EF3461EF3461The Economies of Mainland The Economies of Mainland

China and Hong KongChina and Hong Kong

Tutorial 6Tutorial 6Hong Kong’s Hong Kong’s

Monetary SystemMonetary System

City University of Hong KongCity University of Hong KongDr. Isabel YanDr. Isabel Yan

1. HK’s Monetary System – 1. HK’s Monetary System – the Currency Board System (Li(2003), Ch5)the Currency Board System (Li(2003), Ch5)

The Monetary System of HK:The Monetary System of HK:• The monetary system in HK is the The monetary system in HK is the currency board systemcurrency board system

. It requires that . It requires that any change in the Monetary any change in the Monetary BaseBase (the sum of banknotes and coins, the balance of banks (the sum of banknotes and coins, the balance of banks held with the HK Monetary Authority and the Exchange held with the HK Monetary Authority and the Exchange Fund Bills and Notes ) Fund Bills and Notes ) has to be fully has to be fully backed by change in the Foreign Reserves at a backed by change in the Foreign Reserves at a fixed exchange ratefixed exchange rate..

• The currency board system was adopted in HK since The currency board system was adopted in HK since October 1983 in order to stabilize the HK dollar during the October 1983 in order to stabilize the HK dollar during the confidence crisis over the political future of HK.confidence crisis over the political future of HK.

Exchange Fund’s Foreign Reserve

Monetary base

The Note Issuing Mechanism behind the Currency Board System:The Note Issuing Mechanism behind the Currency Board System: • The Monetary Authority has authorized three private commercial banks to issue The Monetary Authority has authorized three private commercial banks to issue

HK notes. They are: (i) Hong Kong and Shanghai Banking Corporation Limited HK notes. They are: (i) Hong Kong and Shanghai Banking Corporation Limited (ii) the Standard Chartered Bank and (iii) the Bank of China.(ii) the Standard Chartered Bank and (iii) the Bank of China.

• The note issuing banks submit US dollars (at HK$7.8=US$1) to the Hong Kong The note issuing banks submit US dollars (at HK$7.8=US$1) to the Hong Kong Monetary Authority’s Exchange Fund account and get the Certificates of Monetary Authority’s Exchange Fund account and get the Certificates of Indebtedness ( ) in turn. Thus the Hong Kong monetary base Indebtedness ( ) in turn. Thus the Hong Kong monetary base (including the bank notes and coins, the balance of licensed banks maintained (including the bank notes and coins, the balance of licensed banks maintained with the HK Monetary Authority and the outstanding Exchange Fund Papers) is with the HK Monetary Authority and the outstanding Exchange Fund Papers) is fully backed by US dollar denominated reserve.fully backed by US dollar denominated reserve.

Hong Kong Monetary Authority

The 3 note-issuing banks

Submit US dollar

Get Certificate of Indebtedness to issue HK dollars at HK$7.8=US$1

Public

(including other commercial

banks)

M1: currency held by the public + demand deposits

The linked exchange rate (HK$7.8=US$1) is maintained through an The linked exchange rate (HK$7.8=US$1) is maintained through an automatic arbitrage processautomatic arbitrage process which does not require the HK Monetary which does not require the HK Monetary Authority to exercise any discretion:Authority to exercise any discretion:

Capital inflow

Market participants buy HK$

Upward pressure on HK$

exchange rate

(e.g.HK$7=US$1)

The note issuing banks sell HK$ in the market and buy US$ Get

US$1

Sell HK$7

HK Monetary Authority

Sell US$1

(buy certificate of Indebtedness)

Get HK$7.8

(Issue HK$)

HK’s monetary base expands and interest

rate falls

Stabilizes the capital inflow

2. Will the persistent fiscal deficits in HK affects the 2. Will the persistent fiscal deficits in HK affects the credibility of the currency board system?credibility of the currency board system?

The total reserves of HK consist of two parts:The total reserves of HK consist of two parts:

Fiscal reserves

About HK$300 billion as at Dec 2002

Exchange Fund reserves

About HK$989 billion as at Dec 2000

Use to finance fiscal deficits in HK

Use to back up the monetary base in HK

Total reserves

The fiscal deficits are financed by the fiscal reserves but not the Exchange Fund reserves. The two parts are completely separated from each other.

3. Advantages of a Currency Board System3. Advantages of a Currency Board System1.1. Assure convertibility and hence increase public Assure convertibility and hence increase public

confidence confidence All the HK dollars are fully backed by US dollars which enables the HK All the HK dollars are fully backed by US dollars which enables the HK Monetary Authority to honor any demand for conversion.Monetary Authority to honor any demand for conversion.

2.2. Discipline over fiscal policyDiscipline over fiscal policySince the issue of HK dollars require the availability of US dollar denominated Since the issue of HK dollars require the availability of US dollar denominated reserve which is determined by the amount of exports and capital inflow, HK reserve which is determined by the amount of exports and capital inflow, HK cannot increase the money supply arbitrarily to finance fiscal deficits.cannot increase the money supply arbitrarily to finance fiscal deficits.

3.3. Provides a balance of payment adjustment mechanismProvides a balance of payment adjustment mechanismBalance of payment deficits result in the reductions of the foreign reserve and Balance of payment deficits result in the reductions of the foreign reserve and hence drops in the money supply. This raises the interest rate and thereby attracts hence drops in the money supply. This raises the interest rate and thereby attracts capital inflow, which leads to an improvement in the balance of payment account.capital inflow, which leads to an improvement in the balance of payment account.

4. Disadvantages of a Currency Board System4. Disadvantages of a Currency Board System

1.1. HK Monetary Authority loses the ability to exercise HK Monetary Authority loses the ability to exercise monetary policymonetary policyMoney creation is linked to the flows of foreign reserve which is Money creation is linked to the flows of foreign reserve which is determined by the external balance of payment. Not the HK Monetary determined by the external balance of payment. Not the HK Monetary Authority can determine the money supplyAuthority can determine the money supply. .

2.2. HK Monetary Authority loses the ability to serve the lender HK Monetary Authority loses the ability to serve the lender of last resort function of last resort function Currency board limits the ability of the authorities to extend domestic Currency board limits the ability of the authorities to extend domestic credit. This is because extending domestic credits violates the basic credit. This is because extending domestic credits violates the basic monetary rule under a currency board system of issuing domestic monetary rule under a currency board system of issuing domestic currency only in exchange for foreign currency. Thus domestic banking currency only in exchange for foreign currency. Thus domestic banking is left without a lender of last resort.is left without a lender of last resort.

3. Sudden shocks may require internal adjustments due to the 3. Sudden shocks may require internal adjustments due to the inflexibility of the exchange rate inflexibility of the exchange rate

Sudden shocks that trigger sharp depreciation of the currencies of HK’s Sudden shocks that trigger sharp depreciation of the currencies of HK’s export competitors requires a download adjustment of HK’s internal export competitors requires a download adjustment of HK’s internal price/cost in order to maintain competitiveness. HK cannot gain price/cost in order to maintain competitiveness. HK cannot gain competitiveness through an exchange rate depreciation. competitiveness through an exchange rate depreciation.

5. Alternatives to the Linked Exchange Rate System5. Alternatives to the Linked Exchange Rate System DelinkDelink

Possible alternative exchange rate regimes:Possible alternative exchange rate regimes:

(i) Crawling peg/ crawling band (introduce a band which can be adjusted)(i) Crawling peg/ crawling band (introduce a band which can be adjusted)(ii) Managed float(ii) Managed float(iii) Free float(iii) Free float Disadvantage: Which should HK choose? Disadvantage: Which should HK choose?

Keep the linked exchange rate system, but re-peg HK dollar to a Keep the linked exchange rate system, but re-peg HK dollar to a lower level (i.e. devaluate HK dollar)lower level (i.e. devaluate HK dollar)Advantage: (most widely argued)Advantage: (most widely argued)

(i) HK’s export becomes more competitive(i) HK’s export becomes more competitive Disadvantages: Disadvantages: The political dimension of the re-peg can be important because there are The political dimension of the re-peg can be important because there are winners and losers as a result of the re-peg:winners and losers as a result of the re-peg:

(i) (i) Imports will be more expensive (e.g.imported food, clothes). This Imports will be more expensive (e.g.imported food, clothes). This hits hits

the low-income earners especially the poor elderlythe low-income earners especially the poor elderly

(ii) (ii) HK dollar depositors will lose and those holding foreign currency HK dollar depositors will lose and those holding foreign currency will will win – this hurts the less well off who only hold HK dollar. People win – this hurts the less well off who only hold HK dollar. People

with liabilities denominated in HK dollar will win.with liabilities denominated in HK dollar will win.

(iii) (iii) Foreign companies will enjoy lower cost of doing business in HK Foreign companies will enjoy lower cost of doing business in HK when expressed in terms of foreign currency.when expressed in terms of foreign currency.

(iv)(iv) HK Government gets a windfall gain on its reserves which are in HK Government gets a windfall gain on its reserves which are in foreign currency. However, the HK civil servants will lose foreign currency. However, the HK civil servants will lose

because because their civil service pensions are in HK dollar.their civil service pensions are in HK dollar.

DollarizationDollarization

The substitution of the HK dollars by a foreign currency (in most cases, the The substitution of the HK dollars by a foreign currency (in most cases, the US dollar) as the legal tender.US dollar) as the legal tender.