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The Dollar Link : Is the Peg Sustainable?

by Norman T.L. Chan, Deputy Chief Executive, Hong Kong Monetary Authority

(Speech at the Far Eastern Economic Review's Fourth Annual Countdown to 1997: Roadmap to Hong Kong's Continued Prosperity, Hong Kong)

23 June 1997

  1. Ladies and Gentlemen, I am delighted to be invited to attend this Countdown to 1997 Conference, which carries a special meaning as we have just 7 days remaining before Hong Kong becomes a Special Administrative Region of China.
  2. The topic for this particular session is "The Dollar Link: Is the Peg Sustainable?" This has been a much debated subject ever since the Link was introduced back in October l983. Over the years, a variety of views have been expressed on this subject. Some have queried whether the main benefit of the Link in providing exchange rate stability is sufficient to compensate for the disbenefit of not being able to use independent interest rate policy to combat domestic inflation. But it seems to me that in the last few years there is growing consensus among the people of Hong Kong that the Link has served Hong Kong well by providing an anchor for monetary stability, based on which Hong Kong has developed into the premier international financial centre in the region with real GDP growth at an average rate of 6.2% per annum since 1983, far above that for the OECD economies. Now the debate is more often focused on whether the Link, which most of us agree is good for Hong Kong, is sustainable.
  3. In order to answer this question, we have to go back into history to see how the Link has performed in the last 14 years. As most of you are aware, there have been no shortage of events and shocks during this period, all of which put the Link under stress and test. These include the October 1987 Stock Market Crash, the 4 June incident in 1989, the Gulf Crisis in 1990, the closure of BCC(HK) in the summer of 1991 and the subsequent runs on a number of banks in Hong Kong, and the ERM turmoil in 1992. In January 1995, there was a very brief speculative attack on a number of Asian currencies, including the Hong Kong dollar. In February this year, we met with the news of Deng Xiaoping's death. On each and every occasion the Link has demonstrated its strength and resilience, as a result of which the HK$ exchange rate has remained remarkably stable against the US dollar.
  4. The performance and resilience of the Link has no doubt disappointed many who have predicted for quite a number of years on the so-called "inevitable" demise of the Link in the run up to 1 July 1997. Contrary to the pessimistic scenario depicted by these skeptics, Hong Kong remains a vibrant and buoyant international financial centre while local and overseas confidence in the Hong Kong dollar remains high. But the question is : will this last? To address this question objectively, one must look at the factors contributing to the success of the Link and, more importantly, whether these factors will continue in the future. There are five key factors that have been important to the success of the Link since its inception in 1983.
  5. Firstly, the Link is underpinned by a robust and effective monetary management framework. The core feature of our monetary system is the currency board system, in which all Hong Kong dollar bank notes are issued and redeemed against US dollars at the fixed rate of 7.80. In other words, all HK dollar banknotes are fully backed by foreign currency reserves. In fact, they are almost 600% backed by foreign currency reserves held by the Exchange Fund. This instills a high degree of discipline on the creation of the monetary base and hence public confidence in the currency. Moreover, through a series of monetary reforms in recent years, the HKMA is equipped with a wide range of instruments to defend the Hong Kong dollar as and when necessary. This significantly enhances the resilience of our Linked Exchange Rate System, as clearly demonstrated during the January 1995 episode when the HKMA successfully fended off the speculators.
  6. Secondly, Hong Kong has sound economic fundamentals and prudent macroeconomic policies. These include a long track record of fiscal discipline. In the last 13 years, Hong Kong has budget surplus in all except one year, as a result of which the fiscal reserves had reached HK$163 bn as at end-March 1997. Including the Land Fund, the SARG will have accumulated around HK$330 bn by 1 July. Moreover, Hong Kong's market structure is flexible and efficient, which enhances Hong Kong's resilience in absorbing external shocks and ability to make adjustments quickly. The best example is the labour market. Owing to massive relocation of the labour and land intensive manufacturing industries to Southern China, the work force I n the manufacturing sector declined by almost 60 percent from 870,000 in 1986 to 325,000 in 1996. In most economies, one would have seen a jump in structural unemployment and even call for government intervention. But not in Hong Kong. In fact, the labour market is so flexible and efficient in relocating workers that the unemployment rate in Hong Kong was consistently below 2% in the late 1980s and early 1990s.
  7. Thirdly, the HKMA's efforts to defend the Link are backed by very substantial external reserves which rank the 7th highest in the world. By end-May 1997, the foreign currency reserves amounted to US$67 billion. Moreover, our capability to intervene in the foreign exchange market has also been enhanced by the series of bilateral repurchase agreements that the HKMA has signed with 10 central banks/monetary authorities in the region. Under these agreements, the HKMA can obtain US$ cash quickly by repoing US Treasuries with these central banks.
  8. Fourthly, Hong Kong has a sound and stable banking system, which is the foundation for monetary stability. We have seen many examples in which maintenance of exchange rate stability has been adversely affected by a weak banking system. The Mexican peso crisis in 1994 is a very good example. It is therefore essential to have in place a robust and prudent regulatory framework, as we do in Hong Kong.
  9. Last but not the least, it is through many years of unwavering commitment on the part of the Government that we established a high degree of policy credibility, without which our work in defending the Link would become a lot more difficult.
  10. Having looked at the factors which have contributed to the success of the Link in the past, the next step is to assess whether these factors will continue to prevail after 1 July. Under the concept of "one country, two systems," Hong Kong will enjoy autonomy in formulating financial and monetary policies on its own after 30 June 1997. Hong Kong will continue with the long established policy of fiscal discipline which is, as a matter of fact, a requirement stipulated in Article 107 of the Basic Law. There are adequate constitutional safeguards to ensure that Hong Kong can retain the vitality and flexibility in its economy, which have been the key to Hong Kong's economic success in the past.
  11. There have been concerns that Hong Kong's foreign reserves may be absorbed by mainland China, whether directly or indirectly. These concerns are groundless. The Joint Declaration and the Basic Law clearly state that the HKSAR shall use its revenues and reserves exclusively for its own purposes, and that they shall not be handed over to the Central People's Government. It is also stated that the Central People's Government will not levy taxes in the HKSAR and that the Exchange Fund of the HKSAR shall be managed and controlled by the Government of the SAR, primarily for regulating the exchange value of the Hong Kong dollar.
  12. There have also been concerns that, given the increasing economic, trade and financial integration between Hong Kong and the Mainland, the Hong Kong dollar would soon be linked to the RMB instead of US$ or that the Hong Kong dollar would disappear because the RMB will take over HK$ as the legal tender in Hong Kong. Again, these concerns are unfounded because Hong Kong's monetary autonomy and the position of the Hong Kong dollar are guaranteed by the Basic Law after 30 June 1997. Governor Dai Xiang-long of the PBoC stated very clearly in his luncheon speech in Washington D.C. last September : "The principles establishing the basic monetary relationship between China and Hong Kong under the principle of 'one country, two systems' can be conveniently summarized as 'one country, two currencies, two monetary systems and two monetary authorities', within a sovereign state. ... The co-existence of two currencies, that is, the Hong Kong dollar and the Renminbi, is a clear demonstration of the differences between the economies of Hong Kong and the Mainland. It is therefore essential that the two monetary systems should be mutually independent. The Renminbi will not replace the Hong Kong dollar." Governor Dai has also reiterated that two mutually independent monetary systems mean that the Hong Kong Monetary Authority and the PBoC are two mutually independent monetary authorities and one is not superior to the other.
  13. The Government of Hong Kong will continue its commitment to maintain the Link after 30 June 1997. Mr. C.H. Tung, Chief Executive of the HKSAR has made clear the SAR Government's continued commitment to maintain the Link in his address to the IMF/HKMA conference in March this year. The Chinese Government has also repeatedly stated its support to the Link. The Governor and Deputy Governor of the PBoC have indicated on many occasions that the PBoC stands ready to assist in defending the Link if so requested by the HKMA. While we are most grateful to the PBoC for their support, we are confident that the HKMA, with a sizable foreign currency reserves and an effective monetary management mechanism, will be able to maintain exchange rate stability on our own without the need for outside help.
  14. The conclusion that one can reach is that, as the factors which have contributed to the success of the Link will continue, we will be able to maintain the Link, which is so important for Hong Kong's prosperity and stability.
  15. Finally, I would like to comment on the debate on the merit of a fixed exchange rate system versus a floating rate system. It seems clear to me that no exchange rate system is perfect. While a fixed rate system may offer stability of the external value of the currency, it takes away the autonomy of the central bank to use interest rate to achieve domestic price stability. On the other hand, while a floating rate system allows the use of interest rate to curb domestic inflation, possible volatility in the exchange rate of the domestic currency may have destabilizing effects on the economy. To me, the important point is that either the fixed rate or the floating rate can in principle work. There are many examples in which the floating rate system has worked successfully. However, in Hong Kong's case, which is a small and open economy with heavy reliance on external trade and susceptible to external shocks, it makes a lot of sense to adopt a fixed rate system to provide an anchor for the financial system. The impressive performance of the Hong Kong economy under the Link in the past 14 years underlines the usefulness of this monetary anchor. It is equally important that once we have chosen a system that has worked, we better stick to it as it takes a long time to establish public confidence and credibility on the policy and on our commitment to maintain the policy.
Last revision date: 1 August 2011
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