To Peg, or Not to Peg?

Current Policy in Hong Kong

During the last currency crisis in 1983, Hong Kong abandoned the floating exchange rate system which had been in place since 1974. The new system linked the HK dollar to the US dollar in the ratio of HK$7.80 to US$1. In effect, this meant that every additional HK dollar issued must be covered by an equivalent value of US dollar at the official rate. In practice, the system has been fairly successful in stabilizing the HK dollar. This success is as good a reason as any in the choice of exchange rate and monetary systems. Still, some of the theoretical and practical aspects of the current system merit closer examination.

One of the justifications for the fixed exchange rate system hinges on an automatic adjustment mechanism which is presumed to exist in the economy. If a country exports more than it imports, its foreign currency reserves will increase. Exporters will sell the foreign currency to buy the local currency, and hence local money supply will increase. Consequently, domestic spending and therefore prices (inflation) will rise. Over time, the exporters will become less competitive as costs rise, and will gradually lose their export business. Ultimately, the country may even suffer a trade deficit, leading to a reduction in foreign currency reserves. This will reduce domestic spending and prices, thereby raising international competitiveness. This automatic mechanism is more often known as the specie-flow mechanism in the field of international monetary economics and dates back to the Scottish philosopher David Hume. In theory, it should ensure that Hong Kong does not persistently accumulate or lose foreign currency reserves beyond desirable levels. The reduction of reserves is especially worrying, because it may be the underlying cause of a currency crisis.

There is no successful theoretical model for the real multi-currency world with capital flows. These are two of the essential features of today's world, and indeed, of Hong Kong's small, open economy. The theoretical model above only focusses on two currencies fixed in a constant ratio to each other.

In reality, while the HK dollar is pegged to the US dollar, it floats against all important currencies. Secondly, there is no guarantee that the above mechanism will work when capital account transactions (such as stock and real estate) are as important as current account transactions. For Hong Kong, much evidence suggests that transactions in assets (capital account) are as significant as normal trade (current account). Besides the above two theoretical considerations, the very different rates of inflation between Hong Kong and its key trading partners also suggest that the mechanism may not be working as postulated.

Dr. George Hui, lecturer at the University's Department of Finance, has launched a research project that focusses upon inflation in Hong Kong and its exchange rate policy. Entitled `Exchange Rate Policy of a Small Open Economy in a Multi-currency World with Capital Flows', the project won a competitive grant of HK$266,000 from the Research Grants Council in 1993.

Dr. Hui's project covers both the theoretical and practical aspects. For the former, the two essential features mentioned earlier are being built into the specie-flow models to see if the major predictions of the model are still valid. The latter examines whether or not the modified mechanism still applies to Hong Kong. With fixed exchange rate systems of the Currency Board variety being revived in countries like Russia, Bulgaria, Estonia and Argentina, such a project will generate interest beyond its immediate environment.