The US dollar interest rate increase

Our linked exchange rate system means that Hong Kong dollar interest rates are closely tied to those for the US dollar. Past experience suggests, however, that we should not overstate the disadvantages that this might bring.

The larger than usual 50 basis point increase in US interest rates on Tuesday has, understandably, raised questions in some circles about the appropriateness of a fixed exchange rate as the objective of monetary policy in Hong Kong. With Hong Kong dollar interest rates tied closely to those for the US dollar, the concern is, of course, whether this week's development will undermine the current recovery of the Hong Kong economy.

In the viewpoint article of 6 April entitled "US and Hong Kong economic cycles" I did discuss this subject, somewhat in anticipation of such questions being raised again. I concluded then that while Hong Kong would best be served by no interest rate hikes at all, the cautious approach to interest rate hikes in the US would likely give adequate time for our economic recovery to gather greater momentum and put us in a better position to absorb the burden of higher borrowing costs.

In a little over a month since then we have certainly seen stronger signs in our economic recovery. Available indicators show the year-on-year growth rate of GDP in the first quarter at possibly double digits, with this momentum likely to be sustained into the second quarter. Indeed, notwithstanding strong productivity gains as the new economy emerges in Hong Kong, the unemployment rate has been steadily falling. The public finances are looking better and better almost by the day. And all this is not exerting any noticeable pressure on consumer prices. Furthermore, the effect of higher interest rates on borrowing costs has been helpfully dampened by the competitive forces in the banking sector and by some inflow of capital. Indeed, despite the successive increases in interest rates in recent months, the economy has been recovering much more quickly than most analysts had earlier expected.

I accept, however, that US monetary policy, which we import through our linked exchange rate system, may not always be appropriate for Hong Kong, given that the economic cycles of the US and Hong Kong may not always be in sync. At particular moments in the past the linked exchange rate system may even have appeared to some to be damaging the economy, for example, because of associated inflation, in particular asset price inflation under the influence of negative real interest rates, or below-trend growth. But the accompanying doubts about its appropriateness for Hong Kong have always proved to be unfounded. The generally enviable overall economic performance of the Hong Kong economy over the past 17 years of history with the linked exchange rate - a period not without highly destabilising events - speaks for itself. And given also Hong Kong's proven track record of internal flexibility, there is little reason why the linked exchange rate system should now be a significant brake on underlying economic prospects.

The historical experience throughout the region suggests, furthermore, that interest rates for most currencies are affected by fluctuations in US dollar interest rates, regardless of whether the currencies in question are linked to the US dollar. It should not be assumed that abandonment of the fixed exchange rate would immunise Hong Kong against the impact of US dollar interest rates.

Joseph Yam
18 May 2000

More information on the Linked Exchange Rate System can be found here.

Related article:

• US and Hong Kong Economic Cycles (6 April 2000)

Click here for previous articles in this column

Document in Word Format