The relationship between the budgetary position and the monetary system is a complex one, particularly in a small and open economy.
In around September last year the premium of the one-year forward exchange rate of the Hong Kong dollar over the spot exchange rate increased fairly sharply over concerns about the possible implications of the burgeoning budget deficit on the sustainability of the fixed exchange rate. From a level of about 40 points (equivalent to a one-year forward exchange rate of 7.8040), the premium jumped to almost 400 points and stayed at a high level throughout October and into November, as the markets continued to react nervously to every piece of news on matters relating to the fiscal and monetary systems. There was indeed some risk that Hong Kong could just worry itself into a financial crisis. Thanks largely to Premier Zhu's very supportive comments during his visit to Hong Kong in November, the one-year forward premium in the exchange rate fell back quickly to around 160 points, where it has stayed since.
The relationship between the budgetary position and the exchange rate is a delicate and complex one. It should not be difficult, however, to understand its main characteristics from a theoretical point of view. If the maintenance of a stable exchange rate is the objective, or the intermediate target, of monetary policy, then there is a need, among other things, for rather strict discipline in the management of public finance. Persistent budget deficits, beyond the level justified by short-term, counter-cyclical intentions, create doubts about the ability of governments prudently to finance them in the long term without resorting to the printing press, or to their "monetisation". This would eventually undermine the value of the currency and therefore the sustainability of a fixed exchange rate.
The dynamics of that relationship are far more difficult to grasp. They depend on many factors. The more obvious ones include the level of public debt outstanding and the level of fiscal reserves. The dynamics also depend on the characteristics of the monetary system, and the credibility and robustness of the monetary management mechanism in place. Furthermore, the dynamics of that relationship are a lot more different in an economy that is externally oriented and committed to openness than in an economy that is protected by exchange controls and other forms of restrictions. Where, for example, there are no restrictions to the free flow of capital and where financial markets have attained a global dimension, flows of international capital are highly sensitive to the perceived strength and weakness of policies, in particular financial policies. These financial markets move on expectations of the future. They sometimes hand down judgement even before the actual crime has been committed. And perception is something that does not have a predictable behaviour: it is easily influenced by even the most trivial of events, but is often insensitive to objective analysis, particularly from the official sector. That is why monetary management is a much more demanding task in a small economy with open markets than in a large economy or one practising controls and restrictions. The Asian financial turmoil of 1997-98, and the subsequent drift in Asian economies towards controls and restrictions, confirms this clearly.
I am glad, of course, to see that the forward premium has settled down. I am also glad that the Policy Address by the Chief Executive The Honourable Tung Chee Hwa earlier this month has had the effect of consolidating the recent calmness in the forward market for the exchange rate. In paragraph 43 of that address, Mr Tung also pointed out the risks to the monetary system of a failure to solve the current fiscal deficit: these risks include exposing Hong Kong to "heightened speculation, which may trigger outflows of capital, rising interest rates, turmoil in the financial markets leading ultimately to possible attacks on our linked exchange rate system." Mr Tung's frankness here is admirable - and it has been underlined by similar comments from the Financial Secretary. This emphasis on the relationship between the budgetary position and the exchange rate and the "basic thinking and guiding principles" set out in the subsequent paragraphs of the Policy Address are, to me, a clear demonstration of determination on the part of the Government to reinstate fiscal discipline, which has been eroded by deflation and structural change in the economy. I believe that the market shares this view and, in remaining calm, has given its endorsement to Mr Tung's strategy to deal with the budget deficit. Now we await the details to be revealed by the Financial Secretary on budget day.
Joseph Yam
23 January 2003
Related Viewpoint Article:
Click here for previous articles in this column.
Document in Word format
