Hong Kong's Monetary Scene: Myths and Realities


10 Sep 1996

Hong Kong's Monetary Scene: Myths and Realities

Joseph Yam, Chief Executive, Hong Kong Monetary Authority

(Speech at the Bank of England Seminar, "Hong Kong's Monetary Arrangements through 1997", London, reprinted in the HKMA Quarterly Bulletin Issue No. 9)


  1. Today I shall address a number of popular and highly sensationalized myths about Hong Kong's future on the monetary front by giving you the relevant facts and analyses. These myths depict a doomsdayish scenario for monetary affairs in Hong Kong after 1997, characterized by:
(a) a serious erosion of monetary autonomy as a result of interference from China;
(b) massive capital flight;
(c) the Hong Kong dollar disappearing soon after 1997, replaced by the Renminbi;
(d) the Hong Kong dollar's link with the US dollar will soon break after 1997;
(e) the absorption of Hong Kong's substantial foreign reserves by China, as China covets Hong Kong's wealth; and
(f) regulatory standards deteriorating as corrupt practices creep in as a result of the need to grant special privileges to influential interests from the mainland.
  1. What Deputy Governor Chen Yuan has said just now provides a very useful background for discussing these issues. I am grateful for his helpful presentation.

Myth Number One - Erosion of Monetary Autonomy

  1. Let me first tackle the doubts about Hong Kong's monetary autonomy after 1997, starting with the relevant legal provisions. The Joint Declaration specifies that "The Hong Kong Special Administrative Region will enjoy a high degree of autonomy, except in foreign and defence affairs" and "The Hong Kong Special Administrative Region Government may decide its monetary and financial policies on its own."
  2. The Basic Law specifies that "The Government of the Hong Kong Special Administrative Region shall, on its own, formulate monetary and financial policies, safeguard the free operation of financial business and financial markets, and regulate and supervise them in accordance with law."
  3. Furthermore, the monetary relationship between China and Hong Kong under the concept of "one country, two systems" has now been defined as one country with two currencies, two monetary systems and two monetary authorities which are mutually independent.
  4. The meaning of the term "mutually independent" is clear in both the English and the Chinese languages, and so there is no scope for misunderstanding. Insofar as the two currencies, the two monetary systems and the two monetary authorities are concerned, one does not have precedence over the other, one is not superior to the other and one does not take instructions from the other.
  5. Defining the monetary relationship as a "mutually independent" one is sensible and pragmatic. Although Hong Kong is clearly quite small in terms of population and area when compared with China, its currency and monetary system are very substantial indeed:
(a) Hong Kong's money supply is 39% as big as China's;
(b) the assets of Hong Kong's banking system is 1.3 times that of China's;
(c) Hong Kong's foreign reserves, including the Land Fund, is about 80% as large as China's and we have no external debt;
(d) Hong Kong's stock market capitalization is five times that of Shanghai and Shenzhen combined; and
(e) Hong Kong's foreign exchange market turnover is in vast multiples of China's.
  1. A mutually independent relationship with monetary autonomy for Hong Kong is consistent with the declared objective in the Joint Declaration and the Basic Law of maintaining Hong Kong's status as an international financial centre, and enables China to maximize Hong Kong's utility as an international financial centre for promoting the reform and liberalization of China's monetary and financial systems.
  2. I suspect not many people are aware of this. Notwithstanding the high degree of monetary autonomy Hong Kong has been enjoying, there will in fact be an even higher degree of monetary autonomy for Hong Kong as a result of the transfer of sovereignty. This can be illustrated by a comparison between the relevant provisions in the Royal Instructions to the Governor of Hong Kong and the Basic Law. Currently under the Royal Instructions, the Governor shall not assent to "any Bill affecting the Currency of the Colony or relating to the issue of Bank notes", or "any Bill establishing any Banking Association, or amending or altering the constitution, powers, or privileges of any Banking Association" without previously obtained the approval of the Secretary of State. Under the Basic Law, however, there is only the corresponding general requirement that "laws enacted by the legislature of the Hong Kong Special Administrative Region must be reported to the Standing Committee of the National People's Congress for the record." Furthermore, it is specified that "the reporting for record shall not affect the entry into force of such laws".
  3. Nevertheless, unlike the Royal Instructions, the Basic Law also prescribes in considerable detail the systems to be practised in the Hong Kong Special Administrative Region. This is unusual in constitutional law, but in the circumstances of Hong Kong this is helpful and indeed necessary. The transfer of sovereignty is a big change and there is a need for adequate safeguards to ensure that the systems that contribute to Hong Kong's success are retained. As businessmen I hope you find this useful.
  4. The higher degree of monetary autonomy that Hong Kong will enjoy is also evident in recent changes to Hong Kong's monetary legislation. Amendments have been introduced in the past few years, after consultation with the Chinese, to ensure that the relevant laws are consistent with the Basic Law. One significant amendment common in this exercise is the removal of the need to refer matters to the Secretary of State, which if not removed, would mean the need to refer matters to, presumably, the Hong Kong and Macau Affairs Office of the State Council after 1997 - a mirror image for arrangements before and after the transfer of sovereignty. Let me give a few examples:
(a) the investment of the Exchange Fund in securities;
(b) the determination of the limit for borrowing for the account of the Exchange Fund;
(c) the movement of foreign reserves surplus to the requirement of the Exchange Fund;
(d) the authority to appoint banks to issue bank notes; and
(e) the authority to proclaim coins as legal tender, mint coins and appoint minting agency
were all subject to the prior approval of the Secretary of State before amendment of the relevant ordinances. Now these authorities have been brought entirely into Hong Kong and rest either with the Financial Secretary or the Governor in Council.
  1. I hope you will agree that there exists a clear framework which safeguards Hong Kong's monetary autonomy. There may, however, still be risks of erosion, but I believe that with this framework we will be able to defend robustly our monetary autonomy. We must, furthermore, be able to demonstrate to all concerned that we are in a position to exercise that autonomy in the best interest of Hong Kong by:
(a) pursuing credible monetary policy;
(b) being transparent and accountable in our market operations;
(c) being open in the provision of information such as our reserves and how they are managed; and
(d) being professional in the performance of our functions and in a manner that commands the confidence of the people of Hong Kong and the international financial community.

Myth Number Two - Massive Capital Flight

  1. Let me turn to the myth that there has been massive capital flight from Hong Kong ahead of the transfer of sovereignty. This can be easily dispelled by looking at some facts. Somewhat belatedly the Government is going to compile balance of payments statistics. As part of the preparatory research work, we in the Hong Kong Monetary Authority have conducted a rough desk-top exercise for 1994, in consultation with the International Monetary Fund. The results show:
(a) a small balance of payments deficit in the current account amounting to 1% of GDP;
(b) substantial private sector capital inflow; and
(c) as a result a substantial increase in official foreign currency reserves held in the Exchange Fund.
This information clearly does not suggest that there has been capital flight from Hong Kong, at least not in 1994.
  1. More facts. If there had been capital flight from Hong Kong, the exchange rate of the Hong Kong dollar would not have been so stable and on the stronger side of the fixed level of 7.80 to the US dollar. Hong Kong dollar interest rates would not have stayed so close to US dollar interest rates. The stock market would not have outperformed many other stock markets. The Hong Kong dollar deposit base would not have shown a growth rate matching closely that of economic activity, as measured by the growth rate of the GDP in money terms.
  2. Some have, nevertheless, pointed to the fact that the share of Hong Kong dollar deposits in the total deposit base of the banking system is now only about half and saw this as an indication of capital flight and the lack of confidence on the Hong Kong dollar. Quite the contrary, this is a reflection of Hong Kong's status as an international financial centre. Foreign currency deposits are placed in Hong Kong to take advantage of our liquid market in our time zone. This is a characteristic of international financial centres. In London, sterling deposits, or deposits denominated in the domestic currency, represent only about 40% of total deposits. The corresponding figure for Singapore is about 47%.
  3. Hong Kong residents do hold a diversified asset portfolio. Part of the diversification may even be politically motivated. But the effect of such diversification must have been more than offset by inflows of funds from non-residents to take advantage of the economic dynamism of Hong Kong and the region.
  4. Hong Kong sits right in the middle of the fastest growing area in the world, performing a most important role as an international financial centre and as the free market window to China which, with continuing reform and liberalization, will soon become the largest economy in the world. The prospects are bright and that is where money should and would go. Capital flight from Hong Kong is a myth.

Myth Number Three - Disappearance of Hong Kong Dollar

  1. Let me go on to the third myth regarding the fate of the Hong Kong dollar. One story that has been circulating recently is that China will not tolerate two currencies after 1997 and so the Hong Kong dollar will soon disappear and be replaced by the Renminbi.
  2. It is important first to note that there is a clear requirement in the Joint Declaration and the Basic Law for the Hong Kong dollar to continue to circulate as the legal tender in the Hong Kong Special Administrative Region and for it to remain freely convertible, at least for 50 years after 1997. The law does not allow the Hong Kong dollar to disappear. The law does not allow the Renminbi to replace the Hong Kong dollar. Furthermore, as pointed out by Deputy Governor Chen Yuan, the relationship between the two currencies is defined as one in which the Hong Kong dollar will be regarded as foreign currency in China and the Renminbi will be regarded as foreign currency in Hong Kong.
  3. But let us also consider the economic realities, although the skeptics have never focused on them. It can be argued that, for two close trading partners, a single currency or a fixed exchange rate between the two currencies may, under certain circumstances, be preferable to having two currencies under the influence of different monetary policy objectives. This would:
(a) eliminate or minimize uncertainties arising from exchange rate movements for those engaging in cross border business transactions;
(b) facilitate greater mobility of capital between the two economies; and therefore
(c) enhance economic development and the well being of the economies concerned.
  1. Indeed this is one of the lines of arguments in favour of European monetary union. But I am sure you are all well aware of the fact that EMU is predicated on each participating economy satisfying a number of convergence criteria to safeguard against unacceptable disruption to the economies concerned and the possibility of uncontrollable contagion of economic problems among members of the union. The costs of convergence are recognized by all as very high. And notwithstanding the European countries being a rather homogenous group, the prospects for some in meeting these criteria are slim. If, for the sake of argument, one is to apply a similar set of convergence criteria for monetary union to China and Hong Kong, one gets a picture in stark contrast with Europe.
  2. One would certainly have no difficulty concluding that the case for China and Hong Kong argues clearly for monetary segregation rather than monetary union. It will be difficult to find two significant economies that are more different than those of China and Hong Kong. The Heritage Foundation recently named Hong Kong as the world's freest economy while the corresponding ranking for China is 121st. The Hong Kong dollar will continue to exist as a freely convertible currency and the legal tender of Hong Kong. It will not disappear. It will not be replaced by the Renminbi. And this is regardless of whether or not the Renminbi becomes freely convertible, in whatever time frame.

Myth Number Four - Exchange Rate Link Abandoned

  1. Myth number four: the Hong Kong dollar's link with the US dollar will soon be abandoned. Having a fixed exchange rate is nothing new, particularly in Continental Europe. It makes a lot of sense for a highly externally oriented economy like Hong Kong to have, as the objective of its monetary policy, a stable external value for its currency. This is a firm policy of the Hong Kong Government. And to the extent that some may feel that this is relevant, this policy has the strong endorsement of:
(a) both the United Kingdom and the Chinese Governments;
(b) the International Monetary Fund in its annual Article IV consultations with Hong Kong;
(c) the Bank for International Settlements who described our exchange rate link as a "rather special case" and arguing further that the sheer size of our international reserves "has given this commitment almost unparalleled credibility"; and
(d) Milton Friedman who, at a seminar in Hong Kong in 1993 to talk about the exchange rate link, said that "a small country is better off linking its own currency to that of a major country".
  1. In the history of the Hong Kong dollar, we have for most of the time operated with a fixed exchange rate. The only exception is the nine year period from 1974 to 1983 when the Hong Kong dollar was freely floating. But the experience of those nine years was not a happy one, as a comparison of economic performance with the 13 subsequent years under the current linked exchange rate system would show. During the nine years of floating, Hong Kong experienced rapid credit expansion and monetary growth, leading to double-digit inflation, sharp volatility in property and stock prices, instability in the banking system and a sharp depreciation of the Hong Kong dollar. By contrast, the experience under the linked exchange rate system has been a lot more pleasant.
  2. There is of course a cost involved in fixing the exchange rate and this is that we have conceded our right over monetary policy to the Federal Reserve Bank. Our interest rates are determined by the Fed and not by ourselves and we cannot make use of interest rates to curb inflation, although one must note that, for an externally oriented economy, a stable external value for its currency should bring stability to its internal value as well. But desirable it may be to be able to use interest rates as a tool for curbing inflation, it is considered not desirable enough for us to give up the exchange rate stability that is so essential to the stability and prosperity of Hong Kong.
  3. Technically, the Hong Kong dollar's link with the US dollar is a form of a currency board system, which is quite a strong form of a fixed exchange rate system, stronger than for example the arrangements under the Exchange Rate Mechanism of Europe.
(a) It requires Hong Kong dollar bank notes to be issued and redeemed against US dollars at the fixed rate of 7.80 to the US dollar. In other words, it requires full foreign currency backing for Hong Kong dollar bank notes in circulation;
(b) In practice, Hong Kong dollar bank notes are over five times backed by the foreign currencies held in the Exchange Fund;
(c) Monetary reform measures have been introduced in the past ten years to strengthen Hong Kong's monetary system and put the authorities in a strong position to ensure exchange rate stability; and
(d) More recently, Asian central banks have entered into agreements to provide each other with liquidity in case of need. These take the form of bilateral repurchase agreements for US Treasury securities.
  1. The Hong Kong dollar's link to the US dollar is not vulnerable under speculative attacks. Hong Kong has strong economic fundamentals. Speculators typically also do not have Hong Kong dollars. They have to borrow to cover their Hong Kong dollar positions. As lender of last resort for Hong Kong dollars, the Hong Kong Monetary Authority will not lend cheaply, directly or indirectly, for this purpose. Financial institutions intermediating Hong Kong dollar funds have been put on notice and are on side. They are aware of the market and interest rate risks they may be exposed to in funding speculators.
  2. As would be the case in any other currency, the future of the Hong Kong dollar is in the hands of those holding Hong Kong dollar assets. For as long as they remain confident in the currency, confident in the system, confident in the determination and the ability of the authorities in maintaining that system, confident in the ability of the authorities to pursue prudent economic and budgetary policies, the link cannot be broken. And confidence must be pretty good when the risk premium of Hong Kong dollar debt issued by the Exchange Fund is only slightly higher than US Treasuries. The message from the market is clear.

Myth Number Five - Reserves Absorbed by China

  1. Myth number five: China covets Hong Kong's wealth; our substantial reserves will be absorbed by China. Again the Joint Declaration and the Basic Law contain clear safeguards:
(a) The Hong Kong Special Administrative Region shall use its financial revenues exclusively for its own purposes, and they shall not be handed over to the Central People's Government.
(b) The Central People's Government shall not levy taxes in the Hong Kong Special Administrative Region.
(c) The Exchange Fund of the Hong Kong Special Administrative Region shall be managed and controlled by the government of the Region, primarily for regulating the exchange value of the Hong Kong dollar.
  1. In any case China is, as at the end of June this year, the second largest foreign reserves holder in the world. China does not need Hong Kong's financial resources. But the myth went further to predict that China would exert influence on those who manage Hong Kong's Exchange Fund to hold Chinese Government or Renminbi debt, which would mean using the Exchange Fund to finance China's budget deficit. In this connection I would like to point out that:
(a) the Exchange Fund's investment policy is highly transparent and is published for public scrutiny;
(b) it is determined by Financial Secretary with the advice of the Exchange Fund Advisory Committee comprising leading figures in the monetary and banking fields;
(c) the Fund is professionally managed by the Hong Kong Monetary Authority and a handful of external managers;
(d) the Hong Kong Monetary Authority runs a stringent credit review system that rules out unacceptable credits;
(e) the Exchange Fund does not currently hold assets in currencies which are not convertible and not traded in major foreign exchange markets; and
(f) China is currently not a sovereign issuer on the list of acceptable credits in the investment policy of the Exchange Fund.
  1. I would not, however, rule out the possibility that in time China or the Renminbi may become acceptable credits under our investment policy. I sincerely hope that this day will come, just as we comfortably hold Gilts now. But I can assure you that when this happens, it will not be the result of pressure from China. And if ever there were such pressure, as Monetary Authority of Hong Kong, I will ensure that the people of Hong Kong and the international financial community will be among the first to be informed.

Myth Number Six - Deterioration of Regulatory Standards

  1. Let me turn to the sixth and final myth that financial regulatory standards will deteriorate as special privileges have to be given to Mainland interests. Let me echo what Deputy Governor Chen Yuan has said just now concerning Mainland financial institutions operating in Hong Kong. The playing field will not be tilted in favour of Mainland interests after 1997. The regulatory treatment of Chinese financial institutions in Hong Kong will follow closely the following principles:
(a) Chinese financial institutions will be treated as if they are foreign institutions in Hong Kong;
(b) Chinese banks operating in Hong Kong will continue to be supervised by the Hong Kong Monetary Authority in accordance with Hong Kong's policies and practices; and
(c) Chinese financial institutions operating in Hong Kong will enjoy no special privileges compared with other financial institutions.
  1. Now, you may be thinking that principles are all very well, but will they be applied in practice? The answer to this depends ultimately on the professionalism and integrity of those involved in regulation in Hong Kong. I am confident that my colleagues have the necessary qualities, but they need to be given the appropriate framework within which to work. This is why we established the Hong Kong Monetary Authority over three years ago - to enable the central banking functions within Hong Kong to be carried with the necessary expertise and continuity both before and after 1997. I think that it is fair to say that the Hong Kong Monetary Authority has achieved the necessary credibility amongst its fellow central bankers and the public at large to dispel the myth that there will be a vacuum in monetary and supervisory control in Hong Kong after 1997.
  2. Underlying the way in which we approach our responsibilities in the Hong Kong Monetary Authority is the need to ensure that Hong Kong retains its status as an international financial centre after 1997. Indeed, this is a requirement laid down in both the Joint Declaration and the Basic Law. We know that we will only achieve this objective if the 493 foreign banks from over 40 countries which are represented in Hong Kong feel that they are getting a fair deal from the regulators. This means that our supervision must be applied in an open, fair and consistent manner based on supervisory policies and practices which are in line with international standards. I can assure you that we do. More specifically:
(a) we meet fully the supervisory standards recommended by the Basle Committee on Banking Supervision;
(b) we have a clear framework which defines the powers and responsibilities of the regulators - we have this in the Banking Ordinance;
(c) we are very transparent on how the statutory framework will be interpreted and applied by the regulators, for example as regards licensing decisions - we have this in the Guide to Applicants for authorization under the Banking Ordinance which we published last year;
(d) we have a clearly defined mechanism for reaching supervisory decisions and judgments within the Hong Kong Monetary Authority so that there are appropriate checks and balances - we have this in the Banking Supervision Review Committee which advises me on major authorization decisions under the Banking Ordinance;
(e) we maintain a close dialogue with the industry through a number of active statutory advisory committees and the Hong Kong Association of Banks; and
(f) we offer guidance to the industry through statutory guidelines issued under the Banking Ordinance and a Code of Banking Practices which is in preparation.
  1. I believe therefore that we are highly conscious of our supervisory and other central banking responsibilities and have the means to ensure that they are carried out in an honest and impartial manner after 1997. In doing so, we will not stand alone. We will be able to continue to rely on the support of the banking community in Hong Kong and of the central banking fraternity of which we are now a part, including particularly the two other central banks represented here today - the Bank of England and the People's Bank of China. This seminar is a practical example of that support. I would like to extend my thanks to the Bank of England for hosting the seminar and to Governor Eddie George in particular for the guidance and support he has so kindly given me and the Hong Kong Monetary Authority over the years. I would also like to thank the People's Bank of China and the three note-issuing banks for taking part. This shows how we can work together to ensure that Hong Kong not only "survives" 1997, but actually goes from strength to strength.
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