Linked Rate Mechanism
Hong Kong’s currency was linked to mainland China’s silver dollar until 1935 when the value of silver became unstable. It then switched to a sterling standard, which remained until sterling became unstable in the early 1970s, and it was floated from 1974 until the currency crisis of 1983. As editor of the Asian Monetary Monitor at the time, I proposed linking the Hong Kong dollar to the US dollar. This system was adopted and has worked well for 28 years, but recent instability in the US economy has raised questions about its future.
Instead of going over familiar arguments for keeping the US dollar link, I should first point out that Hong Kong is in a monetary union with the United States. Europe’s monetary union, of course, is currently faced with unprecedented pressure, which may end in the exit of one or more of the participants, or even the break-up of the union itself.
Why has the European monetary union come under such immense stress after only 12 years of existence? Why is Hong Kong’s monetary union with the US more robust?
Economists have always cited these criteria for a successful monetary union: labour mobility; openness, capital mobility and price/wage flexibility; a central fiscal transfer mechanism to redistribute income; and similar business cycles between the participant economies. These are, in my opinion, necessary but not sufficient conditions for a successful union.
Based on Hong Kong’s experience, there are eight criteria for success: wage/price flexibility; labour and capital mobility; limited welfare state; fiscal discipline; strongly capitalised banks; banks maintaining ample liquidity; low household debt; and low corporate debt.
The first three conditions are necessary for an optimal currency area; the next five are needed to avoid bubbles or busts. Essentially, they require that the balance sheets in the major sectors – government, banks, households and non-financial corporations – must not be allowed to become so over-leveraged as to precipitate a crisis. Hong Kong limits the build-up of leverage. Consequently, when a bubble bursts in Hong Kong, negative equity in the household sector or corporate bankruptcies will be limited.
In terms of fiscal discipline, since 1983 the Hong Kong government has maintained an average annual budget surplus of 1.4 per cent of gross domestic product, deliberately accumulating in good times a fiscal reserve that can be run down in recessions. The virtue of fiscal prudence has been repeatedly emphasised by successive financial secretaries of Hong Kong.
Banks in Hong Kong today generally maintain capital ratios of 14-18 per cent. Banking supervision in the territory is widely admired in Asia, and loan underwriting standards are carefully monitored. Since 1991 Hong Kong has limited household leverage by imposing a maximum loan-to-value ratio of 70 per cent (recently tightened) on all residential mortgage loans by banks; the city has never permitted the 120 per cent “Ninja” loans – no income, no job or asset – of the kind seen in the recent US and British housing bubbles.
In addition, since November 2010, loan-to-value ratios have been extended to commercial property loans, effectively restricting all property-related leverage. Since it is predominantly companies that buy commercial property, this restriction limits corporate debt.
Applying these rules to, say, Greece’s troubled economy; it is clear what it – and other peripheral economies in the euro zone – needed to do in order to be viable members of the monetary union.
One could say that European Monetary Union had been too lax in applying the Maastricht convergence criteria, which included a maximum 3 per cent budget deficit and a maximum 60 per cent government debt-to-GDP (gross domestic product) ratio and a maximum CPI (consumer price index) inflation rate.
The maintenance of a fixed exchange rate is not a purely technical matter. In Hong Kong’s case, the authorities have long taken the view that while the exchange rate is fixed, the economy must be as flexible as possible, but that alone is not enough. They have therefore sought to ensure, in addition, that Hong Kong’s institutions are as robust as possible in order to ride out the inevitable external shocks.
I believe these eight fundamental rules accurately convey the spirit of the monetary and financial regime that Hong Kong is currently attempting to operate.
I know some in Hong Kong are investigating the idea of linking HK dollar to a “basket of currencies”, but I basically agree with those who, like former government economist K C Kwok, argue: “Hong Kong has many other problems to fix and Hong Kong should not focus on fixing this one. If it is not broken, don’t fix it!”
John Greenwood (祈連活)
Chief Economist of Invesco (景順集團首席經濟師)
27 October 2011
The above article was published in South China Morning Post INSIGHT Page on 27 October 2011. It is reproduced with South China Morning Post’s permission.
Reproduction of the article requires written permission from the author.