The Effect in Hong Kongs Economy Essay Example for Free

The Effect in Hong Kongs Economy Essay I. Introduction The financial crisis in the Asian economies in 1997 has created tremendous interests in the economic point of view. This report focuses on the economic situation of Hong Kong in 1997-98, which has some very special features among the economies in the region. In the Asian Financial Crisis, the economy in Hong Kong did not sufferer from any banking or currency crisis like some of the Asian countries such as Indonesia, Malaysia, South Korea and Thailand, which their troubles began with a severe depreciation in their currencies. This triggered capital outflow and bankruptcy of many financial intermediaries and firms. The currencies of these countries have long been maintained at a relatively constant rate with the US dollar until 1995. Their depreciation is due to the central banks were unable to defend speculative attacks. Regarding to this, the government of the Hong Kong Special Administrative Region of the Peoples Republic of China successfully supported the currency by paying the cost of having high interest rates. Hong Kong dollar is pegged with the US dollar, at a rate of HK$7.8 to US$1 since 1983. This is due to the effort of the Hong Kong Government and the Hong Kong Monetary Authority (HKMA), the central bank of the Hong Kong. However, the economy is expected to enter one of the most severe recessions in the post-war period after the Asian Financial Crisis. Section 2 in this paper will offer background information of the Linked Exchange Rate System. It defines how the monetary authorities defend the currency peg. Section 3 will summarize on how and why the Hong Kong dollar was under speculative attacks during the Asian Financial Crisis. Section 4 is a postscript on how the HK government reacts to the situation and the actions that was taken. II. The Background of the Linked Exchange Rate SystemAs a small opened economy, the currency of Hong Kong was used to be backed by stronger currency, pound sterling at first and later, US dollar. There was only about nine years (1974 -1983) in which a floating exchange rate regime was  adopted. By the end of 1983, under both external (speculative attacks) and internal (political uncertainty) factors, the authorities decided a fixed exchange rate regime and peg Hong Kong dollar with the US dollar at HK$7.8 to US$1. The latter is known as the Linked Exchange Rate System, which is effective since October 17, 1983. The Linked Exchange Rate System is in practice a modified version of a classical currency board. A classical currency board is a system where there is no place for a central bank. The current Hong Kongs currency board maintains certain functions of the HKMA as the central bank of the SAR. The rest of this subsection discusses their distinction. In general, currency board refers to a monetary institution that issues base money solely in exchange for foreign assets, specifically the reserve currency. (Williamson, 1995, p.2)With the currency board, the monetary authorities can not change money supply at will. If the currency board would like to issue new cash, it must first increase its stock of the chosen reserve currency given certain fixed exchange rate stipulated by law. Which means the supply of home currency can increase only when commercial banks puts an equal amount of reserve currency in the currency board. Usually, the foreign reserve is more than the monetary base (cash in circulation plus deposits from commercial banks), so there is a net worth on the liabilities side that equals to the excess amount of foreign reserve. With buying or selling domestic credits, the central bank can perform open market operations and sterilized intervention of exchange rate. The currency board can stabilize the value of the home currency to a stronger one. This is an attractive feature for small countries. With people having confidence in this monetary system and the fixed exchange rate, a stable economic environment will promote trade, and investment. Over the recent decade the Hong Kong Government has increased the power of the monetary authority as a central bank. In April 1, 1993, the Hong Kong Monetary Authority (HKMA) was established to perform many of the functions of a central bank. Due to historical reasons, instead of a central bank, three note-issuing banks, the Standard Chartered Bank, HDBC and now Bank of China are allowed to issue notes. In order to issue notes, under the management of HKMA they have to pay the Exchange Fund in US dollars and receive the Certificates of Indebtedness (CIs) at the official rate HK$7.8 to US$1. With this system, the money supply is determined when firms in the export sector gain more US dollars through trade. They still need to pay their workers in HK dollar so they will use the US dollar in exchange for the domestic currency with the licensed banks. When banks are short in HK dollar, they can exchange for HK dollar with the US dollar in their hand with the note-issuing banks at HK$7.8 to US$1. If the note-issuing banks are short of HK dollars, they will use the mechanism of currency board to obtain CIs and supply more domestic currency to the economy. In principle, the exchange rate in the market floats. There is no law that forbids any bank to use a rate different from the official one. It is an arbitrage mechanism that helps to fix the exchange rate in the market. For instance, if the rate in the market is HK$8 to US$1. Banks will submit Hong Kong dollar to the note-issuing banks for US dollar at the official rate HK$7.8. They will gain the differential 20 ¢ by selling the US dollar in the market. More banks will follow and thus the demands of HK dollars increase. As a result, HK dollar will appreciate and the above arbitrage process will end when the market rate goes back to the official rate. When there is pressure of depreciation in the domestic currency against US dollars, the note-issuing banks will have to use the CIs to exchange for US dollars with the Exchange Fund. Contagion in the market in response to the depreciation will finally lead to a huge reduction in the foreign reserve. III. Speculative Attacks on Hong Kong Dollar in 19971. Before October, 1997During the first two quarters of 1997, Hong Kongs economy performed extremely well. Even though other Asian economies began to expose their problem in the second half of the year, Hong Kong has no sign of down-turn even in the third quarter. 2. After October, 1997The Asia Financial Crisis began with the speculative  attacks on other Asian currencies: the Thai baht, Philippine peso, Malaysian ringgit, Indonesian rupiah and Singapore dollar. While the Thai and Indonesian governments seek assistance from the IMF, Philippines central bank attempted to intervene the market and the Singapore central bank allowed the currency to depreciate. Hong Kong dollar remained steady, but later the HKMA admitted that US$1 billion of the foreign had been used to defend the currency. A second attack occurred in mid-August. From the summer to October, the stock market is very volatile and the Hong Kong dollar is strong but under pressure, while other currencies depreciates against the US dollar; however, the Hong Kong Government reassured the public that the peg exchange rate will sustain and there was adequate reserve to defend from speculative attack. However, the speculative pressure on both Hong Kong finally stroke Hong Kong stock market at the end of October. On October 23, the Heng Seng Index dropped to 23% from the previous Friday. The HKMA used interest rate to intervene the market to defend the currency peg as overnight HIBOR increased drastically except in mid-July. Naturally, the corresponding impact on the stock market was negative and severe. 3. Why were there speculative attacks?With adequate foreign reserve, the HK government has for a long time maintained budget surplus every year and the fundamentals of the economy are sound in the first three quarters, so what has attract the international speculators to target the Hong Kong dollar? Unlike some Asian countries, the financial system of Hong Kong is well-regulated and well-supervised. Although a few investment banks and firms have bankrupted after October due to overinvestment, the sort of crises in Indonesia and South Korea did not occur in Hong Kong. In fact, being one of the most developed financial centers in the region, financial and banking regulations have been continuously introduced and strengthened in the past few decades, this has helped avoid the problem of moral hazards. For example:†¢The Protection of Investors Ordinance (1974): this prohibits firms using fraudulent, coercive and exaggerated means to induce investors of buying or selling securities. It also regulates the issue of associated documents and publications. (Edward, 1987, p. 82):†¢The Securities Ordinance (1979): this regulates the operations of the Stock Exchange, the  registration of dealers and investment advisers and trading practice. It forbids dealers to involve in transaction outside the exchange, allows investigation of malpractices, and provides for the establishment of a Stock Exchange Compensation Fund to compensate the clients of defaulting brokers. (Edward, 1987, p. 82)†¢The Banking Ordinance (1986): this ordinance (i) governs both banks and DTCs under the supervision of the Commissioner of Banking (now a part of HKMA); (ii) institutes a minimum capital to risk assets ratio requirement; (iii) imposes a new liquidity requirement and (iv) allow the commissioner to issue guide-lines for banking operations from time to time. (Ho, 1991, p. 98) Still, there are three possible reasons for speculative attacks:First, the real exchange of Hong Kong and US dollars has a large appreciation of Hong Kong dollars since 1983 which reflects Hong Kongs lack of competitiveness. Yet, Hawkins and Yiu (1995) compute the Real ERRI for traded goods and show no loss of competitiveness for traded goods sector. However, the fact that Hong Kong has transformed into a service-based economy, the competition Hong Kong faces might be more in financial services and tourism, rather then in manufacturing products. Since other Asian currencies have depreciated, Hong Kong might suffer from lack of competitiveness against financial centers like Singapore, or tourism industries in regions like Thailand and Malaysia. Furthermore, as an important entrepà ´t, between China and the rest of the world, because the Renminbi has not been devalued also reduces Chinas competitiveness. This might have a negative impact on Hong Kong re-export sector. There were increasing requests and rumors for the devaluation of Hong Kong dollars to put a lift of competitiveness in 1997, which gives political pressure on the local authorities, and under such environment, speculators might perceive that their attacks will succeed. Second, political uncertainty also increases the probability of speculative attacks. On July 1, 1997, the former British colony was handed over to the Peoples Republic of China. Foreign investors might be skeptical on the independence of Hong Kong economic policy. Some of the economists did not show confidence on this matter. Anna Schwartz (1993) thinks that Hong Kongs experience with a currency board represents a dilution of the features that distinguished the institution. It did not maintain a fixed  exchange rate between the Hong Kong dollar and sterling during the years when it was linked to sterling; it then shifted to a link to the US dollar, after which it let the exchange rate float; and it then returned to a fixed exchange rate with the US dollar. It has since introduced discretionary powers for the Exchange Fund to exercise. Limited as these powers may be currently, they strike me as a slippery slope that portends further erosion of rule-based behavior. Chinas willingness to maintain rule-based behavior once the island reverts to its control adds to the uncertain future of a currency board in Hong Kong. (Schwartz, 1993, p.176) Maurice Obstfeld and Kenneth Rogoff (1995) share Schwartzs concern, After China takes over in 1997, it will also assume ultimate ownership of Hong Kongs foreign currency reserves. Despite its promise not to tamper with Hong Kongs economy, China would not likely want to see its dowry squandered in battling speculators. Thus, even Hong Kongs currency ultimately could fall. (Obstfeld and Rogoff, 1995, p.91) Was George Soros as pessimistic (or optimistic) as these economists in 1997?Third, many people have suggested that the actual target of the speculators is really the stock market. If the speculators can successfully give pressure to the Hong Kong dollar and the only response of the HKMA is to increase interest rate; therefore, speculators will be able to gain by short selling stocks in the market. If this is the case, the authorities should be flexible in choosing the instruments to defend the currency. IV. A PostscriptWith the estimates of a -2% growth rates and 4.2% unemployment rate for the first quarter of 1998; and a recession was expected. This suggests that the full impact of the Asian crises on the real sectors have began. During this period, interest rates stayed high and Hong Kong dollar was under discretionary speculative attacks. In June, the further depreciation in Japanese Yen gave additional pressure. On June 22, as a result of internal political pressure, the government adopts the first budget deficit policy since 1982 in order to stimulate the economy without abandoning the currency peg. The policy turned an initial surplus estimate of HK$10.7 billion into a deficit of HK$21.4 billion. This HK $44 billion rescue package involves:†¢Suspending land sales until March 31, 1999 to slow down the collapse of the real estate market in Hong Kong†¢An exemption of  interest earned locally from profits tax †¢Putting out HK $2 billion to help small and medium firms in non-export related sector. †¢rates rebate for the first quarter (worth HK$3.85 billion)This expansionary fiscal policy has helped shorten the recession of Hong Kong. As the Asian economy slowly recovered from the Asian Financial Crisis, Hong Kong has also managed to climb back from its recession. Reference Corsetti, G., Pesenti, P. and Roubini, N. (1998). What Caused the Asian Currency and Financial Crisis?. New York University. Edwards, A. Hong Kong: a guide to the structure, development and regulation of financial services. The Economist, 1987Government of Hong Kong Special Administrative Region. (1998, February). 1997 Economic Background. Government of Hong Kong Special Administrative Region. (1998, May). 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