The Linked Exchange Rate System – 30 Years On
Hong Kong experienced a turbulent, if not nerve-wrecking summer in 1983. After several rounds of Sino-British negotiations, investors had become increasingly anxious about Hong Kong’s future in 1997. The Hang Seng Index fell sharply from 1,102 in July by over 30% to 758 at the end of September. Public confidence in the Hong Kong dollar diminished, and there was severe selling pressure on the local currency. Under a floating exchange rate regime at that time, which had been in place for nine years, the Hong Kong dollar depreciated sharply from HK$6.5 to US$1 at the beginning of 1983 to nearly HK$10:US$1. Hong Kong was facing a currency and financial crisis. I can still remember vividly a sweltering summer’s evening 30 years ago. On my way home from work I saw a long queue of people outside a large supermarket, waiting to snatch whatever goods they could for fear of further devaluation of the Hong Kong dollar. Public confidence in the Hong Kong dollar was collapsing. The empty shelves in the supermarket, once filled with groceries, staple food and toilet papers, further amplified people’s anxiety. The crowd refused to leave until they saw trucks of supplies arriving at mid-night to meet their demand. The chaos continued until the introduction of the Linked Exchange Rate System (LERS) on 17 October 1983 to link the Hong Kong dollar to the US dollar at a fixed rate of HK$7.80:US$1, after which the confidence crisis gradually subsided. I guess many young people in Hong Kong may not have much of an impression of what happened in the summer of 1983.
2. Some people have argued that the LERS, as a contingent measure put in place when Hong Kong was facing a serious crisis three decades ago, has accomplished its goal and possibly outlived its usefulness. They suggest that it is now time for us to consider a new exchange rate regime for Hong Kong. There are also views that the LERS is intrinsically flawed and strips Hong Kong of its ability to set its own interest rates to tackle inflation as compared with economies that adopt a floating exchange rate regime. With a weakening US dollar in recent years, some consider the LERS the main culprit for Hong Kong’s overheating property market. They argue that the government should consider switching to some other exchange rate system, such as a peg to the renminbi or even a floating exchange rate regime.
3. First of all, I must point out that there is no perfect monetary and exchange rate system in the world. The LERS has its advantages as well as shortcomings. However, when we look at the pros and cons of the LERS, we should note that it is not just a mechanism to ensure exchange rate stability. Our monetary system is a Currency Board system which is also described as a monetary system backed by an “anchor” currency. During the 30 years after World War II, major currencies in the world maintained a fixed exchange rate against the US dollar while the US government guaranteed that every US$35 could exchange for 1 ounce of gold. This is a “quasi” gold standard (also known as a gold exchange standard), or a monetary system with an “anchor”. Yet, the US experienced great difficulties in the late 1960s with fiscal deficits and a rapidly deteriorating current account balance which eventually turned into a deficit. Some of its trade partners exchanged the US dollars they received for gold at the fixed rate. As the US government was unable to keep on supplying gold at the official rate, it abolished the quasi gold standard and the world entered an era of fiat money in 1971. The US, as well as other major developed economies, are able to adopt fiat money and a floating exchange rate regime of fiat money because of their economic might and their dominance of the global trade, financial system and reserve currencies. However, it is a very different story for small emerging market economies. In particular, as an international commercial, trade and financial centre in the region, Hong Kong has to handle large-scale inflows and outflows of funds on a daily basis. A monetary system with an “anchor”, which means that our currency is backed by a major international currency, will enhance confidence in the Hong Kong dollar and minimise the risk of a recurrence of the 1983 crisis. Such a system is also important for supporting the development of Hong Kong as an international financial centre.
4. As regards the most appropriate "anchor" for the Currency Board system, the US dollar was our only option in 1983. As of now, the US dollar continues to be the most commonly used international currency in international trade and cross-border financial transactions. Financial markets in the US and other financial markets with US dollar-denominated transactions rank first in terms of depth, breadth and liquidity. In addition, the US Federal Reserve has a good track record of keeping inflation low in the US for more than 30 years, thereby achieving a high credibility in maintaining price stability. As an international commercial, trade and financial centre, Hong Kong’s economic cycles and financial conditions are, to a large extent, influenced by US and global economic/financial environment. The Fed’s recent indication of possible tapering of the asset-purchase programme has sent shockwaves throughout the global financial markets. Bond yields surged globally and currencies of emerging economies depreciated sharply alongside massive capital outflows. All these have demonstrated the dominance of the US monetary system and the considerable impact it has on the global economy and financial markets.
5. Now that Hong Kong has returned to China, and with Mainland becoming the second largest economy in the world and the renminbi embarking on internationalisation, should we peg Hong Kong dollar to the renminbi instead of the US dollar? As I have explained previously on many occasions, the pre-conditions for a peg to the renminbi still do not exist. One important pre-condition is that the "anchor" currency must be totally and freely convertible so that we could hold the "anchor" currency assets as backing for the Hong Kong dollar. This is crucial in upholding confidence in the Hong Kong dollar and maintaining exchange rate stability. Our foreign currency reserves, which are mainly held in US dollar assets, currently stand at over US$300 billion. If the anchor currency were changed to the renminbi, the Exchange Fund would have to hold nearly RMB2 trillion worth of assets, which far exceeds the amount of renminbi assets in the offshore renminbi market presently in existence. Therefore, it is too early to consider the use of the renminbi as our anchor currency while it is not yet freely convertible and the capital account of the Mainland is still not fully liberalised.
6. Some consider that a fixed exchange rate regime is flawed because we are unable to control our interest rate and thus deprived of an instrument for managing inflation and bubbling assets prices. Some think that Hong Kong should therefore switch to a floating exchange rate regime. I should point out that a floating exchange rate regime may appear to be an acceptable choice when the markets are peaceful and calm. However, in times of market stress or turbulences, it is highly likely for small and open economies and international financial centres such as Hong Kong to be hit by the erosion of confidence and massive capital outflows, leading to a vicious circle of sharp currency depreciation, confidence crisis, stresses in the financial institution and eventually a financial crisis.
7. Looking back, Hong Kong has weathered through a succession of shocks and crises in the past three decades, including notably the Asian financial crisis in 1997, the Global Financial Crisis in 2008/09 and the recent European Sovereign Debt Crisis. Whenever Hong Kong experienced turmoil, the LERS demonstrated its resilience and served as the cornerstone for Hong Kong’s monetary and financial stability.
8. Some people also argue that the continued depreciation of the US dollar in recent years due to quantitative easing in the US has adversely affected the Hong Kong dollar, resulting in high inflation and overheating in the property market. This view seems to suggest that with a floating exchange rate regime, all these problems can be resolved. I beg to disagree. We must recognise what works in theory does not necessarily work in practice or cannot be proven by empirical evidence. During the past few years, following quantitative easing in many advanced economies, there were large capital inflows into the emerging markets. If Hong Kong had a floating exchange rate regime, we may have to raise interest rates to counter inflation and asset bubble, and we could end up attracting even more capital inflows, including some “predatory” hot money speculating on the Hong Kong dollar, aiming to profit from the appreciation of the Hong Kong dollar and the high interest rates. However, as and when the US eventually embarks on the inevitable exit of the highly accommodative monetary policy, massive outflows from Hong Kong would occur. The Hong Kong dollar would then devalue sharply and asset prices would plunge. The market dynamics could become very complicated if not violent. In fact, this is the kind of challenges that some of the larger emerging economies with a flexible exchange rate are now facing.
9. Next I want to talk about the relationship between Hong Kong dollar exchange rate and the competitiveness of Hong Kong. We all know a stronger Hong Kong dollar means greater purchasing power of Hong Kong people for foreign goods and services. So it should be good news for our imports of consumer goods and outbound tourism. But a strong Hong Kong dollar would be quite a negative factor for our exporters because their goods and services would become very expensive to foreign buyers. Theoretically, changes in exchange rates are affected by differences in the productivity growth of the relevant economies in the long run. For example, as Japan’s economy soared and experienced much faster productivity growth than its trading partners in the post-war years, the Japanese yen was on an appreciation trend from the 1970s. However after the burst of the “super bubble” in Japan, its economic growth stagnated and the yen took on a wobbling trend. Meanwhile, as Mainland China’s productivity growth continued to outperform that of the US and other major economies, the renminbi rose by around 30% against its main trading partners (and 35% against the US dollar) since the introduction of foreign exchange reform in July 2005. As an emerging market economy, Mainland China’s productivity would be able to maintain relatively fast growth for a prolonged period of time. If the Hong Kong dollar were pegged to the renminbi, Hong Kong’s exports and the overall competitiveness of the economy would substantially weaken. As Hong Kong’s labour productivity growth is much slower than that of the Mainland (our estimates suggest an average annual rate of about 3-4 % over the past ten years for Hong Kong versus almost 10% for the Mainland), we would have to go through the pain of pay cuts and deflation before our competitiveness could be restored. Indeed, many countries have been much worried by the continued or excessive appreciation of their currencies. Switzerland was one of them when it experienced continuous capital inflows since the Global Financial Crisis. In September 2011, the Swiss central bank took an unprecedented step by launching an exchange rate ceiling, capping the Swiss franc at 1.2 CHF to 1 EUR.
10. It is not easy to explain monetary economics or monetary systems in simple and plain language. To help the public develop a better understanding of the LERS, I attach to this article a set of Frequently Asked Questions with Answers. We should bear in mind that the currency regime is the basic building block of all our economic and financial activities. The monetary regime must be handled with utmost care and caution in order to preserve continuity and credibility. Shifting from one regime to another carries enormous risks and may lead to disastrous outcomes. Over the past three decades, Hong Kong’s LERS has worked well and proved to be effective. The LERS has served as the cornerstone for Hong Kong's monetary and financial stability. We acknowledge that it is not a perfect regime. We have studied and evaluated many different alternatives, and have reached the conclusion that the LERS is still the most appropriate regime for Hong Kong. This is the same conclusion shared by the International Monetary Fund. Lastly, let me reaffirm that for the reasons set out above, there is neither the need nor the intention to change the LERS.
Norman T.L. Chan
Hong Kong Monetary Authority
14 October 2013