Hong Kong’s Money Panic
Around midday on Friday September 23rd, 1983, the latest round of Sino-British talks in Peking on the subject of Hong Kong’s future concluded. Very quickly it became apparent in Hong Kong that no progress had been made. The announcements that were were no announcements sparked a run on the Hong Kong dollar. The currency, which had slid to HK$8.40 per US dollar on the previous Monday, ended Friday’s trading at HK$8.83.
On Saturday morning the panic developed with the currency being quoted between HK$9.00 and HK$10.00 per US dollar, depending on where you went. The official (T/T rate) close was HK$9.60 per US dollar at the end of Saturday morning’s session. By mid-morning however, most banks and currency dealers had run out of US dollars and there were enormous lines at the major gold dealers’ windows as the people of Hong Kong rushed to convert their Hong Kong money into real assets.
The panic continued over the weekend and by Sunday afternoon all stores had been cleaned out of rice and cooking oil, and in most supermarkets there were enormous gaps on the shelves as people stocked up on storable goods in anticipation of higher prices the following week. On Sunday evening the government made a vague announcement that it would “do something” to stabilize the Hong Kong dollar. The following Monday morning the banks raised the prime rate by 3% — to 16% — and the currency “stabilized” around the HK$8.50 level where it remained in an increasingly nervous environment awaiting the government stabilization scheme.
On Saturday, October 15th, Hong Kong’s financial secretary, Sir John Bremridge, announced a stabilization package which effectively pegs the exchange rate of the Hong Kong dollar to HK$7.80 per US dollar. The measures he announced are not a simple fixing of the exchange rate — as is common in many other countries — but rather a “return to the gold standard” except that the US dollar rather than gold is the asset backing the Hong Kong dollar.
In a world of paper currencies — in John Exter’s words “IOU nothings” — the Hong Kong dollar is unique. It is a currency with no visible means of support. Its unique supply mechanism means that it is a currency with a potentially infinite supply; the uncertainty surrounding Hong Kong’s future means that the currency potentially has zero demand. If uncorrected there will inevitably be a rapid panic flight from the currency, resulting in an uncontrollable runaway inflation in Hong Kong dollars. The beginnings of such panic were seen on September 23rd and 24th: it is inevitable that such a panic will resume at some unknown time in the future, unless the government manages to stabilize the currency.
Even without the political factor — the possibility that China will resume Hong Kong in 1997 or before — the monetary structure of the Hong Kong dollar ensures that the currency will steadily decline against the US dollar and other stronger monies. It is for this reason that the Worl Monday Analyst has been consistently negative on the Hong Kong dollar since August of 1981, well before Mrs. Thatcher’s visit to China and Hong Kong in August of 1982 turned the question of Hong Kong’s future into an immediate political issue. The consequent uncertainty resulted in a rush out of Hong Kong dollar-denominated and Hong Kong-located assets, which, by culminating in September’s currency panic, dramatically revealed the underlying fundamental weakness of the Hong Kong dollar.
The plight of the Hong Kong dollar is exhaustively analyzed in the special Worl Monday Analystreport, The Emperor Has No Clothes, so here I’ll only highlight the most glaring flaws in Hong Kong’s monetary system.
The issue of the Hong Kong dollar differs from other paper currency administrations in two important respects. First, there is no central bank in Hong Kong and therefore what would be considered the monetary base in say, the United States, consists in Hong Kong only of banknotes. Elsewhere, two items constitute the monetary base: banknotes and accounts with the central bank. The actual printing and distribution of Hong Kong banknotes has been licensed by the government to two private banks: The Hongkong and Shanghai Banking Corporation and the Chartered Bank. To increase their note issue, the note-issuing bank must purchase from the government’s Exchange Fund a “Certificate of Indebtedness” (CI). To purchase a CI — a license to print more banknotes — the note-issuing bank must deposit with the Exchange Fund either foreign currency or Hong Kong dollars. When they deposit Hong Kong dollars they simply credit in the government’s account with themselves the appropriate number of Hong Kong dollars. In this transaction the Exchange Fund is passive; that is, it does not have a “monetary policy,” it simply issues CIs whenever the banks demand them.
The monetary base of Hong Kong’s total money supply is controlled by the two note-issuing banks, who expand the note issue whenever the market demands an increase in the number of banknotes. At no time does the monetary base in Hong Kong act as a restraint on total monetary growth: if money ever became “tight” in Hong Kong, the note-issuing banks would simply exchange a part of their Hong Kong dollar assets for the right to increase the banknote issue, thus increasing the monetary base and so enabling the expansion of the other forms of money (M2 etc) to continue apace.
The second flaw, however, ensures that money will never become “tight” in Hong Kong. Just as the note-issuing banks can expand the monetary base at will, so any Hong Kong bank can expand its own reserves at will. One of the assets a Hong Kong bank can count among its reserves against deposits is “money at call outside the colony.” This however, is not a net item. A Hong Kong bank may owe a million dollars to its New York correspondent bank, and at the same time be owed the same amount from the same bank. Only one side of the balance sheet is counted: the one million dollars the Hong Kong bank is owed by its New York counterpart. Thus, when any bank is short of lendable funds, it simply arranges to borrow, say, a million US dollars from its New York of London head office or correspondent. It then simultaneously lends that million dollars back to the New York or London bank. It has thus created literally from thin air “money at call outside the colony”: it has added to the reserves it must hold against its deposits and it has therefore increased its ability to lend Hong Kong dollars — to create credit.
Demand for credit
As a consequence, the regulator of Hong Kong’s total supply of money — banknotes, bank deposits, etc. — is demand for credit. If demand for credit increases, the banks are immediately able to meet that demand. As the Hong Kong dollar inexorably declined, people and businesses in Hong Kong changed their currency assets so as to be owning US dollars and other foreign currency, but to be owed Hong Kong dollars. As more and more people retained their foreign currency revenues in US dollars, yen, etc., and used those (and other) assets as collateral for Hong Kong dollar-denominated loans with which to make local payments, the supply of Hong Kong dollars continued to rise as the demand for Hong Kong dollars simultaneously fell. Thus began a process which is self-sustaining: indeed, self-fulfilling. As the Hong Kong dollar declined, people became increasingly reluctant to hold Hong Kong dollars — even the man in the street has access to savings accounts in US dollars through most Hong Kong banks — so declining demand for the local currency came from all sectors of the population, not just the wealthy and corporations.
The unlimited availability of credit has other effects. For example, in the years 1979 to 1981 Hong Kong, along with the rest of the world, experienced a property boom. However, the boom in Hong Kong was much greater in terms of price increases for property than anywhere else.
The reason: purchasers of property had unlimited availability of funds from the banks and finance companies with which to buy Hong Kong property.
As is always the case in a boom, nobody ever thinks the boom will come to an end; so bankers were quite willing to lend money to property purchasers in the firm expectation that prices would continue to rise: therefore their money was safe.
You have probably read about the Carrian group, the greatest bubble since the original South Sea bubble in the 1700s. Carrian was a creature of Hong Kong’s unique monetary structure. The company’s promoters initiated a couple of spectacular property deals, and accompanied by rumors of enormous financial backing from either the Marcos family of the Philippines, or rich Malaysian or other overseas Chinese, had no trouble in borrowing any amount of money from Hong Kong’s banks. Easy money fuels a boom, and during a boom lenders don’t ask enough questions. The monetary consequence of all this: in 1982 Hong Kong’s M2 measure of the money supply grew an incredible 77%. Such monetary growth inevitably leads to the depreciation of the currency either in terms of other currencies or in terms of purchasing power — or both.
Thus, Hong Kong’s unique monetary structure ensured the Hong Kong dollar’s decline against the US dollar and other currencies. The Hong Kong dollar is not unique in this respect: all currencies are depreciating in terms of purchasing power due to the political consequences of the government’s money monopoly. In the United States, “monetary policy” is a political football which always results in monetary expansion to finance profligate politicians and bureaucrats. The mechanism is different: the consequences are the same.
Into this monetary mixture comes the political factor: the question about Hong Kong’s future and what will happen in 1997 or before. The price of every commodity, a heading which includes currencies, is determined by the factors of supply and demand. In the case of the Hong Kong dollar, the monetary structure ensured a potentially infinite supply. On the demand side of the equation, the political factor altered a declining demand to a demand of potentially zero.
Every fiat paper currency in the world is only as good as the government that issues it. When the issuer disappears — for example, the government of the Confederate south in the US civil war, or the government of South Vietnam — the currency also disappears and becomes completely valueless. Thus the scepter hanging over the Hong Kong dollar was the potential absorption of Hong Kong into China with the consequent disappearance of both the Hong Kong government and its currency.
Is such a fear valid? Or was September’s monetary panic simply an expression of nervousness resulting from recurrent uncertainty about Hong Kong’s future?
There is an enormous amount of confusion surrounding the current Sino-British negotiations and the status of Hong Kong. For example, one British newsletter predicted the possibility of another war “à la the Falklands” over Hong Kong: i.e., that Britain might defend Hong Kong militarily from a Chinese takeover. Or in the words of a subscriber from New York: “I just can’t believe that anyone would let the communists take over capitalist Hong Kong. How can what I’m reading in the press be true?”
The facts are quite different. There’s no way Mrs. Thatcher or any other British prime minister is going to go to war over Hong Kong. As the Japanese invasion of Hong Kong in 1941 showed, Hong Kong is militarily indefensible to a thrust from the mainland. In answer to our friend from New York. Yes, the chances are the communists will take over Hong Kong in 1997 or before and that this capitalist haven will cease to exist, certainly in the way we know it now.
Spoils of war
Victoria Island — the island also known as Hong Kong — was ceded “in perpetuity” to the British in 1842. The cession was part of Britain’s “spoils” of the opium war of 1841. The Kowloon peninsular was ceded in 1860, also “in perpetuity.” In 1989, the New Territories — the bulk of Hong Kong’s land area — was leased for 99 years to Britain, a lease that expires June 30th, 1997. The cession of Hong Kong to Britain was but one of many privileges the strong western nations of Britain, France, the United States, Russia, Germany and later Japan, wrested from a weak and dying Chinese empire. Following the communist victory in China’s civil war all the other vestiges of western imperialism, such as the treaty ports of Shanghai and elsewhere, were simply swept away, leaving Hong Kong and Macau as the only pieces of Chinese territory occupied by foreign powers.
Center of the world<
China is the oldest continuous civilization in the world. When Portuguese, Dutch and other western adventurers first appeared on the China coast they were treated the same as any other uncultured barbarians: as wishing to give their allegiance and tribute to the “son of heaven,” as the Emperor was called, and to glory in and learn from the accomplishments of the greatest civilization in the known world. From the Chinese point of view, China was the center of the world and everything else was either subservient to it or not worth knowing about.
Westerners received short shrift in China until, as a consequence of the industrial revolution, British naval and military power substantially exceeded that of China. So in 1841 began a series of depredations upon the Chinese body politic backed by superior military force. The weakening Chinese empire was effectively carved up by a variety of western powers. The Chinese call all the treaties signed by successive governments from 1841 onwards “unequal treaties,” as they were signed under duress: if the Chinese government did not sign the treaties requested by the west, they would have suffered further invasion by western military might. Indeed, under British common law, a contract signed under duress can be set aside by a court. The unequal treaties, including the cession of Hong Kong island and Kowloon peninsular and the lease of the New Territories would, were they to be considered by a Hong Kong court, be set aside as being contracts signed under the threat of force, and therefore null and void!
Until superior British and western military force eroded the powers and rights of a declining and rigid Chinese government, the Chinese people viewed the rest of the world through rose-colored glasses of cultural superiority to the barbarians — whether those to the immediate south (in Vietnam, Thailand or Burma), or the red-headed (or long-nosed) barbarians from Europe and the Americas.
I believe that this attitude of cultural superiority continues, though to a somewhat lesser degree. It is reinforced not only by thousands of years of tradition, but also by the isolation of the mainland Chinese from the rest of the world. It is reflected in the attitudes of westernized Chinese, in the degree of pride in the regeneration, albeit under communist leadership, of China’s power and prestige around the world.
Be that as it may, China’s attitude to the west is still colored by its cultural history. Add to this the ideological superiority of Marxists facing the “decadent capitalism” of the west; plus the indubitable successes of the communist regime, from defeating US-supported Chiang Kai-shek to rolling back US troops in North Korea, to the deference that China now receives from both the United States and the Soviet Union: all are factors in China’s attitude to the west — specifically to China’s attitude to the British and Hong Kong.
Under British occupation. From the Chinese point of view, Hong Kong is Chinese territory temporarily occupied by the United Kingdom. This attitude is expressed in a variety of ways, For example, when the Chinese airline, CAAC, advertises its route structure, Hong Kong appears with the words “UK occupied.” When mainland nationals depart for Hong Kong they receive an internal permit to move from one province to another; not an exit permit allowing them to leave the country. Similarly, in negotiating airline landing rights in Hong Kong, Peking treats Hong Kong as a domestic destination: CAAC runs about 60 flights a week from Hong Kong to six or more Chinese cities, while British Airways has one weekly flight to Peking and Cathay Pacific has two to Shanghai.
In many other ways, the Hong Kong government signals its subservience to China. For example, Chinese contractors are given licenses to tender and build in Hong Kong with little more than a cursory inspection of their finances and abilities, while contractors from other countries and from Hong Kong itself, undergo a stringent investigation before any license is issued.
Finally, we should consider another factor contributing to Peking’s attitude towards Hong Kong: its self-perception of its ability to run Hong Kong after 1997 in much the same way as Hong Kong is run now. China’s ageing leaders have no experience of the west; the younger generation has been brought up on a diet of Marxist “economics.” From the Marxist point of view, capitalism is an inferior form of social system which will inevitably be replaced by socialism and communism. Hong Kong’s demise as a capitalist heaven is inevitable; whether it be from the inexorable march of history or China’s resumption of its sovereign rights is surely of little consequence.
To a person trained in Marxist economics at a Chinese university, living in isolation from the west, understanding capitalism from the teachings of Marx and Mao Tse-tung, the conclusion that a communist regime could take over the administration of a capitalist economy like Hong Kong, without jeopardizing its prosperity and stability, must appear glaringly self-evident. Indeed, the Chinese student of Marxist economics would conclude that Hong Kong’s economy could only improve as a result of the change of administration.
“We managed Shanghai…”
Thus in China we have a complex of attitudes which results in the apparently counter-productive pronouncements that emanate from Peking on the subject of Hong Kong’s future. These pronouncements are only counter-productive when seen from the westerner’s point of view; or from the point of view of the Chinese who escaped Shanghai in 1949. Indeed, in private conversation with a western journalist, a Peking official summed up the Chinese attitude with the following words: “We managed Shanghai in the 1950s; there’s no reason why we can’t manage Hong Kong after 1997.”
The western reaction — whether from Hong Kong, London or Washington — has been to treat the Chinese statements as if the Chinese do not mean what they say. Rather, westerners have generally viewed Hong Kong’s obvious value to China as a reason for assuming that China would prefer Hong Kong to remain as it is — meaning remain under British administration — rather than jeopardize those material benefits. The westerner’s attitudes take the following sequence (and in parentheses I have outlined the Chinese reaction, based on what I perceive to be, as enumerated above, the Chinese world view).
Depending on the estimate, China earns between 30% and 40% of its total foreign exchange from its sales to Hong Kong. Most of these sales are products like pigs, milk, vegetables, water and other daily necessities for the Hong Kong market which could not be sold anywhere else for hard currency. The majority of other such sales to Hong Kong are goods for re-export which are channeled through Hong Kong, because Hong Kong companies have the expertise, markets and other know how to take Chinese products and sell them elsewhere in the world. [Probable Chinese reaction: under our administration such sales will continue and since Hong Kong will be a more prosperous society, with a convertible currency, there is no reason to assume that anything will change — except for the better.]
Window on the west
Hong Kong is a place where Chinese firms can invest and trade and learn the ways of the capitalist west. Indeed, China has a significant investment in Hong Kong by way of banks, property companies, factories, trading companies, retailers and a variety of other businesses. It also uses Hong Kong to surmount the rigidities within the communist system which make it difficult to meet deadlines and quality control standards. Therefore it is in China’s monetary interests to maintain Hong Kong as it is. [Probable Chinese reaction: same as above.]
In the event of a Sino-Soviet conflict, the Soviet Union could easily blockade all China’s ports — the Chinese navy is certainly no match for the Russians’. However, the Russians could not blockade Hong Kong while it remains a British colony without declaring war on Britain, and therefore NATO including the United States. Hong Kong is not only the best deep water harbor on China’s coastline, it also has the most advanced docking and transportation facilities. China could thus beat such a Russian blockade by shipping tons of supplies through Hong Kong’s container terminal, load it onto railway wagons and freight it to any part of China via Canton. [China’s probable reaction: In such a circumstance, perhaps Hong Kong’s current status would prove an advantage. However, we believe the resources of the Peoples Liberation Army, and the one billion people of China motivated by the experience of Mao Tse-tung and the Long March and the war of liberation against Chiang Kai-shek would enable us to withstand and defeat any Russian assault.]
A significant portion of Hong Kong’s exports — primarily textiles — are made under a variety of quota arrangements with the United States, Europe and other countries. Although represented by Britain, Hong Kong is treated as a separate country for trade and quota purposes. If Hong Kong is absorbed by China, its status as a separate country will cease and therefore its quota entitlements will become part of China’s entitlement rather than a separate and additional amount. [China’s probable reaction: Hong Kong is Chinese; 98% of the people are our brothers; we will be much more vigorous in looking after Hong Kong’s interests than British imperialists on the other side of the globe.]
One of China’s major foreign policy objectives is to conclude the civil war by reabsorbing Taiwan [called Taiwan province by both communist and nationalist regimes] into China proper. It therefore behooves China to be very cautious and conciliatory in its negotiations over Hong Kong, since Hong Kong’s fate beyond 1997 will substantially influence the attitude of the Taiwanese people to any possible reintegration. [Probable Chinese reaction: it is therefore imperative that we reintegrate Hong Kong into China to show our Taiwanese brothers that, based on Hong Kong’s example, they too can have confidence and maintain their lifestyle and separate economic system when they rejoin the motherland, just as we are promising that the people of Hong Kong will maintain their unique lifestyle under our rule.]
In other words, there’s a significant and probably unbridgeable gulf between the attitudes of China and the west (in particular the British negotiators in Peking) on how Hong Kong would fare if China resumes sovereignty and administration in 1997. I think it would be easier to convince the Reagan administration of the inevitable inflationary dangers that $200 billion deficits will wreak on the US economy and the US dollar than to convince China’s leaders that Hong Kong’s economic viability — including monetary advantages to Peking — depends on the continuation of the status quo.
Probably the overriding consideration, however, is the question of sovereignty. The Chinese have made it clear that sovereignty over Hong Kong is a non-negotiable issue. Their view is that the expiry of the lease in 1997 is merely a convenient time for them to publicly resume the sovereignty they claim now. Although they do not acknowledge the validity of the lease — it is an “unequal treaty” — they do appear willing to concede the timing of the takeover (July 1, 1997) in deference to the United Kingdom. They state that sovereignty and administration are indivisible — and they’re correct.
The issue is the same as ownership versus control: if you own something but cannot control its use and disposal, you do not have full rights of ownership. China thus rejects the possibility of extending the lease; or employing the British to administer the territory past 1997. [Even if the British were so employed, the fact that they were employed would imply that Peking would retain the right of veto over any decision their employees made.]
The full force of this point can only be understood by realizing that any Chinese leader — whether it be Mao Tse-tung or Deng Hsiao-ping or his successors — would be sent to the countryside for re-education regardless of his power, were he to sign any extension of the 1898 “unequal treaty.” Imagine that through some quirk of history, the British had retained a lease over the island of Manhattan at the end of the American revolution. Any American president or congressman who agreed to the continuation of such a lease upon its expiry would be impeached, or otherwise hounded out of office. They you’ll understand where the Chinese “are coming from.”
It seems to me inevitable that China will resume Hong Kong in 1997 (or before). The only remaining question is whether Hong Kong’s free market system will be destroyed immediately — or slowly.
Why Hong Kong works
Hong Kong has been held up by many people as the shining example of the free market in operation. Hong Kong owes its economic success primarily to two factors which create a framework in which individuals are free to pursue their own destiny. As Adam Smith pointed out 200 years ago, when let alone, the operation of the market — “the invisible hand” — inevitably results in the continual expansion of wealth over time. The two primary factors:
1. The British system of law, which means that property rights are respected, contracts can be made by free and mutual consent and if need be enforced, and every individual, rich or poor, is free to keep the fruits of his own labors and use and dispose of them as he sees fit; and,
2. British colonial administration, which, “mired” in the philosophy of Britain’s 19th Century laissez-faire policies — and, because of Hong Kong’s unique situation, not having to prepare the territory for independence — simply continued its “hands-off” policy (albeit with minor exceptions). In the past 15 years the Hong Kong government has become much more activist, but since it is growing from a much smaller base, it remains relatively smaller than governments elsewhere in the world with the consequent benefits that lower intervention brings.
It is difficult to see how British law can continue in Hong Kong following the assumption of sovereignty by China. There would inevitably be changes as the Chinese introduce features of their legal system to Hong Kong, with a consequent increase in the number of exceptions and distortions of the basic respect of property rights and the law of contracts.
Secondly, whether the Chinese appointed their own governor, or whether, as is being mooted, the administration of Hong Kong would be by local people (appointed by Peking), government intervention would inevitably increase removing many of the distinct features that make Hong Kong the economic success it is. This is happening anyway as the Hong Kong government slowly expands its social welfare and other interventionist programs, but under a change of administration it would happen more quickly. Inevitably, Hong Kong’s distinct, relatively free-market economy will take on more of the features of the socialist economies of western (or eastern) Europe, and the only question open to debate is the speed with which this will happen.
Since the overwhelming majority of the Hong Kong population either escaped themselves from the communist regime or are the sons and daughters of people who did, it is hard to believe that these refugees from communism will take the mainland’s pronouncements about their future security at face value. The very fact that the run on the Hong Kong dollar began immediately following the conclusion of one round of the Sino-British negotiations shows the true feelings of Hong Kong’s man-in-the-street. While the government may be able to stabilize the exchange rate of the Hong Kong dollar, it will not be able to stem the flow of funds and assets out of Hong Kong. Given my analysis, it should be clear that those individuals who were selling Hong Kong dollars or Hong Kong assets for other currencies and assets were the people who were (and are) acting rationally. It is thanks to Hong Kong’s relatively free market that even the poor “man-in-the-street” can act upon his own instincts rather than listening to the misleading, misinformed, or bare-faced lies of their supposed superiors.
The political situation warrants a continued negative attitude towards the Hong Kong dollar and all Hong Kong assets. However, the government’s stabilization scheme may have insulated the Hong Kong dollar from the negative political consequences of the Sino-British talks. I say may reservedly: in the final analysis, should the Hong Kong government disappear its currency will become valueless regardless of any scheme or arrangement for the currency’s issue. It is possible however, that in the meantime the linking of the Hong Kong dollar with the US dollar especially the way it has been done, may stabilize the rate “until the last minute.”
It’s instructive to compare the actions of the market place — in other words, hundreds of thousands of Hong Kong citizens selling their currency short — with the statements of government officials and prominent Hong Kong citizens. Most comments especially those of the officials of the department of monetary affairs showed an incredible ignorance of monetary theory in general, and of the structure of the Hong Kong dollar in particular.
The booby prize for the most banal and uninformed comment must be awarded to a prominent, multi-millionaire Chinese businessman. He suggested the cause of the Hong Kong dollar’s decline was that Hong Kong people traveled too much! He seemed to think travel is a superfluous luxury for the lower classes — and were such travel to be curbed a significant outflow of money from Hong Kong would be stemmed.
A widespread misconception which was repeated by many people, from the governor of Hong Kong down, was an analysis that suggested the Hong Kong dollar’s exchange rate should be rising rather than falling, since Hong Kong’s exports are going up in response to the US recovery. It’s widely assumed that the value of the currency is related in some direct way to the resources of the country, or the volume of goods and services produced. Thus you’ll often hear comments like: “The US dollar is backed by the enormous wealth-producing capacity of the United States economy.” This is utter nonsense: there is no relationship between the amount of money issued, or printed, or created, and changes up or down in the wealth of a country. If this kind of relationship did exist in reality, then it would have been impossible for a currency like the Mexican peso, “backed” by all that oil, to have declined so precipitously at a time when the value of oil was rising.
However, if the monetary authority takes such a view, then there is an obvious policy prescription: do nothing, and simply wait for the “inevitable” recovery of the currency (precisely what the Hong Kong government was planning to do until September’s panic showed the error of its ways).
A related misconception, also widely broadcast from government, financial and industry leaders, was the notion that the Hong Kong dollar was somehow “undervalued.” Indeed, the secretary of monetary affairs, Douglas Blye, went so far as to state that the “true value” of the Hong Kong dollar was HK$6.50 per US$. Since the Hong Kong dollar is a currency with a potentially infinite supply, there is no restraining factor on the exchange rate. Any price could be its “true value,” as the supply of Hong Kong dollars would quickly adjust to any rate determined by the market. It is therefore impossible for the Hong Kong dollar to be “undervalued” — or “overvalued.” However, as with the first analysis, if you believe that the currency is undervalued then the correct action is to do nothing and await for the fundamentals to assert themselves.
Given the first two assumptions, the obvious conclusion was the Hong Kong dollar suffered from an over-reaction to the slow progress of the Sino-British talks on Hong Kong’s future. From the time of Mrs. Thatcher’s visit to Hong Kong in August 1982 until September of this year, government officials continually reiterated their logical conclusion: the Hong Kong dollar’s exchange value was suffering from an unwarranted crisis of confidence; people should stop panicking, we were told, “have confidence” in Hong Kong, its economy, its currency and its future — and everything including the exchange rate would return to normal.
Of course the people of Hong Kong didn’t buy the government’s argument: they saw the Hong Kong dollar falling, and the lower it went the more people began to bail out. Both the price level and the rapid changes in that level signaled to the market the fundamental weakness of the Hong Kong dollar. Those who listened to the market rather than to official pronouncements reaped their just rewards.
If you do not live in or deal with Hong Kong, you are probably wondering on the relevance of this tale of woe to you and your situation. Treat it as a cautionary tale: it will probably happen to your currency in the next few years.
The significance of the government’s reaction to the declining currency, is that government monetary policy is based on a theory, or an analysis of the situation. If that analysis is mistaken, if the theory is wrong, or inapplicable, then the action of the government will consequently worsen rather than improve the currency’s decline.
“Not enough money!”
For example, during the German hyper-inflation of the 1920s, it was widely believed that there was not enough money in circulation! The prescription was to increase the rate at which money was printed! Government officials and prominent economists thought there was insufficient money because the total amount of money in circulation — the total money supply — was declining as a percentage of nominal gross national product. Ergo, more not less money was required.
The reality is somewhat different. A hyper-inflation or monetary panic is a flight from the currency. Holders of the currency scramble to get rid of their money for any tangible assets, whether gold or groceries. In an ongoing runaway inflation as the German hyper-inflation was, this scramble becomes institutionalized; people are paid daily, or hourly and immediately rush out to spend their money before it declines further in purchasing power. Prices are changed every day or hour, or are indexed to some other unit such as the US dollar. The economic terminology for this phenomenon is that the “velocity of circulation” has increased dramatically. [Money does not actually have velocity; the correct terminology is: the turnover of the money supply has increased. That is, the number of times in a year that each dollar or mark or shekel changes ownership, rises dramatically. Or to put it another way, individuals reduce to almost zero the time that they are willing to hold any unit of the currency.]
This has the same effect as if the money supply had actually been increased, as the same number of banknotes are now doing substantially more work. The correct prescription is to stop printing money, not increase the speed of the printing presses. The general lack of knowledge of monetary theory and practice is not confined to economists; it is almost universal. It is therefore almost inevitable that any governmental authority, anywhere in the world, will incorrectly analyze the problem and the solution when faced with a monetary panic. The precise possibilities being limited, perhaps, to the number of economists — but the chances are that the prescription will be mistaken nonetheless.
Take, for example, the continuing decline of the Israeli shekel. Israel’s finance minister proposed “dollarization” as a solution. Very simply, he wanted to institutionalize what the market had already done: effectively replaced the shekel with the US dollar.
The Israeli government decided that it was more important to have the prestige (?) of its own currency than to solve its monetary problems — should the solution involve utilizing somebody else’s currency like the US dollar.
An American associate once asked me why should we be concerned about a runaway inflation in the United States, when countries like Argentina, France, Israel and many others continue to function, despite high rates of currency depreciation. The answer is really very simple: the Argentine or Israeli economy can continue to function despite price inflation rates of between 100% and 300% per annum, because the US dollar is used as a parallel currency. Also, of course, the institutional framework has accommodated itself to rapid inflation with a wide variety of payments from social security benefits to interest rates being indexed to the consumer price index (or the US dollar exchange rate).
As long as the US dollar is relatively stable, the US dollar provides the people of Argentina or Israel with the store of value attribute that the local currency has lost. In other words, instead of there being one currency, there are two “half-currencies”: The US dollar serving certain currency functions such as a haven for savings, while the local depreciating unit serves as a means of hand to hand payment. Were hyperinflation to come to the United States, there is no currency available within the United States to serve the function the US dollar now serves elsewhere: as a substitute currency, for certain functions that the depreciating unit has lost.
The consequences of a flight from the US dollar are much more drastic than inflation in the Israeli shekel. In addition to the US economy grinding to a halt, the economies of central and south America, Israel, and elsewhere would be deprived of their most important currency — the one that allows them to maintain a semblance of stability. Of course, the market would probably adjust fairly rapidly and replace the US dollar with gold and/or silver as the store of value and price fixing currency.
Ironically, the people who would be most devastated by a collapse of the US dollar would be all those people in communist countries from Vietnam to Poland, who have managed to squirrel away a few US dollars from the black market. To the people of such countries, the United States and therefore its currency, stands as a symbol of the freedom that they desire and lack. The disappearance of a purchasing power of their hard-earned savings would probably be the most tragic consequence of a US dollar collapse.
It is impossible to predict the precise details of the mistaken analysis government will make when faced with a currency panic. We can only predict that the chances are the analysis will be mistaken. It therefore follows that any government action, based on that mistaken analysis, will tend to increase the currency’s instability rather than solve the problem. This was, in effect, my conclusion about the Hong Kong dollar in The Emperor Has No Clothes.
There are always exceptions to any “rule,” especially when the “inevitable” is a consequence of human action. A currency, its issuing mechanism, plus all the influences that go into determining its exchange rate and purchasing power, are all the results of (perhaps unintended) human action. Any unpleasant consequences of human action — like a currency panic — can be corrected by appropriate human action.
Basically, four factors need to be present for a currency panic to be stopped and reversed:
1. The existence of a person (or persons) who has correctly analyzed the situation and, as a result of their analysis, formulated a prescription for the government or the appropriate monetary authority to follow.
2. It is also a prerequisite that this person(s) is respected and will therefore be listened to, as opposed to a person who may be correct, but is treated with skepticism by the establishment.
3. The officials of the monetary authority must have sufficient humility to realise that they don’t know what to do, and therefore be willing to listen to an outside proposal.
4. And, there must be no significant pressure group who would stand in the way of monetary reform.
These four factors were fortuitously in existence in Hong Kong — but not Israel. In Israel, the finance minister had a valid proposal (1) but it appears that he himself was not respected (2) or listened to (3) and there was considerable immediate hostile opposition from a variety of different sectors of Israel’s body politic (4). In particular, the opposition party, in league with the trade unions, threatened to make the “dollarization” into an immediate and significant political issue. As I mentioned earlier, the prime minister and his cabinet clearly decided that the national prestige of having one’s own currency, no matter how poor a currency, was of much greater importance than having monetary stability.
If the stabilization package for the Hong Kong dollar succeeds — and failure will be primarily due to the political uncertainty about Hong Kong’s future rather than the package itself — then the two primary causes are Hong Kong’s unique political structure as a colonial bureaucracy rather than a pressure group-dominated democracy, and the activities of a single man, John Greenwood.(1)
Pressure group politics does of course exist in Hong Kong, but since the government does not have to answer to any constituency, it can when it chooses prepare measures in complete secrecy and simply announce them without consultation or debate — or the opportunity for any opposition to mobilize itself. Whether the government takes advantage of this situation for good or ill is an entirely different question.
In the case of Hong Kong’s monetary panic, for well over five years John Greenwood has been explaining the flaws that exist in Hong Kong’s monetary structure to anyone willing to listen. As the government officials searched in desperation for a means of avoiding a continual currency crisis, it was almost inevitable that they turn to John Greenwood for advice. Assistance was sought from the Bank of England and finally, the Hong Kong government implemented the only scheme which, under the political circumstances, has any chance of stabilizing the Hong Kong dollar’s exchange rate. To give credit where credit is due, probably few of the officials fully understand the complexities and details of the scheme that they have implemented. (As a generality, ignorance of monetary theory and practice is an almost insuperable barrier to monetary reform — a currency crisis with the accompanying official desperation is almost a prerequisite for monetary reform, but is not a guarantee that reason will prevail).
You will recall that I outlined two major flaws in Hong Kong’s monetary structure: flaw #1 was that Hong Kong’s monetary base — the banknote issue — could be expanded without any limitation simply by the actions of the two note-issuing banks. Flaw #2 was that any bank could create its own reserves by expanding “money at call outside the colony.”
The government’s stabilization package — inspired by John Greenwood’s analysis and prescription — effectively eliminates flaw #1. Following Saturday, October 15th, the note-issuing banks were required to give foreign currency at a fixed rate of US$1.00=HK$7.80 to purchase additional Certificates of Indebtedness from the Exchange Fund. In other words, the banknote issue can only increase when the market’s demand for Hong Kong dollars exceeds the demand for foreign currency from holders of Hong Kong dollars. That’s another way of saying when the “balance of payments” is in surplus. (Of course if it’s in surplus, then it’s not in balance, but never mind that fine point.)
While there is no fixed link between the bank’s liabilities and the amount of cash it must hold as a part of its reserves (cash being one of a number of items banks can hold as reserves against their deposits) a bank is forced to maintain a fixed rate of exchange between cash and its cheque accounts and savings deposits. This is simply a different way of saying that cheque and savings deposits are redeemable on demand in cash. When a bank cannot meet its customers’ demand for cash it experiences a run and usually goes into bankruptcy. In the normal course of events, bank runs occur when a specific bank has overextended itself and becomes seriously illiquid. In the course of day-to-day business, a bank must maintain a certain amount of cash as a prudential reserve against its deposits. Over any business day, customers will deposit cash and withdraw cash. The ratio will fluctuate: on some days the bank will have to pay out more cash than it receives; on other days it will be the reverse. At certain times of the year — Christmas for example, or in Hong Kong, the Chinese New Year holiday — the public’s demand for cash as a percentage of their total money holdings will rise. Banks must hold sufficient amounts of cash in their vaults to meet the most abnormal day-to-day cash requirements of the public. Otherwise, the members of the public with accounts at that specific bank will question whether their demand deposits are in fact equivalent to cash and attempt to force the bank to make good its promise to pay out such deposits in cash on demand.
Most western countries such as the United States, Australia, United Kingdom and so on, have a central bank which directly controls the monetary base. In these countries, where there is a central bank, the monetary base consists of two assets: cash, and accounts at the central bank. In Hong Kong without a central bank, the monetary base consists of only one asset — cash. While the government has not specified a percentage of bank deposits which banks must hold in monetary base assets, prudential requirements dictate that banks do hold a certain percentage of deposits in cash: that percentage is normally 1.5%-2% of their total deposits. Through this prudentially related linkage, the restriction on the growth of the Hong Kong banknote issue also acts as a restriction on Hong Kong dollar credit.
When US dollars “flow” into Hong Kong and Hong Kong residents convert these US dollars into Hong Kong dollars, the note-issuing banks take some or all of these US dollars to the Exchange Fund to purchase Certificates of Indebtedness. Note-issuing banks can thus increase the amount of cash in Hong Kong’s monetary system, which allows the banks to increase their credit by a multiple of that expanded note issue. If the reverse occurs — if Hong Kong residents on balance sell Hong Kong dollars to purchase US dollars, the note-issuing banks may take those Hong Kong dollars to the Exchange Fund to purchase US dollars. When that happens, the appropriate number of Certificates of Indebtedness are cancelled — Hong Kong dollar banknotes are withdrawn from circulation, shrinking the banknote issue and thus putting a squeeze on the banks’ ability to create credit. Whether the note-issuing banks go to the Exchange Fund or the market to buy or sell US dollars depends on whether the free market rate is over or under the fixed Exchange Fund rate.
The free market rate continues to fluctuate according to the usual market forces. However, the restraint on that fluctuation comes from the fixed link between the note-issuing banks and the Exchange Fund, and the consequent arbitrage of the marketplace.
Say the Hong Kong dollar trades at HK$7.60/US$. The note-issuing banks could purchase one US dollar for HK$7.60 in the market; take that one US dollar to the Exchange Fund and purchase the right to issue new banknotes to the amount of HK$7.80 — thus making a profit of 20c. If the currency is trading above the central rate, the market is saying “there aren’t enough Hong Kong dollars to go around at HK$7.80,” and the effect of the arbitrage is that the note-issuing banks respond to the market’s “request” by increasing the banknote issue.
If the reverse occurs, and the Hong Kong dollar is trading at around HK$8/US$, the mechanism will result in a shrinkage of the banknote issue. The note-issuing banks will take HK$7.80 to the Exchange Fund to purchase one US dollar which it can then sell on the market at HK$8, a 20c profit. When the Exchange Fund receives the HK$7.80, those banknotes are withdrawn from circulation and destroyed, reducing Hong Kong’s money supply.
The overall consequence is that US monetary policy is now also Hong Kong’s monetary policy. If the US Federal Reserve substantially expands the US money supply, the US dollar will depreciate against the Hong Kong dollar. The note-issuing banks will expand the note-issue to bring the rate back to HK$7.80/US$. In the process Hong Kong’s monetary base will expand at the same rate as the US money supply.
If at any time there’s a run on the Hong Kong dollar, the exchange rate will fall to, say, HK$8/US$. As the note-issuing banks begin to contract the monetary base, there will be a “squeeze” on the availability of Hong Kong dollars, and this will be reflected in a rise in interest rates. Theoretically, this rise in interest rates will attract short-term money from offshore, attracted by higher-than-US dollar rates of return. The offshore demand for Hong Kong dollars will offset the decline in domestic demand, forcing the rate back to around HK$7.80 without substantial expenditure of the Exchange Fund’s foreign currency holdings. Of course, the greater the Exchange Fund’s sale of foreign currency, the greater the contraction of Hong Kong’s money supply, and the higher interest rates would go. However, in a situation of severe panic — very bad news from Peking — in which people would not wish to hold Hong Kong dollars at any interest rate, the consequences of fraction-reserve banking (and in Hong Kong’s case, flaw #2) could come into play.
When you clean up a messy situation, it usually pays to do a thorough job. Why leave a dirty corner in the room, as it were — or only clean around the furniture?
Hong Kong’s banks can still create their own reserves, limited only by the prudential requirement to hold a percentage of the only scarce reserve asset (cash) against their liabilities. This percentage is not specified: rather, it’s the minimum percentage each bank, individually, decides it needs to hold against its day-to-day customer activity.
Now, Hong Kong’s banks will be pulled between two divergent forces. One: their continued ability to create their own reserves and thus to create credit without limit — the more money a bank can lend, the higher its profits. Two: the need to own a scarce resource (cash) as a percentage of its total liabilities (including its newly-created credit).
The inevitable result: banks will attempt to economize on their need for the scarce resource. If, hitherto, they had held 1.5%-2% of their deposits in cash, they’ll attempt to reduce that to 1%-1.5% or less by improving their banknote management. This means that the vulnerability of Hong Kong’s banking system to a run will significantly increase.
Banking system run?
Recall that bank deposits are a claim on a bank for cash; and that in Hong Kong, now, cash is a claim on the Exchange Fund (via the note-issuing banks) for US dollars. If very bad news comes from Peking and the public begins to sell Hong Kong dollars en masse, they may decide that because of the official link between Hong Kong dollar banknotes and the US dollar, that they’d be safer having their money in cash than in the bank. The consequence would be a colony-wide bank run, affecting the entire banking system.
I admit that such a scenario is tenuous. An important factor propelling a run on a currency is a gradually accelerating decline in the exchange rate — as was the case prior to September 23rd. A rush to buy US dollars dominated by the expectation of a further imminent decline in the Hong Kong dollar is not the same thing as a steady transfer of Hong Kong assets to more politically stable climes resulting from the expectation of political change sometime in the future.
For example, during the 1967 riots in Hong Kong — a spillover from China’s “cultural revolution” — there was a substantial flight of assets from Hong Kong. Property and businesses were being sold at bargain-basement prices. Nevertheless, the Hong Kong dollar exchange rate remained firm — a consequence of the then prevailing system of currency issue, one essentially identical to the post-October 15th regime, except that sterling rather than the US dollar was the numeraire.
The chances of such a banking system run are remote — maybe a thousand or a million to one. It’s the “one” that bothers me — especially when the simple elimination of flaw #2 would reduce that chance to zero.
In the 20+ years since 1983, the Hong Kong dollar’s “peg” to the US dollar has served Hong Kong well. The HK$/US$ rate rarely fluctuates more than a few Hong Kong cents away from the central rate of $7.80.
This stability prompts various uninformed commentators to urge that the peg should be dropped, that it’s “no longer needed,” and that the Hong Kong dollar is either over-valued or under-valued, depending on the person’s predilections.
Such suggestions seems to come in “cycles” of approximately 18 months long — and they all ignore the fundamental problem that the peg solves: the ability of Hong Kong banks to create their own reserves. (See my response to these Pollyannas in Float the Hong Kong dollar? Wait a minute…I want to sell it short first!).
The one downside of the arrangement is that over the last 20 years the Hong Kong Monetary Authority has built itself up into a gargantuan organization with flashy new multi-floor offices in one of Hong Kong’s most expensive offices towers. All this to do a job that really needs no more than one person with a computer and a secretary — with one more as a backup for when he goes on vacation.
Perhaps every cloud has its silver lining. As long as this over-staffed, over-paid and over-expensive institution has a vested interest in the status quo,the Hong Kong dollar’s peg to the US dollar will remain in place.
1 At the time, John Greewood was editor of Asian Monetary Monitor. Most of my understanding of Hong Kong’s unique monetary structure is a result of John’s patient tuition. Naturally, he is in no way responsible for my conclusions.