, by intervening in the market had effectively abandoned their free- market principles.
The HKMA followed this up in September by introducing a number of measures to boost the overall market liquidity, when measured it caused the Hong Kong dollar to halve almost instantly, further burning the speculators. The package of measures contained two major provisions: a convertibility undertaking to demonstrate the authorities’ commitment to the currency board and a cushion of liquidity through a series of technical improvements to that currency board system. On the first, the HKMA provided a crystal clear undertaking to licensed banks to convert Hong Kong dollars in their clearing accounts into U.S. dollars at a fixed rate of HKD7.75 to the U.S. dollar. In addition, from April 1, 1999, that convertibility undertaking exchange rate of 7.7500 would change by 1 pip per
calendar day, taking 500 calendar days to complete the move to 7.80.
On the second provision, the HKMA made a commitment to increase
systemic liquidity reducing the ability of speculators to manipulate
the market, which was what the HKMA saw as levelling the playing
field. More specifically, the HKMA suggested 6 specific measures:
1. Removing the bid rate of the Liquidity Adjustment Facility (LAF)., thus
r keeping more interbank funds in the system.
2. Replacing the LAF with a discount window with the base rate of that
(formerly the LAF’s offer rate) to be determined occasionally by the
HKMA but in general by the market.
3. Removing the restriction on repeated borrowing of overnight Hong
Kong dollar liquidity through repo transactions using Exchange Fund
Bills and Notes.
4. New Exchange Fund paper to be issued only when there is an inflow of
funds, ensuring that all EF paper is fully backed by foreign exchange
reserves.
5. Introducing a schedule of discount rates applicable for different
percentage thresholds of holdings of Exchange Fund paper by the
licensed banks for the purpose of accessing the discount window.
6. Retaining the restriction on repeated borrowing in respect of repo
transactions involving debt securities other than Exchange Fund paper.
Joseph Yam, the HKMA Chief Executive, said: “These measures aim at strengthening Hong Kong’s currency board arrangements and achieving an even higher degree of transparency and disclosure. They will enhance the robustness of Hong Kong’s monetary arrangement, characterized by the linked exchange rate system. They should also help to reduce excessive volatility in interest rates.”4
The measures were aimed at significantly boosting systemic liquidity and at the same time increasing transparency of the currency board system, thus allowing the potential for the market itself to offset speculative interest. Despite further criticism of these measures and ongoing criticism of the stock market intervention, it is no exaggeration to say that this package of measures was brilliant. In addition to those stated aims, they eliminated much of the market concern regarding the HKMA’s previous apparent policy of stating a convertibility rate of 7.80 to the dollar while actively intervening in the foreign exchange market at 7.7500, thus allowing the potential for arbitrage and putting into question its commitment to the currency board - if the HKMA believed in the strength and efficacy of the currency board system, why did it need to intervene at all instead of letting the mechanism work.
The HKMA’s response to repeated attacks against the currency board system attracted praise from none other than the New York Fed President William McDonough for its steadfastness and resiliency in the face of the most trying of financial market conditions. Yet, while it seemed to have won a series of battles, the fundamental economic situation remained dire. After seeing its economy expand by an impressive 5.3 in 1997 - the height of the boom in local asset markets, in the run up to the Handover on July 1, 1997 - Hong Kong’s conomy contracted by 5.1 in 1998, a stunning reversal of lO.4 points. Unlike other Asian countries which saw their currency depreciate, deliberately or inadvertently as a result of the crisis, Hong Kong did not have that luxury given the currency board peg requirement. Equally, on the fiscal side, the HKSAR - Hong Kong Special Administrative Region of China - was restrained by the Basic Law from having significant fiscal deficits which would be deemed fundamentally imprudent. Hong Kong ran a budget deficit of -2.5 of the GDP in 1998 on the basis that this was an emergency situation, which is likely to have been followed by a deficit of -2.9 in 1999. Despite some degree of deficit spending and a cut in the national income tax, the main brunt of the adjustment fell on the three main pillars of the Hong Kong economy: property, financial services and tourism/retail trade. On the first issue, the government, which remains the sole owner of remaining plots of land due to the Colonial heritage of the place, ceased having new auctions to try and rebalance the supply/demand equation. The second issue, resulted in mass layoffs of bank staff as financial institutions sought to downsize to reflect greatly reduced demand for financial product, of whatever sort. On the third, tourism collapsed.
Fundamentally, this adjustment in the form of asset prices and demand was actually no bad thing, for Hong Kong by 1997 was an extremely expensive, un-competitive place, as reflected most clearly by house prices (which doubled from January-June 1997 alone). Hong Kong did not have the problems that Thailand, Indonesia and Korea had, namely of excessive short-term foreign currency debt and a shaky banking system. On the contrary, the HKMA was a very prudent and sound regulator of the banking system, ensuring the maintenance of bank capital adequacy ratios substantially in excess of the Bank of International Settlements (BIS) requirements. No, Hong Kong’s problem was one simply of loss of price competitiveness, a loss which was shown up and greatly exacerbated by the Asian currency devaluations against the Hong Kong dollar as well as the U.S. dollar in the wake of the crisis given Hong Kong’s need to maintain a fixed exchange rate commitment. The HKMA was right to maintain that commitment to the currency board system at the time, during the crisis given that the alternative would have courted a financial disaster potentially worse than Thailand given the proportion of the U.S. dollar and Hong Kong dollar assets in the system as a result of the currency board, and more specifically the fact that the domestic banking system’s capital base was in Hong Kong dollars. If the peg had been let go at any time during the crisis, the resulting devaluation of the Hong Kong dollar could not have been limited and would have caused a proportional devaluation of the banking system’s capital base. It would have caused the one thing it had not done to any degree up until that point, a loss of confidence in the domestic supervisory institutions and in the domestic banking system. There would have been mass panic, runs on banks. The banking system would have imploded, domestic interest rates would have skyrocketed rather than fallen as demand for Hong Kong dollars collapsed and the stock market and the economy would have gone into meltdown. It would have been the type and degree of financial catastrophe from which it would have taken Hong Kong decades to recover. During the crisis, there was absolutely no benefit to the HKMA in letting the peg go, and every reason to maintain it. Those who called for its abandonment were talking utter nonsense. This does not mean to say that a currency board cannot be eventually replaced by another form of exchange rate regime. It is to say that if the currency board system had been seen to be defeated, it would have caused disaster, and not just for Hong Kong. All other currency boards in the world would have been instantly targeted. Argentina has much to thank Hong Kong for, and vice versa.
Going forward, Hong Kong may decide that a policy change is necessary given more suitable conditions and fundamentals, however what it did in 199 7-98, maintaining the peg at all cost was exactly the right thing to do. Anything else would have been disgracefully irresponsible. The Hong Kong authorities also, justifiably, deserve much praise. What one can say however is that their policy response was not asymmetric. They intervened against what they saw as excessive and manipulative selling pressure against the Hong Kong dollar and its asset markets, but they were not so similarly zealous when those same asset markets were rallying excessively in 1996-97. Was this not also speculation? It is not a sufficient answer for the HKMA to say that they do not intervene in financial markets, since they plainly did do exactly that in August 1998. It would not have been beyond the remit of the monetary authority at the time to warn against the potential dangers of speculative gains, indeed it should have done so, though political factors ahead of the Handover might have made that somewhat difficult and a sensitive issue in practice.