Fixed exchange rates

inSight

23 Sep 1999

Fixed exchange rates

Economic adjustment under a fixed exchange rate is a long and painful process, but it provides Hong Kong with the best option for a real and robust recovery.

It is difficult to deny the general assertion that, with a fixed exchange rate, economic adjustment in response to an external shock is a longer and more painful process than it would be under a flexible exchange rate. Indeed, from a theoretical perspective, when the exchange rate is fixed there is one less "degree of freedom", or "one less economic variable", to facilitate the adjustment process.

But, like almost everything in life, it is not quite as simple as that. A devaluation of the exchange rate can reasonably be expected to boost exports and curb imports in terms of quantity. But one cannot make the same assumption in terms of their total value. Most of us would still want to continue eating a bowl of rice a meal when imported rice costs 20% more because of a 20% devaluation of the exchange rate. But we may still only be able to sell 10% more of our own products overseas. The overall value of imports may therefore go up, rather than down, and by much more than the increase in the overall value of exports. In other words, the balance of trade may deteriorate rather than improve. As most economics textbooks on international trade and finance point out (and pardon the economic jargon), it all depends on how the four "elasticities" of demand and supply of imports and exports interact.

In Hong Kong, we import most of our necessities, including much of the water we drink, almost all the food we eat, and even the sand we use for building. The demand for these necessities is clearly and strongly price inelastic. And the consumer products we sell overseas - shoes, clothes, toys, computers - are things that you would probably not buy 20% more of, even if they were 20% cheaper.

If devaluation in the exchange rate leads to deterioration in the balance of trade, the chances are high that the balance of international payments will deteriorate as well. More financial resources are required to service external debt, and foreign direct investment and foreign portfolio investment will just sit on the sidelines, awaiting cheaper opportunities as the exchange rate further depreciates under a flexible exchange rate system, and exacerbated by a flight of domestic capital. With liberalised and globalised financial markets, international currency players, who are able to command substantial financial resources, will strike with a vengeance, taking large short positions well out of proportion to the perceived problems of the economy in question. Then the currency devaluation gets out of hand, for, despite the claims put forward by those who advocate free exchange rate floats, there are indeed no hands to guide an exchange rate when it is supposed to be freely floating. The possible outcome is a financial meltdown in which all would suffer a lot more than when the exchange rate is fixed.

The alternative is that we sit tight for an otherwise longer period and bear the possibly excruciating pain of economic adjustment with a fixed exchange rate. And there may even be casualties as the hardship becomes unbearable for the vulnerable members of the community. But, no pain, no gain. Economic adjustment with a fixed exchange rate is painful, but in the circumstances of Hong Kong there is no easy way out. Exchange rate adjustments may not have the desired effects on the balance of international payments and they are almost certainly uncontrollable. For others, adjusting through the exchange rate may be viable and thus an easy way out of difficulties. But looking at the actual "successful" examples in this region, their success is predominantly due to restrictions of one type or another that have been effective in guiding the path and the extent of exchange rate adjustment. As we all know, many of these restrictions are prohibited in the Basic Law of Hong Kong, and for good reasons.

Furthermore, the easy way out - exchange rate adjustments - can often be a disincentive for the type of structural adjustments necessary to enhance the long term robustness of the economy. I wonder whether readers have noticed that there have been proportionately more corporate restructurings in Hong Kong, and more in the pipeline, since the financial turmoil broke, than in many of the economies seen to be recovering ahead of us. Steady we go.

 

Joseph Yam
23 September 1999

 

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Last revision date : 23 September 1999