EF3461 The Economies of Mainland China and Hong Kong. Tutorial 6 Hong Kong’s Monetary System City University of Hong Kong Dr. Isabel Yan. 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
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EF3461The Economies of Mainland China and Hong Kong
Tutorial 6Hong Kong’s
City University of Hong Kong
Dr. Isabel Yan
The Monetary System of HK:
. 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.
Exchange Fund’s Foreign Reserve
M1: currency held by the public + demand deposits
Submit US dollar
Hong Kong Monetary Authority
The 3 note-issuing banks
(including other commercial banks)
Get Certificate of Indebtedness to issue HK dollars at HK$7.8=US$1
The Note Issuing Mechanism behind the Currency Board System:
(buy certificate of Indebtedness)
Upward pressure on HK$ exchange rate
Market participants buy HK$
HK’s monetary base expands and interest rate falls
Stabilizes the capital inflow
The note issuing banks sell HK$ in the market and buy US$
HK Monetary Authority
About HK$300 billion as at Dec 2002
Use to finance fiscal deficits in HK
Exchange Fund reserves
About HK$989 billion as at Dec 2000
Use to back up the monetary base in HK
The fiscal deficits are financed by the fiscal reserves but not the Exchange Fund reserves. The two parts are completely separated from each other.
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.
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.
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.
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?
Advantage: (most widely argued)
(i) HK’s export becomes more competitive
The political dimension of the re-peg can be important because there are winners and losers as a result of the re-peg:
(i) Imports will be more expensive (e.g.imported food, clothes). This hits
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.
The substitution of the HK dollars by a foreign currency (in most cases, the US dollar) as the legal tender.