FRBSF Economic Letter
99-36; November 26, 1999
Economic
Letter Index
Why Attack a Currency Board?
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
On October 23, 1997, a massive speculative attack took place against
the Hong Kong dollar. Interbank interest rates soared into triple digits,
and one-month interest rates hit 50%. Although high interest rates successfully
repelled this initial attack, it turned out that "Black Thursday" was
just the beginning. Major attacks also occurred in January, June, and
August of 1998. The prolonged period of high interest rates took a serious
toll on Hong Kong's economy, which is heavily dependent on the interest
rate-sensitive real estate and financial services sectors. Output declined
by over 5% during 1998.
But wait a minute. Doesn't Hong Kong have a currency board? Doesn't that
mean a speculative attack could never succeed and, therefore, should never
have occurred in the first place? After all, Hong Kong's foreign exchange
reserves are more than three times greater than the outstanding stock
of currency. Wasn't it rather quixotic of speculators to think that with
all those reserves backing up the Hong Kong dollar they could bring down
the currency?
This Letter will argue that there is a crucial and often neglected
characteristic of currency boards that is essential for their credibility
and success. Not only must there be sufficient reserves to back a well-defined
notion of the monetary base, but it must also be clear that these reserves
will be used if necessary. In other words, there is an important distinction
between the ability to defend a peg and the
willingness to defend a peg. There was never any doubt about
Hong Kong's ability to defend its peg to the U.S. dollar. Instead, the
attacks were precipitated by the market's suspicion that Hong Kong might
not be willing to defend the peg at all costs.
I will start by reviewing several institutional changes that took place
during the past decade which cumulatively had the effect of planting the
seeds of doubt about the willingness of Hong Kong to adhere to its peg.
Then I will review several more recent changes that seem to have restored,
or at least enhanced, the credibility of Hong Kong's currency board.
The evolution of Hong Kong's currency
board
China has always been important to Hong Kong's economy, so it is not
too surprising that for much of its early history Hong Kong linked its
currency to China's. Since China pegged to silver, so did Hong Kong. As
it turned out, however, the tide of history was against silver, and as
the rest of the world shifted away from bimetallism to a gold standard,
China's peg to silver became increasingly problematic. Large swings in
the price of silver led to large swings in the competitiveness of China's
and Hong Kong's exports. Then, in 1934, largely in response to domestic
political interests, the U.S. enacted the Silver Purchase Act, which aimed
to raise the world price of silver. The attempt to raise the price of
silver led to a massive outflow of silver from China and Hong Kong, which
translated into a contractionary force on their economies. Consequently,
in late 1935, both China and Hong Kong abandoned silver as a monetary
standard. Given its colonial status at the time, Hong Kong naturally turned
to the British pound as backing for its currency. This change was formalized
in the "Currency Ordinance" of 1935, which set up a fund (unimaginatively
called the Exchange Fund) to purchase silver from the public and then
sell it in London in exchange for pound sterling. The Exchange Fund continues
in operation to this day, and the Currency Ordinance remains its legal
basis of operation.
From 1935 to 1967, Hong Kong operated pretty much like a classic colonial
currency board, except that private banks, not the government, actually
issued the currency. Nonetheless, the assets of the Exchange Fund automatically
backed fully the note issues of the banks, since each note had to be backed
by a so-called Certificate of Indebtedness, which could be acquired only
by depositing (at zero interest) pound sterling at the Exchange Fund.
Unfortunately, beginning in the late 1960s, the international monetary
system began to unravel. One of the first signs of trouble was the forced
devaluation of the pound in 1967. Subsequent instability in the value
of the pound made it unattractive as a currency anchor. So, beginning
in the late 1960s, and with the permission of the British government,
Hong Kong took steps to switch to a U.S. dollar anchor. This involved
a gradual conversion of the Exchange Fund's assets from pound-denominated
securities to dollar-denominated securities.
As it turned out, this first attempt to peg to the U.S. dollar proved
to be short-lived. Like the pound before it, the U.S. dollar came under
attack in the early 1970s. In response, the U.S. decided to let the dollar
float, and it promptly began to sink. At this point, rather than attempt
to find a more stable anchor, Hong Kong decided to go with the crowd and
let its currency float too. Floating worked reasonably well for a while,
but as the Sino-British negotiations on reversion approached, speculation
against the Hong Kong dollar erupted. This speculation peaked during October
1983. The Hong Kong dollar depreciated so rapidly that authorities feared
it would produce a run on the banking system, which would have reinforced
the currency crisis. As a result, it was decided that the only way to
restore confidence in the financial system was to go back to a currency
board arrangement. So at the end of October 1983, Hong Kong ended its
experiment with floating exchange rates and announced that it was pegging
its currency to the U.S. dollar at a conversion rate of 7.8 to 1.0. Remarkably,
despite enormous changes in the political landscape and the world economy,
the peg endures to this very day.
From rules to discretion
During the early years of the restored currency board, the Exchange Fund
could influence liquidity in the banking system (and hence influence short-term
interest rates) in only two ways. One, it could use its reserves to intervene
directly in the foreign exchange market. Two, it could borrow and lend
directly in the interbank funds market. For a while, these limited tools
seemed to be adequate, and the currency board performed smoothly.
Starting in late 1987, however, the U.S. dollar began to depreciate sharply.
The weakness of the dollar led to speculation that Hong Kong would revalue
its currency. To maintain the peg, the Exchange Fund had to intervene
massively in the foreign exchange market to soak up the excess supply
of U.S. dollars. Paradoxically, while this intervention in itself certainly
did not create a problem for the sustainability of the peg (after all,
Hong Kong was gaining reserves, not losing them), it triggered a string
of "technical" changes in the operation of the currency board that gradually
increased the discretionary powers of the Exchange Fund. It was this gradual
move toward discretion that created the real threat to the currency board.
First, the Exchange Fund was not happy with the way interbank clearing
was done, and it wanted some way to "manage" interbank liquidity more
efficiently. Initially, all interbank clearing and settlement ultimately
took place on the books of a single private commercial bank--the Hongkong
and Shanghai Banking Corporation (HSBC). The government felt that this
was an antiquated system and that it created unnecessary volatility in
the interbank funds market. For example, private commercial transactions
of HSBC could influence the overall level of liquidity in the banking
system. So, in July 1988, a law called the Accounting Arrangements was
passed. This law required HSBC to open a clearing account with the Exchange
Fund. The balance in this account would then represent the net liquidity
of the banking system. Importantly, the Exchange Fund gained complete
discretion over the level of this clearing balance.
A second step toward discretion was taken in June 1992, when the Liquidity
Adjustment Facility (LAF) was established. The LAF was like a discount
window. It allowed banks to make late adjustments to their clearing accounts
through repurchase agreements with the Exchange Fund. Importantly, the
bid and offer rates at the LAF established floor and ceiling rates in
the interbank overnight funds market.
The third step toward discretion involved the establishment of a government
securities market. Hong Kong's government has typically run a surplus,
so there was little need, for fiscal reasons, to issue government bonds.
In the early 1990s, however, it was decided that a government securities
market would improve the functioning of Hong Kong's financial system.
Government securities would enhance firms' ability to hedge, and their
yields would provide an informative yield curve. By and large, their introduction
has indeed been quite successful along these dimensions. At the same time,
however, the existence of government securities allowed the Exchange Fund
to commence open market operations. Buying and selling government securities
is a more efficient way to manage bank liquidity than direct intervention.
The problem, from a credibility standpoint, is that the distinction between
managing liquidity and conducting discretionary monetary policy was becoming
increasingly unclear.
The line between liquidity management and monetary policy became even
more unclear in December 1992, when the Exchange Fund Ordinance was amended
and the Hong Kong Monetary Authority (HKMA) was born. Not only did the
HKMA take over operation of the Exchange Fund, but it also gained powers
of bank regulation. To outsiders, the new HKMA looked more like a central
bank than the passive overseer of a currency board.
Suspicions about the HKMA seemed to be confirmed in March 1994, when
it announced a change in operating procedures. Until then intervention
by the HKMA had been sporadic, taking place only in support of the peg.
Now the HKMA said it was going to target the interbank interest rate.
This is exactly how the Fed and other central banks behave. (Of course,
the peg placed constraints on the rate it could target, i.e., it couldn't
depart too much from the U.S. federal funds rate.) The switch to interest
rate targeting greatly increased the market presence of the HKMA and,
to many observers, was the clearest signal of all that perhaps Hong Kong
was not willing to defend the peg.
The HKMA puts its money where its mouth
is
At this point it is important to emphasize that these steps toward discretion
were the unintended consequences of well-meaning efforts to enhance the
operation of the currency board. No one believes Hong Kong was trying
to establish an independent central bank. Still, actions do speak louder
than words, particularly in the monetary policy arena, and the increased
ability and evident desire to target the interest rate sounded warning
bells in the market. The HKMA can set one price, not two, and it became
less and less clear that, if confronted with a choice between the interest
rate and the exchange rate, the HKMA would necessarily choose the exchange
rate. Thus, the attacks of 1997-98.
To their credit, the authorities in Hong Kong were quick to recognize
that they needed to enhance their credibility. Unlike some other countries,
they refrained (for the most part) from blaming speculators and instead
took positive and credible measures to convince them that they would lose
if they bet against the Hong Kong dollar (or, more precisely, that the
government would incur large costs if they succeeded).
After the fourth major attack in August 1998, a list of seven "technical
measures" was drawn up to increase the currency board's credibility. Two
were particularly important. First, under a so-called Convertibility Undertaking,
the HKMA announced that it was guaranteeing the U.S. dollar value of the
clearing accounts of all licensed banks. Essentially, the banks were given
a put option on their clearing accounts. This shifted a large amount of
currency risk from the banks to the HKMA. Now if the peg were abandoned,
the government would have to make up for losses on at least some of the
banks' Hong Kong dollar-denominated assets. Under Hong Kong's common law
system, this guarantee would be enforceable in the courts.
The second key measure was to allow banks to use Exchange Fund bills
and notes as collateral for discount window borrowing. In combination
with the Convertibility Undertaking, this second measure effectively guaranteed
the U.S. dollar value of all Exchange Fund paper. At the stroke of a pen
the currency board's monetary base doubled, since the combination of the
existing clearing balances and the outstanding stock of Exchange Fund
paper roughly equals the outstanding stock of currency. This means that
it will now take a much larger attack to produce a given increase in interest
rates.
These guarantees appear to have been successful. Virtually overnight,
the large spread between short-term Hong Kong dollar interest rates and
U.S. dollar interest rates disappeared. In addition, there has not been
a significant attack since these measures came into effect. Still, it
would be rash to argue that the HKMA's credibility problem has been resolved.
These measures were put in place as the Asian Crisis was ending.
It is not at all clear whether they would have prevented the
initial attacks. After all, the HKMA still has more discretionary powers
than it started with. The recent measures have only increased the costs
of inappropriately using this discretion. Would it perhaps not be better
to forsake discretion altogether?
Kenneth Kasa
Senior Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
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Research Department
Federal Reserve Bank of San Francisco
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