Interest Rates and the Hong Kong Economy

inSight

20 Jul 2000

Interest Rates and the Hong Kong Economy

Hong Kong's externally oriented and open economy would make any attempt to pursue an independent interest rate policy very difficult.

In describing the characteristics of the Hong Kong economy, I have often emphasised that it is highly externally oriented, on top of being very open. There is an important distinction between the two characteristics that should not be confused. The Hong Kong economy is highly externally oriented in that the value of total external trade is over 2.5 times the gross domestic product (GDP). It is also a very open economy: there is virtually free access for non-residents to a wide range of economic activities - one of the widest in the world - and there is no restriction on residents investing or conducting other activities abroad. By contrast, the United States is not very externally oriented, given that its total value of external trade is less than a quarter of its GDP. But it is an open economy.

The extreme external orientation of the Hong Kong economy imposes an important constraint on the economic policies that we can prudently and realistically pursue. For example, since we import almost everything we consume, including the water we drink and the sand we use for construction, the import leakage in domestic spending is high, which reduces the scope for Hong Kong to try and spend its way out of a recession. The multiplier effect, as economists call it, is low in view of the high import leakage, so that an expansionary fiscal policy would be less effective here than in less externally oriented economies.

Of more direct concern to the HKMA is the implication of our external orientation for monetary policy. A lot of business is done with people outside of Hong Kong, and large numbers of people are employed in this and in related activities - in factories, in the import and export trades, in tourism, and in banking and other services. A stable and predictable external value for our currency, in the long term, facilitates the conduct of such business, ensures the job security of those employed, directly or indirectly, and promotes economic growth. The question, of course, is whether these obvious benefits, which many have over the years taken for granted, justify the costs of maintaining the linked exchange rate.

There is no doubt that the costs have been real. At times they have involved tremendous pain, particularly on the part of borrowers, as autonomy in the determination of interest rates has been given up. Clearly, the level of interest rates for the currency to which we are linked is not always appropriate for us. And when external shocks are readily transmitted to the domestic economy through the fixed exchange rate, or rather the lack of cushioning through exchange rate adjustments, and further have the tendency of being frequently magnified in view of our openness, the pain, to some, can be severe. There is also no effective monetary tool to pre-empt or deal with overheating when it threatens to develop, thus possibly exacerbating the amplitude of economic cycles.

These are valid descriptions of some of the costs involved in our linked exchange rate, at least from a theoretical point of view. But we need also to examine calmly and objectively the practicality of any alternative, and we in the HKMA have done so repeatedly over the years. One of the key questions that we should all ask ourselves is whether it is really possible for Hong Kong to pursue an interest rate policy that is meaningfully independent of world - in particular US - interest rate levels. There is room for serious doubt. Against highly volatile international financial conditions, the currency of a small and open economy, with highly developed financial markets, is likely to be vulnerable. Without an effective exchange rate anchor, exchange rate "over-shooting" can easily be accentuated, leading to wide and destabilising swings in financial prices. When this happens in Hong Kong, it would put tremendous strains on many sectors of our externally oriented economy, risking systemic crises and an intensification of the overshooting, which would require almost certainly the raising of interest rates, possibly to beyond those of US interest rate levels. The price effects of depreciation will also be substantial, given the external orientation of our economy. Our research work shows that a depreciation of 10% is likely to raise consumer prices by at least 3%. This strong responsiveness, combined with the important role of asset prices in determining inflation in Hong Kong, is likely to pose a major complication to using inflation targeting as the alternative objective of monetary policy. Giving up the exchange rate anchor could well end up with higher, rather than lower, interest rates.

There is no safe alternative to the present policy and this is definitely not a time to take risks that could well be unmanageable.

 

Joseph Yam
20 July 2000

 

More information on the Linked Exchange Rate System can be found here.

Click here for previous articles in this column.

 

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Last revision date : 20 July 2000