The Hong Kong Dollar: A Speculators Graveyard
So, why is there so much confusion and misunderstanding about exchange rates — particularly fixed exchange rates delivered by currency board systems, like Hong Kong’s? To answer that question, we must develop a taxonomy of exchange-rate regimes and their characteristics. As shown in the accompanying table, there are three types of regimes: floating, fixed, and pegged.
In fixed and floating rate regimes the monetary authority aims for only one target at a time. Although floating and fixed rates appear dissimilar, they are members of the same free-market family. Both operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a floating rate, a central bank sets a monetary policy, but the exchange rate is on autopilot. In consequence, the monetary base is determined domestically by a central bank. With a fixed rate, there are two possibilities: either a currency board sets the exchange rate and the money supply is on autopilot, or a country is “dollarized” and uses the U.S. dollar, or another foreign currency, as its own and the money supply is again on autopilot.
Under a fixed-rate regime, a country’s monetary base is determined by the balance of payments, and the base moves in a one-to-one correspondence with changes in its foreign reserves. With either a floating or a fixed rate, there cannot be conflicts between monetary and exchange rate policies, and balance-of-payments crises cannot rear their ugly heads. Floating and fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of- payments crises.
Most people use “fixed” and “pegged” as interchangeable or nearly interchangeable terms for exchange rates. In reality, they are very different exchange-rate arrangements. Pegged-rate systems are those in which the monetary authority aims for more than one target at a time. They come in many varieties: crawling pegs, adjustable pegs, bands, managed floats, and more. Pegged systems often employ exchange controls and are not free-market mechanisms for international balance-of-payments adjustments. They are inherently disequilibrium systems, lacking an automatic adjustment mechanism. They require a central bank to manage both the exchange rate and monetary policy. With a pegged rate, the monetary base contains both domestic and foreign components.
Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And when outflows become “excessive,” a central bank often attempts to offset the decrease in the foreign component of the monetary base by buying bonds, increasing the domestic component of the monetary base. Balance-of-payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange rate and monetary policies and force a devaluation, interest-rate increases, the imposition of exchange controls, or all three.
With Hong Kong’s currency board, the monetary base (reserve money) must be backed by foreign reserves — 100%, or slightly more. The accompanying chart shows that this so-called currency board “backing (or ‘stock’) rule” is strictly followed in Hong Kong. The “flow rule” — that reserve money must change in a one-to-one relationship with changes in the currency board’s foreign exchange reserves — is also strictly followed in Hong Kong (see the accompanying chart).
There has never been a system that followed currency board rules — like Hong Kong’s — that has been broken by a speculative attack. And Hong Kong’s will not be the first. Indeed, its currency board is operating exactly as it should, which is why it can’t be broken.
So, what will happen? When the U.S. Fed embraced quantitative easing, USDs flowed into Hong Kong. Now that the Fed has started to notch up the Fed funds rate, the flows have reversed. In consequence, the currency board is automatically tightening up, and both broad money and credit to the private sector are decelerating and are below their trend rates (see the accompanying chart).
This is just what is supposed to happen. We should expect a slow-down in the Hong Kong economy. But, the HKD will remain rock solid.