The involvement of the Hong Kong Monetary Authority (HKMA) in the stock and futures markets in August, whilst controversial, are well justified, the Chief Executive of the HKMA, Mr Joseph Yam, said in Singapore today.
Speaking at the Hong Kong lunch jointly hosted by the Hong Kong Special Administrative Region Government and the Hong Kong Trade Development Council, Mr Yam outlined the situation in August when the potential for serious market dislocation had been building up on the securities side.
The hedge funds had been borrowing and sitting on large amounts of Hong Kong dollars, he said. There had also been much selling pressure on the Hong Kong dollar in the first half of August.
He explained that in contrast to October last year, when people had to pay very penal interest rates to fund their short Hong Kong dollar positions, the hedge funds had pre-funded themselves during the currency attack in August.
"This they did by swapping US dollars for Hong Kong dollars, through intermediaries, with multilateral institutions which had issued Hong Kong debt paper, incurring an interest cost of HK$4 million a day for the HK$30 billion position. But this was not a lot of money to them.
"We had reason to believe that they had been building up and maintaining quite large short positions in the stock index futures," he said.
With an estimated 80,000 short contracts held amongst these hedge funds, he said that for every thousand-point fall in the stock market index, they stood to profit HK$4 billion. "The cost and benefit calculation is clear. And this is the case regardless of economic or market fundamentals.
"So they waited for a good opportunity to sell the Hong Kong dollars they had borrowed, in the hope of creating a severe shortage in the money market and sharply higher interbank interest rates, thereby sending the stock market into a nosedive," he said.
But it did not quite work out the way they intended, he said. They miscalculated on two counts.
First, they did not factor in the need for the HKSAR Government funding this year's budget deficit, unexpected at the time when the budget was drawn up, through a draw down of foreign reserves. And so the currency board adjustment mechanism involving sharply higher interest rates was not triggered.
Second, they did not realise that the HKSAR Government was far from the sitting duck they thought we were, he said.
"Committed to the free market as we may be, we took the view that free markets do not mean that markets can be freely manipulated. They need to be fair markets as well. We have a responsibility to tackle market manipulation and avoid serious market dislocations developing."
So after much agonizing we acted on two fronts, he said. "First we intervened in the stock and futures markets to deter market manipulation, by making sure that the manipulation did not pay off. Second we followed this action through with various measures to strengthen our monetary and financial systems.
"On the monetary side, we introduced technical measures to modify our currency board arrangements of our linked exchange rate system to make it less susceptible to manipulation. On the securities side, we are in the process of introducing a series of reform measures to lessen the potential for market dislocation."
Mr Yam was happy to say that the actions had been successful. There has been no indication of further market manipulation since the end of August.
"We have seen substantial unwinding of the short positions in our currency by the hedge funds, with considerable losses. And with the stock market having recovered substantially from the level at which we entered the market in the middle of August, more considerable losses were incurred also in their short positions in the stock index futures.
"Much of the interest rate premium of the Hong Kong dollar over the US dollar has disappeared, clearly reflecting with hindsight the extent of the excessive pain that had been so mercilessly inflicted on the community by the manipulative plays."
Turning to the accusation that Hong Kong was trying to jack up the market against trends dictated by fundamentals, Mr Yam said the aim had been to deter market manipulation, not to jack up the market.
"We do not mind where the level of the market is. No official view on the 'right' market level has been taken and there never will be such a view.
"But we are against market manipulation, specifically the manipulation of our currency market, taking advantage of our passiveness under the discipline of the rule-based currency board arrangements, to produce very high interest rates with a view to sending the stock market into a nosedive and benefiting from a short position in stock index futures.
"Such manipulation was conducted with no regard to economic fundamentals. This presents serious risks of market dislocation or overshooting, with asset markets ratcheting down every time this double play is staged.
"This can be highly damaging to the stability of the whole financial system of Hong Kong. It also presents the serious risk of undermining general confidence in our currency," he said.
On the second accusation that Hong Kong panicked because the pain of adjustments with a fixed exchange rate had become unbearable, Mr Yam said the government was trying to prevent the market panic and overshooting that those manipulating the markets were trying to engineer.
"Hong Kong is prepared and well equipped to bear the inevitable pain of economic adjustment necessitated by the financial turmoil that originated in this region and is now spreading to the developed market," he added.
Mr Yam denied the third accusation that Hong Kong had dangerously departed from the currency board discipline and ventured into discretionary monetary management.
The measures introduced recently have the effect of strengthening the currency board arrangements of Hong Kong rather than eroding them, he said.
He noted that in modern day finance the majority of transactions were conducted electronically without the use of cash. For the effective operation of currency board arrangements, the organisation responsible for running the system has to manage the electronic interbank clearing system as well.
This requires that the banks operate clearing accounts with the currency board and that the aggregate of the balances in their clearing accounts forms the crucial part of the monetary base which is subject to the monetary rule of the currency board, he said.
This puts the responsibility for the provision of liquidity to the banking system squarely on the currency board. But this arrangement need not involve any significant departure from the discipline of currency board arrangements.
He noted the important issue was how liquidity for the purpose of facilitating the clearing of interbank transactions was provided. In Hong Kong he said that this was provided through the repurchase of debt issued by the currency board and fully backed by foreign reserves. There is therefore no departure from the discipline of currency board arrangements.
He said the fourth accusation was that HKMA was too late in introducing the technical measures to strengthen currency board arrangements.
"Frankly, I do not think that we could have turned around the market sentiment with just part of the package of actions.
"The measure to strengthen our currency board arrangements have been effective. But basically what we have done, amongst other things, was to dampen interest rate volatility by accepting some fluctuation in our foreign reserves."
The larger fluctuations in foreign reserves may affect confidence. It may be seen as a sign of weakness, although with foreign reserves in multiples of the monetary base this should not be a cause for concern, he said.
"Tightening the provision of liquidity to the banking system by denying access to the discount window paper other than those issued by the currency board may affect the development of the debt market. And making explicit the passive convertibility of the monetary base into foreign reserves may dampen activity in the foreign exchange market.
"The pros and cons must be considered carefully before making these significant changes," he said.
Hong Kong Monetary Authority
14 October 1998
