Friday, May 20, 2005

WSJ : Goodbye to the 'Currency Board'

By GARY MOON-CHEUNG SHIU [Editorial writer for Apple Daily in Hong Kong]

May 20, 2005

Imagine you were an investor, then ask yourself the following question: with the wide interest rate differential between Hong Kong and the U.S., why shouldn't one borrow money in Hong Kong where interest rates are low, convert them into U.S. dollars and then invest these in the U.S. to reap higher returns?

With a "currency board" in place here in Hong Kong, that is exactly what is supposed to happen when interest rates diverge. The "arbitrage" you would have just performed would make interest rates rise in Hong Kong, while the increased abundance of dollars in the U.S. would make interest rates there drop. Such activities would thus restore the balance between the two places.

That has stopped happening in Hong Kong of late, however. A large inflow of hot money betting on the revaluation of the Chinese yuan has resulted in a local rate that is lower than the American one. The question is why?

The answer lies in a series of reform measures orchestrated by the Hong Kong Monetary Authority (HKMA) in 1998. In a bid to forestall future speculative attacks on the local currency following the Asian financial crisis, the HKMA introduced a host of reform measures aimed at mending loopholes in the currency board system that provided openings for speculators. One of those measures was the so-called Convertibility Undertaking.

Under this arrangement, licensed banks can convert Hong Kong dollars into U.S. dollars at the fixed exchange rate of HK$7.75 to US$1 through clearing accounts with the HKMA. But that is not all.

As the HKMA only allowed cash transactions, the extent to which the conversion could take place is limited. And therein lies the explanation of why the above arbitrage mechanism does not work this time round.

What the cash transactions requirement does is limiting peoples' ability to engage in arbitraging activities. For it will require an arbitrager to accumulate large amounts of cash to make such activities economically justifiable. And with arbitrage activities discouraged, an interest rate differential between Hong Kong and the U.S. will persist.

Now the perverse consequences of such interest rate differentials have surfaced. Signs of a property bubble are emerging amid a low interest environment here in the territory. To prevent such a property bubble from happening, HKMA recently extended its convertibility commitment. Now conversion of one U.S. dollar into the local dollar can take place within the HK$7.75 to HK$7.85 band. In other words, instead of correcting the malfunctioning of the interest rate arbitraging mechanism by getting rid of the cash requirement, HKMA has started tinkering with the exchange rate in a bid to restore the interest rate balance.

The major problem with this shift in approach is that the HKMA is gradually, without anyone noticing, transforming itself into a central bank. In the process, Hong Kong's arrangement is drifting further and further away from what an orthodox currency board system should look like. The main virtue of an orthodox currency board system is that it works under autopilot. Under such an arrangement, the government's hands are tied regarding monetary matters. Government discretion in monetary matters is thereby prevented and monetary stability ensured. The latest move by the HKMA, in creating an upper and lower exchange rate band within which it will intervene, puts some discretionary power back in the hands of the monetary authorities.

And this is not the first time. Back in 1999, in a paper entitled "The Importance of Being Orthodox", American economist Kurt Schuler wrote, "[t]he HKMA today looks more like a typical central bank than an orthodox currency board. It manages government funds, issues securities; lends to banks; supervises financial institutions; influences interest rates; intervenes in the foreign-exchange market; and in 1998 it even supported the stock market -- none of which a simple, orthodox currency board does, and some of which many central banks do not even do."

That's why we now use quotation marks when referring to Hong Kong's "currency board," because the territory's current monetary arrangements have turned the term into a misnomer. The latest act on the part of the HKMA only reinforces that belief.


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