1. EF3461 The Economies of Mainland China and Hong Kong Tutorial 6 Hong Kong’s Monetary System City University of Hong Kong Dr. Isabel Yan

2. 1. HK’s Monetary System – the Currency Board System (Li(2003), Ch5) The Monetary System of HK: The monetary system in HK is the currency board system The monetary system in HK is the currency board system. It requires that any change in the Monetary Base (the sum of banknotes and coins, the balance of banks held with the HK Monetary Authority and the Exchange Fund Bills and Notes ) has to be fully backed by change in the Foreign Reserves at a fixed exchange rate.. It requires that any change in the Monetary Base (the sum of banknotes and coins, the balance of banks held with the HK Monetary Authority and the Exchange Fund Bills and Notes ) has to be fully backed by change in the Foreign Reserves at a fixed exchange rate. The currency board system was adopted in HK since October 1983 in order to stabilize the HK dollar during the confidence crisis over the political future of HK. The currency board system was adopted in HK since October 1983 in order to stabilize the HK dollar during the confidence crisis over the political future of HK.

3. Exchange Fund’s Foreign Reserve Monetary base

4. The Note Issuing Mechanism behind the Currency Board System: The Monetary Authority has authorized three private commercial banks to issue HK notes. They are: (i) Hong Kong and Shanghai Banking Corporation Limited (ii) the Standard Chartered Bank and (iii) the Bank of China. The Monetary Authority has authorized three private commercial banks to issue HK notes. They are: (i) Hong Kong and Shanghai Banking Corporation Limited (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 Monetary Authority’s Exchange Fund account and get the Certificates of Indebtedness ( ) in turn. Thus the Hong Kong monetary base (including the bank notes and coins, the balance of licensed banks maintained with the HK Monetary Authority and the outstanding Exchange Fund Papers) is fully backed by US dollar denominated reserve. 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 Indebtedness ( ) in turn. Thus the Hong Kong monetary base (including the bank notes and coins, the balance of licensed banks maintained with the HK Monetary Authority and the outstanding Exchange Fund Papers) is 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

5.  The linked exchange rate (HK$7.8=US$1) is maintained through an automatic arbitrage process which does not require the HK Monetary Authority to exercise any discretion: Capital inflow Market participants buy HK$ 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

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

7. 3. Advantages of a Currency Board System 1.Assure convertibility and hence increase public confidence All the HK dollars are fully backed by US dollars which enables the HK Monetary Authority to honor any demand for conversion. 2.Discipline over fiscal policy 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 cannot increase the money supply arbitrarily to finance fiscal deficits. 3.Provides a balance of payment adjustment mechanism 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 capital inflow, which leads to an improvement in the balance of payment account.

8. 4. Disadvantages of a Currency Board System 1.HK Monetary Authority loses the ability to exercise monetary policy Money creation is linked to the flows of foreign reserve which is determined by the external balance of payment. Not the HK Monetary Authority can determine the money supply. 2.HK Monetary Authority loses the ability to serve the lender of last resort function Currency board limits the ability of the authorities to extend domestic credit. This is because extending domestic credits violates the basic monetary rule under a currency board system of issuing domestic currency only in exchange for foreign currency. Thus domestic banking is left without a lender of last resort.

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

10. 5. Alternatives to the Linked Exchange Rate System  Delink Possible alternative exchange rate regimes: (i) Crawling peg/ crawling band (introduce a band which can be adjusted) (ii) Managed 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 lower level (i.e. devaluate HK dollar) Advantage: (most widely argued) (i) HK’s export becomes more competitive Disadvantages: Disadvantages: The political dimension of the re-peg can be important because there are winners and losers as a result of the re-peg:

11. (i) Imports will be more expensive (e.g.imported food, clothes). This hits the low-income earners especially the poor elderly the low-income earners especially the poor elderly (ii) HK dollar depositors will lose and those holding foreign currency will win – this hurts the less well off who only hold HK dollar. People with liabilities denominated in HK dollar will win. (iii) Foreign companies will enjoy lower cost of doing business in HK when expressed in terms of foreign currency. (iv)HK Government gets a windfall gain on its reserves which are in foreign currency. However, the HK civil servants will lose because their civil service pensions are in HK dollar.  Dollarization The substitution of the HK dollars by a foreign currency (in most cases, the US dollar) as the legal tender.