Experience suggests that Hong Kong needs considerably more in foreign reserves than the bare theoretical minimum to maintain currency stability.
I have recently been asked the question of how much in foreign reserves do we need to ensure that our monetary policy objective of exchange rate stability is comfortably achieved. This is not an easy question to answer. It is true that we have probably the most robust exchange rate system - by design and as a result of our continuous efforts to strengthen it ever since its establishment in October 1983. It is also true that our exchange rate system, characterised by currency board arrangements, only requires our monetary base, currently at about HK$220 billion, to be fully backed by foreign reserves of US$28 billion at the exchange rate of 7.80. It is, therefore, tempting to consider this theoretical minimum as all we need in foreign reserves to ensure exchange rate stability. Whoever takes this view is making a big mistake.
To understand why, let us go back to the international financial crisis of 1997/1998. The size of our monetary base at that time was smaller, at around HK$95 billion, and the amount of foreign reserves needed to back it 100% amounted to about US$12 billion. The crisis came, and there was the initial attack on our currency in October 1997. The robustness of our exchange rate system, as expected, automatically transferred the pressure on the exchange rate on to our interest rates, without the need to use foreign reserves in the Exchange Fund other than those dedicated for the purpose of backing the monetary base. Reflecting the severity of the currency attack, our overnight interest rate went up for a short while to over 200%, and interest rates for longer-term money also rose sharply. This caused a lot of pain, to the community and the speculators alike. The HKMA was blamed for squeezing interest rates and I was given a nickname. The system, by and large, worked in the manner for which it was originally designed. But the pain inflicted on the community, through the hikes in interest rates and the associated slides in asset prices, was considerable.
Then came the wicked month of August 1998, when we were hit by the tidal waves of international finance. The attack on the currency was many times more severe. Furthermore, the currency predators were well positioned to avoid the likely interest rate pain, by pre-funding themselves, and to benefit from the expected sharp slide in asset prices by running huge short positions in stock futures. Thankfully they did not succeed. We put up a gallant fight and Hong Kong won. I am sure readers are familiar with the story and how it played out in the end. But it is important to recap, now that the question of how much in foreign reserves we need has been raised, what it took in terms of foreign reserves. First, we used the opportunity to sell foreign reserves for Hong Kong dollars, in anticipation of the draw down of fiscal reserves deposited with the Exchange Fund, as the public finances moved into a cyclical as well as a seasonal deficit. This relieved some of the pressure on the exchange rate and therefore obviated the need for a repeat of the very sharp interest rate hike of 1997. The amount of foreign reserves utilised in this manner was about US$10 billion. Secondly, we sold large sums of foreign reserves for Hong Kong dollars for the purchase of Hong Kong stocks equivalent to US$15 billion. Thirdly, we made the monetary base much bigger in order to reduce the sensitivity of interest rates to inflows and outflows of funds. This involved committing another US$13 billion as additional backing.
Thus, what was at that time the theoretical minimum requirement of US$12 billion in foreign reserves for the provision of 100% backing to the monetary base became a requirement to mobilise a much higher level of foreign reserves, amounting to a few times the minimum. It should also be noted that we were able to do so without causing a breakdown of confidence in monetary and financial management in Hong Kong on the part of the international financial community, including financial analysts and rating agencies. To a large extent, this was because we had significantly more foreign reserves in the Exchange Fund than the sums mobilised, and the Fund had no significant liabilities other than the fiscal reserves deposited there.
History may repeat itself. The risks of globalisation have not declined, and Hong Kong, as an entirely open market, remains vulnerable. Although over the years we have strengthened our system considerably, I still would rather that we have, in the Exchange Fund, foreign reserves amounting to multiples of the theoretical minimum needed to give 100% backing to our monetary base.
5 April 2001
Related Viewpoint Article:
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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