Foreign currency reserves

inSight

27 Jan 2000

Foreign currency reserves

With our foreign currency reserves at a historic high, is there a limit to how much we need to keep the Hong Kong dollar stable?

Ask those around you the question of how much money they think they need, and you will probably get two types of answers. The more philosophical will say they only need money that is enough for them to live a comfortable life, just enough to be able to enjoy the luxury of not having to worry about money. The other answer will probably be "the more the better", for it would be nice, wouldn't it, to have more than Li Ka-shing or Bill Gates, and you could then, as the Chinese saying goes, command the wind and rain. Even the less ambitious might give that response, because you never know what life has in store for you. Perhaps within our lifetime a visit to Mars will not be impossible, and you would wish to be able to afford that, wouldn't you? And perhaps soon the elixir of life will be invented and you would wish to be able to afford that too.

Don't worry. I am not day dreaming, for I do realise that anyone who wants his dream to come true must first be woken up. But I do have to answer the similar question of how much foreign reserves does Hong Kong need. Again there can be two answers. As we operate a currency board system, all we need is an amount of foreign reserves that gives 100% backing to the monetary base. That is the amount considered to be enough, at least theoretically. An inflow of money causes the monetary base to expand along with the accumulation of foreign reserves. Interest rates will fall to a level that makes the return for holding Hong Kong dollars unattractive, thus stemming and reversing the inflow. Similarly, an outflow of money causes the monetary base to fall along with the loss of foreign reserves through the Convertibility Undertaking. Soon interest rates will rise to a level that makes the return for holding Hong Kong dollars attractive, thus stemming and reversing the outflow.

But you never know what international finance has in store for you as a small economy committed to maintaining open markets. Perhaps not a trip to Mars or the elixir of life, but certainly surprises and shocks well beyond your control. Information technology has worked wonders for financial markets and the world economy. Five years ago, not many people foresaw that it would bring the longest economic expansion in history, at least for the US. Equally, who can be sure about its potential impact on monetary management? Faced with such revolutionary changing times, a monetary authority would perhaps not mind having an abundance of additional foreign reserves available to expand its response options.

Readers will recall that in September 1998 we built a big cushion in our monetary system through enlarging the size of our monetary base by allowing the use of Exchange Fund paper for obtaining interbank liquidity. This involved the commitment of more foreign reserves beyond those required merely to back the issue of banknotes, without departing in any way from the strict rules of a currency board system. There may or may not be the need for further enlarging the cushion, on top of the gradual increase that has already been built in for the monetary base to grow along with the payment of interest on the Exchange Fund paper issued. But once again I cannot rule out that possibility.

Having strong reserves also has a bearing on the ability of the HKMA to deliver, when necessary, the secondary purpose of the Exchange Fund, which is to maintain the stability and integrity of Hong Kong's financial system. For example, without excess reserves, there will be doubts from time to time about whether the monetary authority in a currency board regime can really perform the role of the lender of last resort in light of the backing requirements. In the case of Hong Kong, with reserves at more than three times our monetary base, we would, if called upon to do so, be able to carry out this role in a convincing way.

So, even though I may sound greedy, for the time being the answer I am inclined to give to the question of how much foreign reserves we need is "the more the better". This does not mean simply building reserves for their own sake, without considering the cost, by, for example, borrowing the money to do so. What it means is a natural build-up of reserves, through investment gains, the inflow of funds, or an increase in fiscal placements. After all, we still cannot afford the luxury of not having to worry about money.

 

Joseph Yam
27 January 2000

 

More information on Foreign Currency Reserves can be found here.

More information on the Currency Board System can be found here.

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