Mr Yam discusses the sustainability of monetary and exchange rate policies
Speech by the Chief Executive of the Hong Kong Monetary Authority, Mr Joseph Yam, JP, at
the International Conference on Central Banking Policies: Leading the Way Towards
Sustainable Growth presented by the Monetary and Foreign Exchange Authority of Macau on
14 May 1999.
Dr. Pessoa, Distinguished Guests, Ladies and Gentlemen,
It is a pleasure to be back in this beautiful city, and an honour to be invited to take part in such
an important and timely conference. I warmly congratulate the Monetary and Foreign
Exchange Authority of Macau on having put together a stimulating programme, and on having
chosen this splendid new cultural centre for the venue. Apart from the inherent interest of the
topics under discussion, the conference is significant in at least two respects. It takes place at a
time when we are beginning to emerge from what has been, for much of this region, a period
of sharp economic crisis, so that the questions we are addressing today perhaps have more
relevance than ever. The conference is also taking place seven months before Macau becomes
a Special Administrative region of the People's Republic of China, on 20 December 1999.
Hong Kong, Macau's neighbour across the Pearl River Estuary, has a much shorter history as
a city, but it does have a slightly longer experience as a Special Administrative region under
the 'one country, two systems' formula. I am happy to report that this experience has been a
successful one, particularly from the point of view of monetary autonomy. Indeed, the Basic
Law has, since 1 July 1997, provided Hong Kong with far greater autonomy in its monetary
and financial affairs, and this autonomy has been confirmed in practice by the clear
confidence that the Central Government has placed in our ability to manage things on our
own.
I make this point, not because Macau needs any reassurance from Hong Kong, but because it
is a striking illustration of how some of the deepest forebodings about future events can often
be the product of the most dismal misjudgements. Two years ago, gloomy scenarios were
being painted - not about an Asian financial crisis - but about the impending demise of Hong
Kong's monetary autonomy under Chinese rule: about the breaking of the link between the
Hong Kong dollar and the U.S. dollar, the absorption of Hong Kong's substantial foreign
reserves by the Mainland, and so on. Of course, nothing of the kind has happened, and there
may well be lessons here to apply to some of the more lurid scenarios that are being drawn up
for the first of January 2000. Our topic this morning, however, is not the Year 2000 problem,
but the perennial question of how to devise sustainable and realistic monetary and exchange
rate policies in an uncertain global financial environment. The first part of my presentation
will deal with the theoretical and practical approaches to this issue, particularly in the light of
the Asian financial crisis. In the second part, I shall focus on Hong Kong's experience, since
1983, of a linked exchange rate system. Finally, I shall return to the regional perspective and
examine the prospects for greater exchange rate stability through monetary co-operation and
other routes.
Choice of exchange rate regime
Few of us, I think, would disagree with the proposition that there is no single exchange rate
regime that is suitable to all economies all of the time. Indeed, given the experience of the last
couple of years, one may be tempted to conclude that there is no regime that is satisfactory
any of the time. The difficult choices and trade-offs involved in devising a workable regime
call to mind a cartoon I once saw that theorised that the dinosaurs became extinct when they
tried, unsuccessfully, to devise an exchange rate mechanism. But modern governments cannot
escape the choice, and it is opportune to reconsider what options are available in light of the
recent experience in Asia and elsewhere.
It is now well understood that exchange rate and monetary regimes are inextricably linked.
The days when significant barriers to capital movements allowed governments to pursue
independent monetary and exchange rate policies are long gone. So any decision on an
exchange rate framework is not narrowly confined to external considerations, but must reflect
broader policy choices, as well as the structure of the economy in question. The practical and
theoretical considerations involved in deciding on an appropriate exchange rate system can be
reduced to four broad factors: the external versus domestic orientation of the economy; the
flexibility of its cost-price structure; the exposure to financial shocks; and the reputation and
credibility of policy makers.
These factors, naturally, differ from one economy to another. In theory, the choice is
straightforward enough: the best system is the system that best accommodates a country's
"natural endowment" of these factors. Success in practice, however, is not simply - or even
primarily - a question of choosing the preferred exchange rate framework from a textbook
perspective. Policymakers on the ground need to address the much more demanding challenge
of ensuring consistency between the overall policy framework and the exchange rate regime.
Experience shows us that governments can choose exchange rate systems that do not appear
optimal according to standard economic criteria yet still make them work if other policies are
up to the task. At the same time, a regime that is appropriate on theoretical grounds will yield
unsatisfactory results if it is not supported by other policies.
Consider, for instance, an economy with relatively inflexible wages and prices that adopts a
fixed exchange rate regime. Such an economy would need to ensure maximum scope for
fiscal policy to buffer shocks that would otherwise lead to unacceptable swings in
unemployment. This would require a rather conservative underlying fiscal policy in normal
times to avoid a loss of confidence at times when fiscal stimulus is needed. Similarly, a very
open economy that chooses a flexible exchange rate regime must ensure that its policies are
set in a long-term framework that establishes a clear anchor for inflation. Otherwise, external
shocks that cause large movements in the exchange rate can lead to policy uncertainties and
broader instability.
These lessons have been learnt well, and the view that overall macroeconomic policies must
complement the functioning of the exchange rate regime is now generally accepted.
Unfortunately, the challenges do not end there. Ensuring that macroeconomic policies are
mutually consistent is merely a necessary - not sufficient - condition for ensuring stability
in a world experiencing an explosion in capital flows. The volume, velocity and volatility of
global capital movements introduce a whole new dimension to policy making - a dimension
that is relatively recent, and one that we are only gradually learning to deal with.
How do capital flows affect the sustainability of exchange rate and monetary policies? There
is a school of thought that maintains that mobile international capital can play a useful global
role as a sort of 'policeman' of sound policies. The theory is that, in a liberalised global
financial system, international capital flows reward countries with sound economic policies
and punish those which pursue unbalanced and inconsistent policies. International capital
flows also prevent distortions from getting as far out of line as they would if the economy in
question was closed to outside investors. Thus, according to this view, capital flows act as an
early warning system that forces quick corrections of policy errors.
Undoubtedly, there have been circumstances in the past that have lent substance to this view.
In the Latin debt crisis of the late 1970s and early 1980s, for example, many borrowers were
clearly pursuing unsustainable and destabilising macroeconomic policies. The resulting
outflow of funds and the short-term economic crisis that ensued served to bring policies to
task and to trigger lasting economic reforms in some countries, notably Chile.
More recent experience, however, raises serious questions about this view of the role of
international capital as a robust, reliable and objective referee of the soundness of economic
policies. Events during the Asian crisis naturally come to mind. The flight of international
capital bore practically no relation to a forward-looking assessment of changes in the policies
and macroeconomic fundamentals of the region. It is true that some countries were pursuing
quasi-fixed exchange rate regimes that may have allowed pressures to build up for too long.
But these same exchange rate regimes were in place when the funds were flowing in, which
suggests that they were not viewed as a serious structural flaw by investors at that time.
Similarly, the underlying weaknesses in many Asian economies that so many observers (with
the benefit of hindsight) now point to - 'crony capitalism', inadequate risk management,
speculative lending to the property sector - were all present at the time when the funds were
pouring into the region. Not only did these weaknesses fail to deter investors on the way in:
the abundance of inward investment prior to the crisis tended to exacerbate the problems,
rather than act as a corrective force on policies. More recently, we have witnessed what
appears to be the start of a new wave of capital flowing back into the region, even though it is
far from clear that these structural problems have been fully addressed.
I think it is not going too far to say that these 'hot' capital flows not only failed to act in a way
that policed policies effectively, but actually became a powerful destabilising force in their
own right. The huge swings in interest rates and exchange rates that resulted from capital
flight in this region did far-reaching damage to corporate, financial, and government sectors,
which, in turn, reinforced the initial withdrawal of capital. In such an environment, it requires
a very courageous investor to be willing to step in against such a speculative tidal wave,
regardless of how far out of line with reality markets may have gone.
Pursuing sustainable exchange rate and monetary policies requires countries to devise
defensive strategies against such forces. This is no easy task. Capital controls have been
suggested by some. In Hong Kong's case, such controls would be anathema to our free market
philosophy: they are anyway prohibited by Hong Kong's Basic Law (as they are, with effect
from 20 December, in the Basic Law of Macau). But, even for jurisdictions that wish to
consider the option, the practical problems are considerable. Traditional types of controls have
impeded growth, and have proven difficult to administer. Attempts to impose capital controls
may also foster evasion that undermines the transparency and integrity of markets. More
recently, innovative schemes have been suggested aiming at taxing short-term capital inflows,
or otherwise obliging lenders and borrowers to pay a price that reflects the risk to the overall
economy of this activity. Some of these proposals are quite interesting and may be appropriate
for consideration by some developing countries, especially those in the process of financial
liberalisation.
There are limits to the amount that regulation of short-term capital inflows can achieve. It
would not, for instance, prevent massive speculative positions from being quietly built up in
currency and stock markets. It would not stop manipulation of individual markets by large
investors. And it would not stop speculators from exploiting the reality that sharp capital
movements can themselves affect an economy's fundamentals and panic other investors. For
the avoidance of any misunderstanding I should state once again, for the record, that I am not
advocating capital controls of any kind for Hong Kong.
The concerns that arise from 'hot' capital flows are particularly acute in Asia, whose markets
are relatively small by the standards of the large industrial countries, yet relatively liquid by
the standards of developing markets as a whole. The world will not become a safer place for
such countries - or a better place for intermediating capital flows that ultimately foster
growth and development - until we take concrete steps to reform the global financial
architecture.
Transparency is a critical issue. On the one hand, there is widespread support for the notion
that governments should be more open in their operations - and I am happy to say that Hong
Kong is at the leading edge in this area. On the other hand, there is only lukewarm support for
the notion that the operation of markets could be enhanced by increased transparency on the
part of private participants. I fail to see the basis for this asymmetry on conceptual grounds.
On practical grounds, there are no doubt important issues to be resolved and obstacles to be
overcome. But progress will not be made until all parties concerned start to address the issue
in a more energetic and concerted manner. By 'all parties' I mean both the industrialised
countries and the emerging market economies. Countries that perceive that they have little at
stake in improving the system from their own perspective may be underestimating the
implications on their own growth of sound growth in emerging market economies. And
emerging markets that have been through the crises of the past two years have valuable
experience to contribute and special needs to address.
The path taken by Hong Kong
Let me now turn to Hong Kong's experience in the light of the general points I have made
above. As you may know, Hong Kong had only a relatively brief experience with floating
exchange rates, from 1974-83. This episode was not very satisfactory: inflation rose to rather
high and volatile levels, and the period ended in an exchange rate crisis triggered by
uncertainties about the objectives of monetary policy and about Hong Kong's political future.
Against this unfavourable background, the linked exchange rate system was reintroduced to
restore confidence and stabilise expectations. In addition to these psychological factors, there
was - and still is - a strong case for believing that a fixed exchange rate regime was
appropriate from the point of view of Hong Kong's fundamentals. Hong Kong is a very
externally oriented economy, with a completely open capital account and a large financial
sector. These factors leave us heavily exposed to financial shocks stemming from volatilities
either in domestic confidence or in external markets. As the recent experience has shown,
financial shocks can feed on themselves when they induce large swings in interest and
exchange rates that undermine the fundamentals and further reduce confidence.
At the same time, Hong Kong possesses a highly flexible economic structure that has proven
capable of adapting quickly to new circumstances. This flexibility owes much to the inherent
entrepreneurial instincts of the people and to a tradition of economic management that has
emphasised the role of market forces, self-reliance and individual initiative. Our exchange rate
system has, I believe, supported this flexibility by establishing a clear anchor on which to base
decision-making. It is evident to Hong Kong residents that the ultimate responsibility for
adjusting to new challenges lies with themselves. Armed with this knowledge, people have
continued to behave in a pragmatic and realistic manner in response to changing
circumstances, even as rising incomes have brought unprecedented prosperity. Affluence has
not bred complacency.
The response to the Asian crisis bears this out. Coming at the same time as the bursting of
short-lived bubble in property markets, the crisis led to a plunge in property prices of some
40-50%, from the peaks in mid-1997 to the troughs twelve months later. Yet this striking
decline has been accommodated without major incident. Mortgage delinquencies have edged
up, but they remain below the typical levels in industrial countries, and the banks remain
highly capitalised and profitable. Equally important, property prices have dropped quickly to
levels consistent with underlying supply and demand. As a result, markets have remained
liquid, and activity has recently picked up. There is a renewed sense of optimism that,
whatever adjustments remain to be worked out, the worst is now over.
In labour markets, wage freezes are the norm, combined in many cases with cuts in bonuses in
sectors that have been most affected by the crisis. Nominal wages are likely to show little, if
any, growth this year, compared with increases of 7-8% in the period leading up to the crisis.
Price inflation has also dropped markedly, and has turned negative in recent months. Price
reductions inevitably cause short-run dislocations. But they are a key channel of adjustment
for Hong Kong, and the improvements in our competitiveness that result will set the stage for
a sound recovery. The important consideration is that this process should be completed
quickly, and there is every indication that it will be.
A few critics maintain that we should have 'let the link go' during the crisis to allow nominal
exchange rate depreciation to restore our competitiveness. I believe that such a step would
have been fraught with risks. Any direct impact on growth would almost certainly have been
offset by reduced confidence in our longer-term policy direction and heightened anxieties
about the short-term impact on the financial and corporate sectors. I do not need to remind
you that Hong Kong did not suffer from the structural problems in these sectors that have been
ascribed to some other economies. But there is no guarantee that major and lasting damage
would not have been done by the types of dramatic exchange rate overshooting that have been
witnessed elsewhere in the region. And it is unrealistic to expect that exchange rates would
not have overshot, given Hong Kong's openness and exposure to international capital flows. If
Hong Kong's peg had been abandoned last year, it is likely that the attacks on other regional
currencies would have been even more dramatic and widespread, with negative feedback on
the region and on our own performance. That Asia - including Hong Kong - now appears
to be entering a recovery phase was by no means assured twelve months ago. We might well
wonder what conditions we could now be facing had the crisis proceeded to yet another level,
with widespread currency collapses along the lines witnessed in Indonesia.
Other observers have argued that, from a longer-term perspective, fixed exchange rate regimes
are inflexible and stifle growth. Again, I believe that Hong Kong's experience belies this
view. I would agree that, in the absence of the ability to adjust interest rates in response to
cyclical conditions, output fluctuations can be larger than would otherwise be the case - at
least in response to certain types of shocks. At the same time, though, the certainty generated
by such a solid and clear-cut anchor reduces the impact of shocks to confidence and other
factors that might undermine policy credibility.
At the end of the day, the question is an empirical one. Here, there is no evidence that Hong
Kong's long term growth has been impeded by our exchange rate regime. Indeed, there is
some evidence that Hong Kong has grown more rapidly than would otherwise be expected on
the basis of our factor endowments. Perhaps this should not be surprising. It would seem
natural that the very flexibility required to respond to short-term shocks under a fixed
exchange rate regime would foster a climate of innovation capable of turning challenges into
opportunities. Hong Kong's involvement in the rapid opening and development of the
Mainland economy is an excellent example of this.
It seems to me, then, that the sustainability of our exchange rate system has been demonstrated
through its performance. While the economic logic is important, of course, it is irrelevant
unless it is complemented by a high degree of public support - the ultimate test of
sustainability is that the public at large recognise and endorse the benefits of the linked
exchange rate. The high degree of public support that the linked exchange rate continues to
enjoy - in spite of the painful aspects of the current adjustment process - testifies to the
strength of the consensus that our system is appropriate.
The choices for Asian economies
The linked exchange rate system, with its strict currency board arrangements, has served Hong
Kong well since 1983. I might add here that the currency of Macau, the pataca, has been
linked to the Hong Kong dollar since as long ago as 1977. But not all economies are in a
position to meet the preconditions necessary for linked exchange rates to endure. In the
aftermath of financial crisis in Asia and elsewhere, many economies are searching for new
approaches to exchange rate management. The recent trend is clearly towards more flexible
exchange rate mechanisms. We cannot ignore a smaller camp, though, that is opting for
greater fixity of exchange rates, supported by more robust institutional structures than have
sometimes been in place in the past. The integration of European monetary systems in the
form of EMU is an obvious example. Similarly, a handful of economies have successfully
adopted currency board systems similar to our own.
We must recognise, however, that many economies do not currently have the preconditions to
make such a regime work successfully. It seems inevitable that they will have to live for the
time being with some sort of managed float. The disadvantages of this system are that the lack
of a transparent anchor and of a clear commitment to some well-defined policy objective
make credibility difficult to establish. These conditions invite over-shooting in financial
markets, as speculators attempt to test the limits to which the authorities are willing to let the
exchange rate move.
How can the authorities anchor policies and expectations in such an environment? The only
policy rule in common use in developed countries with floating exchange rates is inflation
targeting: so far this appears to have been quite successful, although the experience is still
limited. The technical requirements are demanding, however, and especially so for developing
economies. Policy makers must be able to accurately forecast not only inflation but also the
response of inflation to changes in the policy levers. This is a challenging enough task for the
highly trained staff in central banks of developed economies, who generally benefit from
dealing with a relatively stable economic structure and from considerable experience in
monetary management under floating exchange rates. Needless to say, the success of
developing economies in operating such a system is far from assured.
An alternative approach would be to proceed along the same path that Europe is pursuing, in
the form of a monetary union. There are clear advantages to this approach. One of these is the
creation of markets in a single currency that are sufficiently large to make it difficult for
individual speculators or groups of speculators to manipulate markets. Another advantage is
that trade within the monetary union is fostered by the certainty and ease of transaction in a
single currency. Of course, as the EMU experience shows, there are important political issues
that must be resolved before monetary union can become a reality. Decision-making power
for monetary policy must be vested in an agency that is both independent but accountable;
other macroeconomic policies must be harmonised; and structural policies must support the
flexible adjustment needed to accommodate shocks.
Looking at this region, I believe that the economic advantages of some form of 'Asian
Currency Unit' are clear. But I have no illusions about the practical and political difficulties
involved in creating such a structure. Moves in this direction will undoubtedly be part of a
long, drawn-out process. In Europe, the process took many decades. In our own politically and
economically diverse region, we have even more hurdles to overcome, so it is unrealistic to
expect rapid progress. But discussion of these issues, even if only at the theoretical level, will
help focus our thinking and perhaps lead to small, practical steps that can improve our
individual exchange rate systems along the way.
A unilateral - but asymmetric - approach to monetary union can, of course, be achieved by
simply adopting the currency of another country. This has been a topical issue of late, with the
dollarisation option that is being widely discussed for Argentina. Some have suggested that
this might also be an option for Hong Kong. Compared with our currency board system, it
would represent an even more irrevocable link to an anchor currency - one that might well
be expected to eliminate currency risk premia and speculative attacks. But there are also costs:
a loss of seignorage; constraints on liquidity management, including the provision of
lenderof-last-resort support; and substantial costs associated with the transition process. In the case
of Hong Kong, we would also face important legal issues regarding the provisions of the
Basic Law, as well as how to provide an efficient US dollar clearing and settlement system in
Hong Kong. We will continue to study these issues because, at the very least, research into all
possible options helps us to clarify and refine our existing policies. I am, however, confident
that the measures taken last autumn to strengthen the currency board arrangements, and the
additional credibility gained from weathering the storm of 1997-98, have put the existing
system on an even more solid - and sustainable - footing.
Conclusion
To recap the main arguments in this presentation, let me reiterate that exchange rate policies
must meet the needs of the economy they serve if they are to be more than mere empty
promises. They must also be compatible with broader policy choices and capable of sustaining
the external shocks that arise in an increasingly globalised financial environment. In
particular, as the Asian financial crisis has demonstrated, the exchange rate regimes devised
for small and open economies must be able to deal with 'hot' capital flows, which are not only
the conductors of external shocks, but increasingly the main agents of volatility and
instability. This is no easy matter, as the collapse of one exchange rate policy after another has
shown. Much can be done by individual governments to craft exchange rate policies that truly
complement economic fundamentals. But actions by individual jurisdictions can only go so
far towards tackling problems that also arise from defects in the international financial
architecture and not just out of local imbalances. Reforms to the international financial
architecture are needed to help ensure that capital flows reinforce, rather than undermine,
monetary stability. In the long run, we should also be looking towards a more sophisticated
and solidly based regional financial system: this would include taking further the debt market
and infrastructural development that is already in progress, as well as greater monetary
cooperation - perhaps, on the distant horizon, even monetary union.
For Hong Kong's part, the experience of the last two years has left us more firmly convinced
of the appropriateness of our linked exchange rate system to the special needs and
characteristics of Hong Kong's economy, and more confident in our ability to defend the link
under the currency board arrangements. I am not so complacent as to suppose that there is no
room for improvement, and we continue to explore ways of refining the system. Nor do I
suggest that such a system is suitable for every economy in the region. But I believe that it has
provided Hong Kong with the anchor of monetary stability that such an externally oriented
economy needs, particularly during these years of global instability. I also believe that it will
continue to serve Hong Kong well in the years to come.