The first anniversary of the three refinements

inSight

18 May 2006

The first anniversary of the three refinements

The three refinements to the Linked Exchange Rate system introduced in May 2005 have worked well in the year since their introduction.

A member of the financial press reminded me that today is the first anniversary of the three refinements to the Linked Exchange Rate system. I am glad that she remembered this and considered it newsworthy. She told me that a great majority of her colleagues thought that the three refinements were working well and their introduction two months before the announcement of the reform to the renminbi exchange rate system demonstrated foresight on our part in maintaining monetary stability in Hong Kong. I have to admit I was flattered by her comments.

Of course, doing our job is not a reason for celebration. But the comments from this journalist did make me wonder how events would have unfolded had we handled the matter differently. There were plenty of people who had doubts about the refinements when we introduced them. This was understandable, since any change to monetary arrangements, however well planned, will always affect markets and may be subject to all sorts of interpretations. There were also alternatives that could have been pursued at that time. But, one year on, we are reasonably sure that, in the absence of the three refinements, monetary conditions would have remained very easy and, with US interest rates having continued to increase since then (the federal funds target rate has been raised 16 times in a row since June 2004), the interest rate gap between the Hong Kong dollar and the US dollar would have become even wider than it was before the refinements were introduced. Whether the inevitable catch-up would have been completed by now is anybody's guess, but we are reasonably sure that the much bigger interest rate gap would have made the catch-up much more destabilising, particularly to borrowers but possibly also to lenders, who are affected by the ability of borrowers to pay back their loans.

Had the three refinements not been introduced, the Hong Kong dollar would have been a much more popular proxy for market participants to take speculative positions on the renminbi. The shifts of sentiment about the renminbi exchange rate would have been reflected in considerably more volatile monetary conditions in Hong Kong. Exchange rate stability is very much a matter of market confidence in the exchange rate policy, the mechanism for achieving stability, and the ability of the responsible institution to deliver it. The maintenance of exchange rate stability therefore depends on how well market expectation is anchored. By introducing an explicit Convertibility Undertaking on the strong side, the three refinements served to anchor exchange rate expectation at a critical moment, when reform of the renminbi exchange rate policy was about to be unveiled. The market will find an explicit Convertibility Undertaking a lot more credible than mere words and assurances from officials, even if they are supported by sound economic arguments.

Nevertheless, we must be realistic and recognise that financial markets sometimes chose to believe only those statements or undertakings that help to justify the market positions being taken. I certainly hope that the three refinements will continue to anchor expectation firmly. This seems to have been the case for the past year. Earlier this week, the renminbi exchange rate passed through the psychological level of eight to the US dollar and this had no noticeable effect on the exchange rate of the Hong Kong dollar. Perhaps this will also be the case if the renminbi passes through another psychological level of 7.80. We will, as always, be watching the market closely, as the factors affecting the renminbi exchange rate continue to evolve: political pressure from the developed markets; progress in the Mainland's monetary and financial reform, including further liberalisation in the capital account; and developments in the current account balance. As I have mentioned before, the Mainland economy and its current account do not seem to be that sensitive to changes in the exchange rate. Under a flexible exchange rate system, one should therefore not expect the current account surplus to be resolved by exchange rate appreciation alone. Now seems to be a good opportunity to liberalise the capital account further and allow the large pool of domestic savings to seek higher risk-adjusted rates of return overseas.

So no celebration, and we remain vigilant.

Joseph Yam

18 May 2006

Click here for previous articles in this column.

Document in Word format

Latest inSight
Last revision date : 18 May 2006