Experience shows that the refinements introduced two years ago have worked as intended.
The HKMA introduced the three refinements to the Linked Exchange Rate system on 18 May 2005 to remove uncertainty about the extent to which the exchange rate may strengthen and help align Hong Kong dollar interest rates more closely with their US dollar counterparts. Now that two years have passed, have the three refinements achieved the intended results? What do the developments in the money and foreign exchange markets since May 2005 tell us about the credibility of the regime? The second anniversary of the three refinements is a good time for me to share my thoughts on these issues with readers.
In my view, developments so far suggest that the refined regime is more credible: the Hong Kong dollar spot exchange rate has decoupled from that of the renminbi, the 12-month forward exchange rate has moved inside the Convertibility Zone or stayed close to the strong-side Convertibility Undertaking, and the interest rate spreads have narrowed. I would argue that this is a remarkable achievement, especially considering how unusual the past two years have been: the renminbi was re-valued in July 2005 and has continued to appreciate through a number of psychological levels, by a total of more than 7%; this was also a period when political pressure on emerging market exchange rates was high and other regional economies experienced strong net capital inflows.
Although the Hong Kong dollar spot exchange rate stayed close to the strong-side Convertibility Undertaking in the latter half of 2005 and in 2006, the Undertaking was never triggered and the Aggregate Balance remained stable. Twice the exchange rate was only a few pips away from the Undertaking, but the exchange rate quickly depreciated away from it. In other words, the market did not test the resolve of the HKMA about honouring the Convertibility Undertakings.
Since early this year, however, the spot exchange rate has depreciated and moved beyond 7.8, the centre of the Convertibility Zone. Is the weakening of the Hong Kong dollar something that we should be worried about? Not really. In fact, because we now have a Convertibility Zone, I would not attach any particular significance to the position of the spot exchange rate within the Zone. Am I worried about the persistence of negative spreads of Hong Kong dollar interest rates compared with the corresponding US dollar interest rates? Yes and No. Yes, because I fear that if the gap closes abruptly, then firms and households and the financial system in Hong Kong might suffer from a large interest-rate shock, which is not good for financial stability. No, because a certain level of spread between Hong Kong dollar interest rates and US dollar interest rates is not inconsistent with a credible Convertibility Zone. Under the refined regime, the natural tendency for the interest rate spreads to become zero may not necessarily happen. It is the speed of change rather than the level of the interest rate spreads that concerns me more.
The experience so far shows that the refined system has worked well and gained credibility without us having to use the third refinement, which allows the HKMA to conduct discretionary monetary operations within the Convertibility Zone if we consider it necessary to remove market anomalies. In fact, intra-zone intervention only took place once to smooth out interest rate volatility induced by an IPO shortly after the three refinements were introduced. Since then, there has been no intervention, even during several very large IPOs in 2006.
But I think the HKMA's communication strategy did play a key role in shaping expectations. For example, it helped prepare the markets for the decoupling of the Hong Kong dollar from the renminbi. I have reiterated, through various means including this column, that the Hong Kong Government has no intention to use the renminbi as the anchor currency for the Hong Kong dollar. We published research papers containing analysis to support the argument that continuation of the peg with the US dollar is the most appropriate option given Hong Kong's economic and trade structure. HKMA staff in charge of market operations also maintained close communication with their market counterparts. These efforts helped to anchor market expectations and made the appreciation of the renminbi beyond the Hong Kong dollar spot rate a non-event.
While I am glad that the three refinements have achieved the intended objectives, I am mindful that two years is not a long time. It may take more time for market players to become used to the operations of the regime and for it to establish full credibility. For example, it remains to be seen how the spot exchange rate will behave when it is close to the weak-side Convertibility Undertaking. But I can assure you that the HKMA has both the will and the wherewithal to defend the Linked Exchange Rate system.
Joseph Yam
24 May 2007
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