Hong Kong's Linked Exchange Rate system works well because it is ruled based and transparent.
Expectation management is very much a part of life. We do it before breaking bad news to minimise adverse impact. We do it before breaking good news to maximise favourable response. I remember doing it when, in primary school, I had to show my parents my report card. Expectation management is also becoming more important for governments in pursuing their policy objectives. This is particularly so where free markets, operating without the day-to-day presence of the government, are involved. The most notable example is the management of inflation expectation for jurisdictions whose monetary-policy objective is price stability. Associated with this is the management of expectations about interest rates, particularly the policy interest rate of the central bank, which in turn determines deposit and lending rates and the yields of debt securities and other financial instruments. Since expectations about the movement of the different types of interest rates influence the behaviour of consumers, investors and other people, managing interest-rate expectation helps to achieve the monetary-policy objective.
The management of expectations about the exchange rate is also an important task for central banks, whether they operate a fixed or a flexible exchange-rate regime. This is obvious for one operating with a fixed exchange rate, where exchange-rate stability is the operational objective of monetary policy. But even for a jurisdiction operating with a flexible exchange rate, where price stability is the monetary policy objective and the external sector is a significant factor affecting exchange-rate movements, the management of exchange-rate expectation is often an essential part of managing inflation expectation. As a general rule, the task of managing exchange-rate expectation is more challenging when there is no foreign-exchange control. The freedom to buy and sell foreign currencies against the domestic currency makes the exchange rate more sensitive to news and rumours, and developments in the economy. In a jurisdiction with exchange controls, the central bank is the counter-party to most foreign-exchange deals and therefore the dominant market player. But the central bank of a jurisdiction without exchange controls tends to be insignificant as a player in the foreign-exchange market and therefore not in a position to dictate the exchange rate. And if the foreign-exchange market is large and liquid, as in an international financial centre, where the flows of funds are much bigger than in jurisdictions where financial activities largely serve domestic needs, the task of managing exchange-rate expectation can be a difficult one.
An interesting mechanism for managing financial-market expectations is the adoption of a rule-based policy. Taking the human element out of the equation, so to speak, can make the policy more credible and therefore more likely to succeed. In the financial markets in particular, there is much scepticism about discretionary decisions by government officials, although with highly professional track records many central banks do manage to gain considerable trust and respect from the financial markets for their interest-rate or other monetary and financial decisions. But even in these cases there is a lot of expectation management, particularly when the central bank is contemplating actions that may surprise the financial markets. In today's financial markets, surprises mean profits and losses, and nobody like to incur losses as a result of decisions by the authorities. And the grievances of those who do can ultimately undermine the credibility of the authorities and the policies they pursue.
In Hong Kong we use a rule-based monetary system to achieve exchange-rate stability through passive foreign-exchange market operations at pre-determined exchange-rate levels, ensuring that the money-market effects of the operations are not sterilised so that the necessary interest-rate adjustments in support of exchange-rate stability take effect as soon as the exchange rate comes under pressure. There is little discretionary action that we need to take to manage the exchange rate. But this does not mean that there is no need to manage exchange-rate expectation at all. The credibility of our rule-based monetary system depends on, among other things, a high degree of understanding, particularly in the international financial community given Hong Kong's status as an international financial centre, of how the system operates and how adjustments under the system are manifested in the financial markets and the economy. This understanding should be based on objective analysis on the pros and cons of a fixed exchange rate compared with a flexible one in the special circumstances of Hong Kong, which is one of the most externally oriented economies in the world.
Joseph Yam
22 May 2008
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