Hong Kong will soon mark its 34th anniversary of having adopted a fixed exchange rate regime. For 30 over years, it has undoubtedly been the crux of Hong Kong’s monetary and financial stability.
Being one of the world's leading international financial centres, Hong Kong has firmly stood at a remarkable placing of the 12th greatest banking centre in the world and the 6th greatest foreign exchange market able to undergo transactions worldwide within 24 hours a day.
Yet, despite a rather well-established fixed exchange rate system, it has sparked off heated debates on whether such a regime is still viable should Hong Kong wish to gain a foothold in the global economy. Or perhaps, it is time for Hong Kong to adjust its exchange rate system to stay competitive and ensure sustainable economic growth in the years to come.
This paper will focus on tackling the question as to whether a fixed exchange rate regime is still the most suitable for Hong Kong in response to rapid changes in the economic environment. We will take a look at the history of Hong Kong Dollar as well as examine the benefits and costs for the adoption of such a regime. We will also analyze the alternative exchange rate systems there are and if we would recommend any of them or should Hong Kong continue on its track.
To start off, we will briefly run through each of the exchange rate regimes and give an overview of Hong Kong’s exchange rate arrangement.
A floating exchange rate is a regime where the currency price is set by the foreign exchange market based on supply and demand mechanism in comparison to other currencies.
If the government or Central Bank steps in to take necessary actions when a free-floating exchange rate gets out of control is known as a mixed exchange rate.
However, if they decide not to intervene in any way possible, this is considered as a pure floating regime which was used in Hong Kong for nearly a decade till late 1983.
Otherwise, it would be a fixed exchange rate regime which is sometimes called a pegged exchange rate, whereby a currency's value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold.
As seen in Table 1, the Hong Kong dollar floated for nine years from 1974 to 1983. Indeed, during this period, the economy performed relatively well, recovering from oil crisis speedily, achieving outstanding economic growth of over 10% with an inflation rate moderated between 4-6%.
Nevertheless, this slowly took a toll on Hong Kong and there were obvious signs of overheating emerging in late 1970s.
The Hong Kong dollar plunged to an all-time low on September 24th of 1983, also termed as the Black Saturday. To restore public confidence, the decision to peg the Hong Kong dollar at a fixed rate was finally announced.
Being a highly externally-oriented economy, there is an obvious need for an effective exchange rate to anchor a stable monetary and financial environment for trading.
It was against this background that Hong Kong believed that it was a wise choice to stabilize the value of Hong Kong dollar against the major currencies in the world.
This formed the basis of the current monetary system in Hong Kong: a fixed exchange rate which is defined to be entirely determined by the government such that the official exchange rate will be tied to another country’s currency or to a uniform price of gold, a conventional method employed under the Bretton Woods system.
In the case of Hong Kong, US was selected given that it is a major trading partner, and thus the US currency predominates significantly and denominated the Hong Kong dollar. Hong Kong dollar was hence pegged to the US dollar at a rate of HK$7.80 to one US dollar.
Having a linked exchange rate has undoubtedly brought about many benefits to Hong Kong, which substantiates why Hong Kong has continued this system for over 30 years.
To start off, a fixed exchange rate system promotes public’s confidence towards the Hong Kong dollar and this is extremely vital for Hong Kong to stand strong as an international financial centre. This system is a currency board system, in other words, each time the Hong Kong government issues Hong Kong dollars, they must be fully backed by the reserve. Thus, investors and depositors would be assured that as long as they hold the Hong Kong dollar in whichever form, there is sufficient assets and reserves with at least a value that is equivalent to back it up. This helps to ensure the risk of any currency uncertainty and panic that could possibly be faced is kept to the minimum. As a result, this will stabilize the value of Hong Kong dollar and restore public confidence.
We all know that over the span of 34 years, Hong Kong has experienced numerous crises, such as the 1987 stock market crisis, the European Exchange Rate Mechanism crisis in 1992, the outbreak of SARs in 2003-2004, not forgetting the two major financial crises that landed many countries in a financial downturn and turmoil. Regardless, the exchange rate of Hong Kong dollar remained fairly stable amidst all these, further establishing the credibility toward this system that Hong Kong adopted. Having a fixed exchange rate regime has once again proved its worth and importance to tide Hong Kong over these difficult financial periods.
Moreover, a firm monetary anchor will help to maintain stability in Hong Kong’s economy which is crucial for a country that is open and highly dependent on external trades. Agreeably, Hong Kong is an international trading hub and is in the position to handle large scale of capital inflow and outflow on a daily basis. The total value of external trade in goods and services annually in Hong Kong comparably amount to over three times of its Gross Domestic Product (GDP). It is inevitable that Hong Kong will hence be extremely vulnerable to any external financial volatility, and any kind of shock could result in fluctuation of its exchange rate. For instance, should foreign countries demand Hong Kong’s exports, it will facilitate a large capital inflow and lead to an appreciation of the Hong Kong dollar. On the flipside, if there is now a capital outflow, Hong Kong dollar will depreciate with no exception. This is where a fixed exchange rate comes in place. By backing up by the US dollar which is a strong currency worldwide, it helps to ensure stability.
We could all be in agreement that a stable exchange rate plays an important role when it comes to a country that is externally-oriented. Hong Kong established itself as an international financial and trade centre, attributed to an exchange rate that facilitates the movement of trade and financial transactions competitively. Being pegged to the US dollar, it ensures that the exchange rate is only allowed to fluctuate within a very narrow limit. This aims to maintain a country’s currency value which allows the country to further flourish. Having this fixed rate will provide exporters, and importers with more information to make better investment choices and greatly reduces any risk or losses that could be caused by exchange rate volatility. This in turn saves costs off the need to hedge against exchange rate risk and thus attract more businessmen to invest since they can now estimate the costs incurred and returns more accurately.
As mentioned by John Greenwood, the chief economist of Invesco and the architect of Hong Kong’s currency peg in 1983, “the stable exchange rate provided a favorable environment for Hong Kong to develop into an international trading hub”. The total assets of the banking sector of Hong Kong have grown substantially by over 13 times and has been consistently maintaining its spot as top five financial centres under the Global Financial Centres Index.
This stability of the Hong Kong dollar cushions a favourable environment for Hong Kong to be an international trading and financial centre.