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Monetary Relationship between Mainland China and Hong Kong after 1997

by Joseph Yam, Chief Executive, Hong Kong Monetary Authority

(Speech to The British Chamber of Commerce)

September 1996


I am honoured to have been invited to address the British Chamber of Commerce. I am particularly glad to note from a recent survey conducted by the Chamber that your members expressed strong confidence in the future of Hong Kong with 98% of respondents stating that their companies would be operating in Hong Kong in the year 2000. Specifically on the currency front, 91% of respondents expressed satisfaction over the Hong Kong dollar's link to the US dollar and 72% expected that the link will stay unchanged by the year 2000. Thank you, although you could have said that it will stay unchanged well beyond the year 2000.

Confidence and Apprehension

By contrast, about six weeks ago an article appeared in a London newspaper with big headlines saying: "Currency speculators aim to force an end to pegging arrangement with US dollar: Soros challenges Chinese over Hong Kong dollar." Very sensational stuff indeed. But Soros related sources quickly denied this. Confidence in our stable currency was unaffected. The exchange rate hardly moved.

I bring this to your attention not that I am worried by the possibility of speculative attacks on our currency. We do have a very robust defensive mechanism for dealing with such attacks. How we dealt with the ripple effect of the Mexican crisis early last year was a good example. For as long as those holding Hong Kong dollar assets remain confident in the currency, there is very little that speculators without Hong Kong dollar assets can do in the market to destabilize our currency and make a profit. They have to borrow in order to cover their short Hong Kong dollar positions, and as the lender of last resort for Hong Kong dollars, the Hong Kong Monetary Authority (HKMA) will not lend cheaply, directly or indirectly, to speculators. I expect financial institutions serving as lenders of first resort to borrowers will also not fund speculators cheaply and expose themselves to the risks of a funding squeeze.

But I was struck by the many factual errors in that article, and the commentary built upon those errors, which is misleading and may be damaging to confidence. For example, it referred to our record US$60 billion of foreign currency reserves at the end of June this year - seventh highest in the world in absolute terms and second highest in per capita terms - as "just $60 billion ...., its lowest level this decade." It also described a 65-point fall in the Hang Seng Index on one day - an index which stood at around 11,000, as arising from "panic selling of blue-chip stocks". It then said that "the index ..... remains extremely volatile", which it has not, "as fears grow in the colony that years of stability may soon come to an explosive end." Sheer ignorance or conspiratorial fabrication? I have no idea. I have seldom read anything that is so irresponsible. But then everybody is entitled to his own views.

The transfer of sovereignty is a big change; and change always involves risks, although there would be opportunities as well. Clearly some apprehension about Hong Kong's future still remains and questions continue to be asked. Stories continue to be written. Where these touch upon the monetary and banking fields, it falls upon myself and other public officers concerned to respond to them objectively and provide a counter balance, although regrettably we will never get the same headline coverage. Meanwhile, thankfully, money continue to be invested in Hong Kong. The strength of our markets and the stability of our currency speak for themselves.

Monetary Relationship between Mainland China and Hong Kong

Today I would like to describe to you how I think the concept of "one country, two systems" will be manifested in monetary arrangements affecting Hong Kong after 1997. The Joint Declaration and the Basic Law have laid down a clear and helpful legal framework for these arrangements. But within that framework, I personally think there is a need further to clarify the relationship between the two systems and to lay down certain principles for dealing with matters arising from that relationship. I take this view because of the many questions that have been asked on the subject, for example, whether one monetary system has precedence over the other, or whether, as the central bank of China, the People's Bank of China (PBOC) will take over the role of the HKMA after 1997, or whether the HKMA will need to report to the PBOC, or whether eventually Shanghai is to replace Hong Kong as the international financial centre in China, or whether Chinese state-owned financial institutions are subject to the regulation of Hong Kong authorities, etc., etc. Not all of these questions have a readily available answer in the Basic Law. I am therefore in favour of elaboration.

I must emphasize, however, that I am not in a position to elaborate on these subjects with singular authority. We are talking about a relationship between two monetary systems. As Chief Executive of the HKMA I only have some authority over one of the systems. We need therefore to work out details with those who are responsible for the other one. This has indeed been an important pre-occupation of the HKMA for some time now, and I am glad to say that clear and helpful principles governing the monetary relationship between Mainland China and Hong Kong are now emerging. These principles are entirely consistent with the Joint Declaration and the Basic Law. You may have already noticed references to these in statements from authoritative Chinese sources, in particular the PBOC recently. But let me share with you my thoughts on a few of these, focusing in turn on the relationship between the two currencies, the two monetary systems, the two monetary authorities and the two financial centres.

Two Currencies

"One country, two systems", in respect of currency matters, will, as you know, be manifested in the co-existence of two currencies in China after 1997. The relationship between the two currencies has now been defined as "two currencies circulating respectively as the legal tender in two different social and economic systems. The issue and management of the two currencies are the responsibilities of the two monetary authorities respectively in accordance with their own arrangements. The Hong Kong dollar will be regarded as foreign currency in the mainland and the RMB will be regarded as foreign currency in Hong Kong."

Whilst there is no doubt about what is intended, there have nevertheless been questions asked as to whether this intention of maintaining two currencies makes economic sense or is practicable. There have even been predictions that the Hong Kong dollar will disappear soon after 1997, neglecting the legal requirement for two currencies, at least for 50 years after 1997. The sceptics have, however, not articulated why they hold this view, other than pointing to the lack of meaningful precedents of two currencies co-existing in one country.

But one argument may be that for two close trading partners, a single currency or a fixed relationship between the two currencies may, under certain circumstances, be preferable to having two currencies under the influence of different monetary policy objectives. This would eliminate uncertainties arising from exchange rate movements for those engaging in cross border business transactions. It would also facilitate greater mobility of capital which would enhance economic development and therefore the well being of the two communities concerned. Indeed, this is one of the arguments for European monetary union and the creation of the Euro, a single currency for Europe.

But I am sure you have also noticed that European monetary union is predicated on each participating economy satisfying a number of convergence criteria. These criteria are strict, and rightly so, for fear of unacceptable disruptions to the economies concerned and the possibility of uncontrollable contagion of economic problems among members of the union. The European countries are already a rather homogenous group in terms of their stages of economic and social development, and their political, legal and other systems. Yet there is only one that qualifies under those convergence criteria now. By contrast, I really cannot find any other two economies which are more different than those of China and Hong Kong. Applying, for the sake of argument, the convergence criteria for European monetary union to our situation, one would, I think, have no difficulty concluding firmly that we need monetary segregation and not monetary union in whatever form, whether one talks about a single currency or a formal linkage between the two currencies. Put simply, the Hong Kong dollar will continue to exist as the currency, the legal tender of Hong Kong. It will not disappear. It will not be replaced by the RMB, and this is regardless of whether or not the RMB becomes fully convertible, in whatever time frame.

In this connection questions have often been asked as to whether the Hong Kong dollar's link with the US dollar would be maintained. The Hong Kong Government's position is of course very clear. The linked exchange rate system and the exchange rate of 7.80 to the US dollar, albeit established in 1983 having regard largely to the political circumstances then, are very appropriate for the economic circumstances of Hong Kong. It makes sense for a highly externally oriented economy to operate with a stable external value for its currency. The system has served Hong Kong extremely well and there is no need and no intention whatsoever for changing it.

The authority of our views on this matter, in respect of the situation beyond 1 July 1997, has been enhanced by equally clear endorsements from China. Whilst emphasizing that the future Special Administrative Region Government shall, on its own, formulate monetary and financial policies, in accordance with Article 110 of the Basic Law, the Chinese have time and again stated that: "for the small and open economy of Hong Kong, a stable exchange rate is the most important indicator of monetary stability. It is also where confidence in Hong Kong hinges to the various sectors of Hong Kong and to the international financial community. The linked exchange rate system of Hong Kong has in the past contributed greatly to the stability of the Hong Kong dollar, and played a very important role in maintaining monetary stability in Hong Kong. We support the linked exchange rate system of Hong Kong and the efforts made by Hong Kong to buttress that system."

Two Monetary Systems

Let me turn to the relationship between the two monetary systems. As Hong Kong is merely a dot in the map with 6 million people or half a percent of the population of China, it is perhaps not surprising that many, particularly those from outside Hong Kong, would expect our monetary system to be dwarfed by that of China in comparison. Not so. Our money supply is in fact about 40% as big as China's. In terms of stock market capitalization, our system is 5 times larger than that of Shanghai and Shenzhen combined. In terms of foreign exchange turnover or interbank market activity, there is no comparison at all. In terms of asset size of the banking system, we are 1.3 times that of China. In terms of foreign currency reserves, the amount we have, including the Land Fund, is about 80% as large as China's, and we have no external debt. The monetary system of Hong Kong is a very significant one by any standards, and it is the one which is a lot more sophisticated.

Recognizing this, China has taken the very helpful view, in defining the relationship between the two monetary systems, that they are to be "mutually independent". This means of course that one system does not have precedence over the other, and one system is not superior or subsidiary to the other. Furthermore, the assets and liabilities between the two monetary systems are to be considered as foreign assets and foreign liabilities. Chinese banks operating in the monetary system of Hong Kong are to be treated as if they are foreign banks, and vice versa for Hong Kong incorporated banks operating in China. In participating in financial markets in Hong Kong, Chinese enterprises expect to be, and will be, treated equally as any other market participants from either Hong Kong or elsewhere, will not seek and will not be given special privileges.

Specifically, the Bank of China will not possess authorities inconsistent with its status as a commercial bank in Hong Kong. It will not take over the role of other financial institutions. As a note issuing bank and the second largest banking group in Hong Kong, the Bank or its representatives are involved, along with others in the banking sector of Hong Kong, in the work of a number of consultative committees and statutory bodies. For example, the Bank of China is currently the Chairman bank of the Hong Kong Association of Banks, performing that role very effectively. It is in this commercial manner that the Bank of China will continue to contribute to the stability and the development of Hong Kong's monetary system.

Two Monetary Authorities

Let me turn to the relationship between the two monetary authorities. As the two monetary systems are to be mutually independent, China's position is that the monetary authorities are also to be mutually independent. This is a very important demonstration of the autonomy that we will have. The PBOC and the HKMA, as two mutually independent monetary authorities, are represented in central banking circles as two separate members responsible for two monetary systems that are quite different and conduct monetary policies independently. They are also seen and accepted by the international financial community as such.

This mutually independent relationship does not of course preclude close cooperation between the two monetary authorities. Indeed this is essential given the close relationship between the two economies of China and Hong Kong, and given that the close economic relationship inevitably involves financial transactions across the two monetary systems. Hong Kong is the largest trade and investment partner of China. Policies, in particular monetary policy, pursued by China will have an impact on the economy of Hong Kong and in particular our financial markets. Similarly, China has considerable financial assets held in Hong Kong and much is in the form of Hong Kong dollar deposits held with the banking system of Hong Kong. The value of these assets will obviously be affected by monetary conditions in Hong Kong. The need for close cooperation between the two monetary authorities, the PBOC and the HKMA, which has been stepped up over the past seven or eight years, is clear.

The scope and nature for cooperation are identical to those that the HKMA has also built up with other central banks, particularly those in this region, although naturally the closeness of the economic relationship between China and Hong Kong is such that cooperation with the PBOC commands much greater attention within the HKMA. The cooperation covers the three important areas of responsibility of any central bank or monetary authority, namely, monetary stability, banking stability and the development of the financial infrastructure.

On monetary stability, the open endorsement by the PBOC of our monetary policy objective of maintaining currency stability through the fixed exchange rate link with the US dollar is of course helpful to market sentiment. But as a more concrete form of cooperation, the PBOC was among a number of central banks in this region that entered into bilateral repurchase agreements on US Treasury securities with us. This is for the purpose of providing mutual assistance in enhancing the liquidity of foreign currency reserves for use in market operations to ensure exchange rate stability. I should point out that these bilateral repurchase agreements, when invoked and subject to availability, would involve only a temporary switch of the foreign currency assets of the provider from US dollar deposit funds into US Treasury securities, which will be reversed very shortly, thus incurring no risks. Cooperation with the PBOC on this front in fact goes further. The PBOC has indicated that if there were to be a need, China's foreign currency reserves could be used to support the Hong Kong dollar, although I wish and I am confident that we would not come to that.

On banking stability, we have, over the years, developed a framework of supervisory cooperation with the PBOC akin to those that we have with other central banks. As mutually independent monetary authorities responsible for two mutually independent monetary and banking systems at very different stages of development, the characteristics of the supervisory systems clearly would differ. Hong Kong promotes and maintains internationally accepted regulatory standards. This is essential to Hong Kong's continuing development as an international financial centre, a requirement laid down in the Joint Declaration and the Basic Law. China's banking system is going through a process of reform and liberalization, so is its banking supervisory system. But China recognizes the need to move towards international standards and there is a clear trend in this direction, with the recent enactment of a central banking law and a commercial banking law. Having regard to these differences, supervisory cooperation between the PBOC and the HKMA is built upon the understanding that there should be no erosion of supervisory standards in Hong Kong and that, where appropriate, the HKMA would provide technical assistance to the PBOC in promoting the move of the supervisory system in China to match international standards. Chinese banks are subject to the same licensing criteria and the supervision of the HKMA, as any other foreign bank entering and operating in Hong Kong. Similarly, Hong Kong incorporated banks are subject to the same licensing criteria and the supervision of the PBOC as any other foreign bank entering and operating in China. The HKMA is also now a popular training ground for supervisory personnel from the PBOC.

On the development of the financial infrastructure, there has been much cooperation at the technical level, notably in the building of real time payment systems for large value interbank transactions in China for the RMB and in Hong Kong for the Hong Kong dollar. The aim here is eventually to have the two payment systems linked up for the purpose of facilitating the settlement of cross currency transactions with the minimum of risks, just as we are pursuing similar linkages with payment systems of currencies of our other major trading partners. There is also cooperation in the building of compatible clearing systems for debt securities and their eventual linkage, not just between the systems in China and Hong Kong, but also with domestic systems of other economies in this region and possibly beyond. We aim to build an efficient network that would facilitate the flow of the very substantial savings in this region to satisfy the huge demand for investment funds arising from the much needed development of the physical infrastructure in this region. This is the concept of AsiaClear that we are promoting.

Two Financial Centres

Let me turn to the relationship between the two financial centres, namely, Hong Kong and Shanghai. This is a subject of great interest to many. And once again, China has been very helpful in clarifying its policy on the matter, particularly on the question of whether Shanghai would eventually replace Hong Kong. There are five points here that the Chinese, at various levels of authority, have made. First, the relationship between Hong Kong and Shanghai is not one which involves one replacing the other. Rather, it is one of mutual reinforcement. Being already an international financial centre after so many years of development, Hong Kong has a clear advantage over Shanghai in terms of its international exposure. Second, in accordance with the Basic Law, China will continue to maintain Hong Kong's status as an international financial centre. To achieve this aim, detailed provisions have been formulated to enshrine this as national policy. Third, again in accordance with the Basic Law, Hong Kong will enjoy a high degree of autonomy after 1997, other than in matters concerning foreign affairs and defence. This will assist Hong Kong in continuing to maintain its efficiency and vitality as an international financial centre. Fourth, Hong Kong will maintain its capitalist system unchanged for 50 years. This will be conducive to maintaining and promoting its economic ties with leading developed countries and regions. And fifth, Hong Kong's economic fundamentals and the strength of its public finances will provide safeguards to the maintenance and enhancement of its role as an international financial centre.

China's view is that it will not be possible for Shanghai to become an international financial centre, at least not before the RMB becomes fully convertible, and this means a freely convertible RMB not only in the current account, which is being planned for before the end of this year, but also in the capital account in which there is as yet no timetable. Even after the RMB achieves full convertibility, I suspect that it will still take some time before the financial infrastructure of Shanghai could catch up with that of Hong Kong and command the confidence of the international financial community in the way that Hong Kong and other international financial centres do. The Chinese recognise this and is taking the view that "Hong Kong and Shanghai will after 1997 become two complementary and mutually reinforcing financial centres that will each develop its own characteristics under one sovereign state". Hong Kong will be the international financial centre in China after 1997 and Shanghai, with the vast hinterland and with RMB transactions as its major business, will develop as a domestic financial centre. In the opinion of the Chinese leadership, Hong Kong as an international financial centre is "incomparable and irreplaceable".


I hope this elaboration of how the concept of "one country , two systems" will be manifested in the monetary relationship between China and Hong Kong has been helpful to you. It is not something that I have dreamt up myself. It is based on years of contact and dialogue with our counterparts in China, during which a high degree of professional trust and understanding has been established. In the monetary area, I am happy to say that there is no controversy. There is instead consensus as to what is in the best interest of Hong Kong and commitment to make it work.

I have just returned from London, where we had a most useful seminar hosted by the Bank of England. The principles governing the monetary relationship between China and Hong Kong that I have described were also elaborated by Mr Chen Yuan, Deputy Governor of the PBOC at that seminar. The HKMA has also on 9 September received recognition in the central banking fraternity by being offered membership of the Bank for International Settlements. All these are concrete examples how the foundations of Hong Kong's prosperity beyond 1997 as an autonomous international financial centre are being steadily strengthened.

We welcome the efforts of the British Chamber of Commerce to promote that prosperity and understanding. Thank you for inviting me to this luncheon.

Last revision date: 1 August 2011
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