The recent movements in the market exchange rate for the Hong Kong dollar show how easily sentiment can reverse itself.
Sentiment in financial markets does have the habit of being slow in picking up signals of change in the fundamentals but fast in making 180 degree turns when triggered by the most unlikely of events. History is full of these sudden market reversals. The best seems, to the extent that I can recall, to be the reversal in the stock market in 1973, when the bubble was pierced by the Fire Brigade sending in an inspection team to the stock trading floor out of concerns about fire safety there. More recently we had the reversal of sentiment towards the exchange rate, although this was brought about by the more relevant event of political pressure building up for a revaluation of the renminbi.
Only weeks ago, the focus had been on deflation, unemployment and a ballooning budget deficit undermining the long-term viability of the Linked Exchange Rate system. Indeed, there had been calls for freeing up the exchange rate and allowing it to depreciate, assuming that this would be the inevitable direction that the exchange rate would follow, thereby enhancing competitiveness, eliminating deflation, boosting economic growth, diminishing unemployment and correcting the budget deficit. What a panacea! The risks of the elasticity of the balance of payments, the economy and the unemployment rate to exchange rate changes being fairly low, and the strong tendency of the foreign exchange market to overshoot to the extent of endangering financial stability and socio-economic order were all dismissed or conveniently ignored. Those advocating the maintenance of the status quo were, rightly, worried about budget-deficit-induced market pressure on the exchange rate translating into high interest rates hurting borrowers and inhibiting economic recovery, thereby eroding support for the Linked Exchange Rate system. Market sentiment, therefore, had clearly and understandably been bearish on the exchange rate. This is notwithstanding the firm policy commitment to maintaining the Linked Exchange Rate system, the robustness of the Currency Board system in delivering this objective, the abundance of foreign reserves, an international investment position relative to GDP being the highest in the world, and the non-existence of official external debt. Indeed, for some time, there had been a significant forward premium on the exchange rate, although its size varied with the coming and going of people, and the occurrence of whatever events considered by the market, in its unpredictable mood, to be relevant.
The openness of our markets made it convenient for the taking of short positions against the currency, for the purposes of hedging or speculation, or from whatever other motives. These have, in fact, been substantial. Anybody interested in the subject should have noticed the big jump in the balance of payment surplus in the current account in 2002 that has been sustained into the first half of this year (although the surplus declined to some extent in the second quarter of this year because of SARS). The surplus is equivalent to about 11% of GDP for the year 2002 as a whole and around 13% for the second half of the year. In dollar terms, we are talking about Hong Kong earning a net US$1.5 billion of foreign exchange every month, or US$18 billion a year. Just stop and think where all this foreign exchange has gone. I suspect the majority has ended up in the hands of those who have gone short in Hong Kong dollars, for one reason or another, through one channel or another. This is not all. We in the HKMA have been funding withdrawals from the fiscal reserves by the Treasury, in relation to the budget deficit, by selling US dollar assets held in the Exchange Fund for Hong Kong dollars - about US$8 billion in the past twelve months. One can imagine the extent to which market players, investors, and others, have shorted or shifted out of Hong Kong dollars.
But another way of looking at the matter is the extent that they have been oblivious of the underlying improvements in the economy, in particular in its competitiveness and its ability to earn foreign exchange, which have been observable for over a year now. Perhaps SARS is partly to blame. And so, notwithstanding the improvements in the fundamentals, the short Hong Kong dollar position continued to build up. Then the sharp reversal came, in the context of the political pressure to appreciate the renminbi, or introduce greater flexibility in the determination of its exchange rate. The read-across to the Hong Kong dollar, and the realisation that the Hong Kong economy was not doing that badly after all, led to a scramble for covering short positions. And so the Hong Kong dollar strengthened, sharply by the standards of our Linked Exchange Rate system, and the forward premium became a forward discount in a matter of a few hours.
I am sure that the market will calm down soon. In the meantime, no doubt there will be critical comments again on the asymmetry in the manner in which we operate the Currency Board system, in that there is no formal convertibility undertaking on the strong side of the Link. But then there is no harm to have a bit of constructive ambiguity, if only for the purpose of making those shorting the Hong Kong dollar realise that this is not so much of a one-side bet. We are in the business of ensuring exchange rate stability, not bailing out currency speculators.
Joseph Yam
2 October 2003
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