Tony Latter: Why blame the peg?
Speech by Mr Tony Latter, Deputy Chief Executive of the Hong Kong Monetary Authority, at a
luncheon of the American Chamber of Commerce in Hong Kong, 12 March 2002.
* * *
Introduction
When things aren't going too well, it's natural to look for scapegoats. In the case of the Hong Kong
economy, the pegged exchange rate certainly gets its fair share of that treatment. What is the basis for
complaints about the peg, and how far are they justified?
Before examining some of the complaints, however, let us review the monetary policy background.
Monetary policy
It is widely accepted that the duty of monetary policy - and that embraces exchange rate policy - is to
provide that monetary environment which is most conducive to long-term growth and prosperity of the
economy. This is seen to imply a desire for stable monetary conditions, but there is scope for
judgement as to how this stability should be defined.
The majority of regimes focus on internal purchasing power and thus aim for low and stable domestic
inflation. Thus, the practice of inflation targeting has now become quite widespread and well
understood. This requires an active monetary policy, necessarily impacting on domestic interest rates
and money market liquidity; and, at least in the strictest form of targeting, it inevitably involves some
exchange rate flexibility, even if not an entirely free float.
A minority of regimes, of which Hong Kong is one, focus on a stable external value of the currency - in
Hong Kong's case through the particular mechanism and discipline of the currency board. The more
externally oriented an economy is, the greater is the weight which may need to be attached to
exchange rate stability within the overall concept of monetary stability.
There are various pros and cons of each approach. Inflation targeting is less precise, in that it is
necessarily based on forward projections, and verifiable indicators of success are only available after a
timelag. It also requires a reasonably accurate forecasting process, which may be simpler to realise in
a relatively closed than in a highly open economy. Nevertheless, experience of several countries
shows that inflation targeting is capable of delivering good results.
An obvious advantage of a fixed-rate regime is that compliance can be monitored very directly and
unambiguously in real time; and, in the currency board version, the regime operates by automatic
mechanisms rather than by the discretion of a central bank. It may, however, result in a less stable
inflation rate, although, assuming that monetary policy in the country of the anchor currency is
conducted responsibly, extremes of hyper-inflation or deflation will be avoided.
Both regimes may be prone to fluctuations in interest rates in response to shocks, but with inflation
targeting, which requires a flexible exchange rate even if managed to a degree, the central bank has a
measure of discretion in the magnitude and timing of its response, whereas, with a fixed rate,
defensive reactions must be more immediate and may hence be potentially sharper.
Hong Kong context
Recent criticisms of Hong Kong's currency board have focused mainly on two aspects - the
implications for the competitiveness of Hong Kong vis-a-vis other economies and the problems of
living with falling price levels. The remainder of this paper is directed mostly at these issues.
Competitiveness
Changes in competitiveness are typically measured by comparing movements in some appropriate
measure of costs or prices at home and abroad, and adjusting for shifts in exchange rates. The
measure of competitiveness thus produced is commonly referred to as the real exchange rate.1 A
stronger real rate means higher relative prices and therefore implies weaker competitiveness.2
I detect two common misconceptions about the real exchange rate.
Influencing the real rate
The first is the belief that the real rate is amenable to control by the central bank or government and
that the chosen regime for the nominal exchange rate is therefore an important determinant of the real
rate.
Let me explain what I believe to be some flaws in this view.
Even if the central bank could, through intervention in the foreign exchange market or actions to
influence domestic interest rates, fix the nominal exchange rate at some particular level, and even if it
succeeded in fixing not simply the bilateral rate but the trade-weighted rate, this would only determine
the real rate for the short term. This is because any monetary policy actions, such as exchange market
intervention or changes in interest rates, in due course have a feedback effect on domestic inflation.
More specifically for example, depreciation tends to raise prices. In a market-based economy the
central bank, if it already uses monetary policy to set the nominal exchange rate, cannot separately
control inflation. Eventually any initial gain in competitiveness from depreciation is offset by the
inflationary feedback, most obviously so in highly import-dependent economies such as Hong Kong.
Empirical studies do not reject the hypothesis that this feedback is eventually 100%, although the full
offset may occur only after a considerable lapse of time.
Meanwhile the real rate is also affected by movements in price levels in other economies, which lie
beyond the home central bank's influence.
In sum, the central bank cannot, except perhaps for the short term, dictate the real exchange rate.
Equilibrium of the real rate
The second misconception about the real exchange rate is that a weak rate (if it could somehow be
arranged) would necessarily be a good thing, because of the benefit which an improvement in
competitiveness, thus measured, would bring to the economy.
History tells a rather different story. Successful economies have typically experienced appreciating
exchange rates during periods of their most rapid development; and the wealthiest economies tend to
be those which appear to be the most expensive in terms of overall price comparisons. It is not so
much the real exchange rate which determines prosperity, as it is the fundamental characteristics of
the economy, such as underlying productivity, which determine the real exchange rate. An economy
which can successfully sell high value-added goods and services on world markets and as a result
enjoy at the same time relatively cheap imports is better off than one which balances its accounts by
selling a higher quantity of cheaper output and buying a lower quantity of dearer imports.
There remains a question of whether there might nevertheless be advantage in a short burst of
competitive advantage - as might be delivered by an engineered depreciation before the inflationary
feedback negated the competitive gains - not just as a means of boosting the economy in the short
term but also hopefully as a means of building a better foundation for longer-term growth. Experience
suggests, however, that this sort of procedure is a bit like a drug to which the patient too readily
becomes addicted. If people come to expect continuing doses of devaluation, then inflation and
inflationary expectations may harden and, perhaps more significantly, businesses are spared the
discipline of searching for greater efficiency or the incentive to move up-market. The dosage of the
drug may be increased as dependency rises, but eventually a fairly severe anti-dote of austerity may
need to be administered to break the growing addiction.
It may reasonably be argued, however, that, even if the underlying path of the real exchange rate is
determined essentially by structural forces within the economy, monetary policy should be utilised so
1
In fact it is necessary to take into account all one's trading partners and thus arrive at the real trade-weighted or "effective"
exchange rate - the REER. For ease of exposition, however, only the term "real exchange rate" is used in this paper.
far as possible to prevent excessive divergences from trend which may prove damaging to the
economy. For example, if a currency is artificially strong for a prolonged period, a particular sector of
the economy may become so damaged that it is incapable of recovering when the exchange rate
eventually returns to equilibrium. In practice, however, it is extremely difficult to determine, at the time,
whether a particular movement in the real rate represents a divergence from the equilibrium path or a
fundamental shift in the path itself. At various moments over the past 20-30 years there may have
been calls for a weaker HK dollar in order to preserve the local manufacturing sector. But few would
doubt in retrospect that the shift away from manufacturing to a higher value-added service-based
economy has been beneficial and that it would anyway have been inevitable eventually. There would
have been little advantage in trying to slow the process through actions of monetary or exchange rate
policy.
In other words, the long-term equilibrium path of the real rate is not necessarily flat. The trend path
may, at any particular moment, be up, down or flat, while the actual rate constantly diverges from its
equilibrium path because of random events such as unforeseen movements in nominal exchange
rates or in cost and price levels at home or abroad, or because of the failure of market adjustment
processes to work quickly enough.
All of this can be quite aptly illustrated by looking at the path of the Hong Kong dollar's real rate since it
was first pegged. The natural trend appeared to be upward, though not smoothly so, for the middle
period of about ten years, but there is nothing here which tells us what will, or should, be the path from
hereon.
Against this background, monetary policy may not be expected to achieve much for competitiveness.
But policy makers nevertheless have to choose. Should a fixed or floating rate be preferred?
Fix or float?
In theory, an advantage of floating is that it may allow for the nominal exchange rate to adjust
continuously and precisely so as to keep the real rate at equilibrium - an ideal situation if achievable.
However, the historical experience, even of the world's major currencies - US dollar, Japanese yen or
the currencies now merged into the euro, for example - is that a floating regime provides no assurance
of a stable real rate. In practice, the market does not steer the rate in a continuously rational manner.
There is also a tendency, even if the authorities are prepared to conduct some intervention, for floating
rates to overshoot occasionally, especially when at the mercy of potentially massive international
capital flows and herding behaviour in financial markets. Indeed, in certain circumstances floating may
magnify rather than reduce short-run volatility in competitiveness, thereby unsettling the environment
for making judgements about costs and prices, and hence for business planning.
The advantage of a fixed rate is that, if credible (and I take Hong Kong's 18-year track record as a
leading example of that), it provides an unambiguous and highly transparent real-time indicator of
whether monetary policy is on track or not, as well as a solid anchor for planning purposes. But, as
with floating, it provides no assurance of a stable real rate. And the disadvantage is that the entire
burden of relative cost-price adjustment falls on domestic costs and prices. Inflation is likely to be more
volatile than under, say, inflation targeting accompanied by floating. Moreover, notably, the fixed
regime may require downward flexibility of costs and prices if the nominal exchange rate becomes too
strong for whatever reason. It is this aspect which has become the focal point of recent attention for
Hong Kong.
Hong Kong's flexibility
In fact, Hong Kong exhibits very considerable flexibility of the sort required. This is not a characteristic
shared to such a degree by many other economies. Comparisons have often been drawn with
Argentina because of, until recently, its currency peg. The charts below compare various indicators for
Hong Kong and Argentina. The timescales are set to align the sudden loss of competitiveness by
Hong Kong in late 1997 because of the Asian crisis, with the sudden loss of competitiveness by
Argentina in early 1999 as a result of the Brazilian crisis and devaluation of the real. Attention is drawn
in particular to the comparison of developments over the subsequent months (to the right of the
vertical divide).
The first chart shows the levels of consumer prices. Hong Kong experienced much more significant
price deflation, with the absolute price level falling almost 10% from its peak in the first two years after
the shock, while in Argentina prices fell only 3-4%, even looking at a somewhat longer period.
A more appropriate measure of internal costs and prices is the GDP deflator. This fell by some 10%
for Hong Kong but was roughly static in Argentina.
Largely as a result of these differences in the response of internal costs, Hong Kong managed to
recoup all of the lost competitiveness (as measured by the real exchange rate), which had amounted
to about 15%, but Argentina failed to achieve any lasting recovery; indeed, loss of competitiveness
resumed, long before lost ground had been recovered.
In view of this evident flexibility in Hong Kong, to what extent is it therefore correct to talk of the peg
imposing some sort of rigidity on the economy? In the strict sense of the word, there is of course some
rigidity, because, even with speedy and flexible adjustments of domestic costs, the correction of these
which may be needed to offset a shock to the nominal exchange rate cannot be instantaneous. But if
this rigidity is judged against how other economies might or do fare under fixed rates, Hong Kong
emerges rather favourably. And, when compared with the alternative of floating, it is by no mean
obvious that the peg delivers an inferior result for Hong Kong, given the possibility of volatility or
overshooting under floating, especially for a small and highly exposed economy.
Indeed, although it is always difficult to predict events in hypothetical circumstances, there is a
concern that a more flexible regime would, rather than liberating monetary policy, actually pose more
problems - especially in the short term as confidence would have to be re-established and might
remain more brittle. This might involve higher rather than lower interest rates because of a risk
premium, plus greater uncertainty.
Before moving on from the subject of competitiveness, let me leave you with a couple of thoughts. If
Hong Kong has, in some underlying sense, been suffering from severe uncompetitiveness, how does
one explain the continuing strength of the trade and current account performance...
... and the fact that the pace of recession in Hong Kong over the last two years has not been
significantly different from that in a number of other economies in the region?
I am drawn to conclude that the criticisms of the peg on competitiveness grounds do not stand up too
well under scrutiny. Even if the foregoing analysis and discussion does not prove unequivocally that
fixing is superior to floating, it does challenge the contention that perceived problems of
competitiveness would dissipate if only we had a floating exchange rate.
Living with deflation
Let me turn now to the other focus of criticism of the monetary regime that I mentioned earlier, namely
deflation. There are four main factors which have been contributing to falling prices in Hong Kong.
First, there is the state of the global economy. A combination of recession and remarkable success in
taming inflation in recent years have left policy makers in several countries facing the unusual situation
of deflation. Hong Kong has not been alone, although the process has perhaps been more prolonged
here than in many other places.
The second factor is the process of integration of the economies of Hong Kong and southern China.
This is something which is generally welcomed in the broader context, but it may put downward
pressure on Hong Kong prices in certain sectors.
The third is the peg which, against the global background mentioned above, has been forcing some
downward adjustment of our costs and prices.
The fourth factor is peculiar to the property market, namely the excesses of the property market cycle
which drove prices to such peaks some five years ago, from which it was almost inevitable that there
would be some correction.
Attitudes to falling prices are, understandably, ambivalent. Other things being equal, consumers,
especially those on fixed incomes, generally prefer falling to rising prices. Even some people who
have had to suffer small cuts in pay may still be better off than previously; after all, the prices which
they face, as measured by Hong Kong's consumer price index, are currently some 14% below their
peak. Meanwhile, those involved in marketing Hong Kong as a business location are eager to
publicise the lower costs. And prospective first-time entrants to the property market are happy.
But for producers who see continuing declines in the likely prices at which they can sell their output,
for wholesalers and retailers whose margins are being squeezed, for home-owners sitting on negative
equity, or for financial institutions worried about the solvency of customers as a result of any of these
developments, the process of deflation is not particularly welcome.
From the monetary policy perspective, the prospect of persistent deflation presents the possible
concern that, even with near-zero interest rates, people may prefer to sit on money balances rather
than to spend, and that this may hinder recovery in real activity. To a certain extent the problem may
only be illusory. Behaviour should be no different when interest rates are zero and inflation (or, strictly
speaking, projected inflation) minus 2%, than when interest rates are 5% and inflation plus 3%; the
real rate is the same in each case. But deflation does prevent real interest rates from going negative. It
is a matter for debate as to how much of an impediment to recovery this limitation could be. Possibly it
would only become significant if the expected pace of deflation was rather sharper than it has been.
In assessing the causes and impact of deflation, and the possible remedies, it is appropriate to
distinguish between the price level for goods and services on the one hand, and that for assets -
whether financial or real estate - on the other.
For goods and services, the consensus view is probably that a low, stable positive rate of inflation is
preferable to a negative one. Nevertheless, both the economy and society may be able to cope for a
certain period with modest deflation - in the range of, say, 0-2% pa - without too much difficulty.
Asset prices, on the other hand, display much greater volatility, and the collapse of property prices has
created problems for some homeowners and financial institutions, despite presenting opportunities for
others. Plainly, stability is preferable to volatility. But the plunge in prices has much more to do with the
earlier exuberance, plus structural influences, such as growing cross-border integration, than with the
exchange rate.
Although the current deflation may undoubtedly be painful to some, before we rush to argue that
deflation could be avoided if only we had a floating exchange rate, let's pause to reflect on the
Japanese experience. At times, Japan experienced deflation accompanied by upward pressure on the
yen, which only served to exacerbate the deflation. It may not be appropriate to draw too close an
analogy, given the contrasting economic circumstances between the two economies, but it is worth
noting that, with a fixed exchange rate, deflation, if it continues, eventually restores any lost
competitiveness and will then bottom out (assuming no significant continuing deflation overseas). In
other words, in the Hong Kong context the peg in effect sets upper and lower bounds to the inflation
rate relative to the rate in the United States.
In sum, the peg has certainly not been the only contributor to deflation, and such contribution as it has
made, has probably not been severe. The presence of deflation does not itself make a compelling
case for altering the exchange rate regime.
Summing up
Back in 1983 when the peg was installed, I recall being asked whether it was the government's
intention that the arrangement should be permanent, or in what circumstances a change would be
contemplated. I said then simply that the peg was for the time being the most appropriate monetary
anchor for Hong Kong. I would give very much the same answer today.
Our peg is not a fixed rate that is supported by or dependent on discretionary intervention. It is a
rulebased currency board system which imposes a particular discipline of adjustment through interest rate
channels and domestic prices. It enjoys widespread support from international observers both in
official circles and more widely. This is not just people being nice to us and choosing not to say
anything which might rock the boat, although there may be one or two of them. Rather it reflects an
appreciation of the unique features of a currency board structure and the benefits which it has brought
over 18 years, as well as an appreciation of the distinctive characteristics of the Hong Kong economy.
The main distinctive characteristics to which I allude are the following: the flexibility in costs and prices,
as discussed earlier; the extreme openness of the economy in terms of both trade and capital flows;
the constitutional commitment, through the Basic Law, to support the free movement of capital and not
to operate exchange controls; and the soundness of the banking sector. Taken together, these factors
help explain why a peg may be feasible and sensible for Hong Kong while it might not be so for others.
This does not mean that Hong Kong would be incapable of operating or continuing to prosper under
an alternative regime. Indeed, we possess the necessary infrastructure to conduct discretionary
monetary policy (although that was not the case back in 1983), and I am confident that my colleagues
would be quite capable of meeting the challenge of any new, more activist regime. However, although
there may be moments when one thinks "If only we had a floating rate, things wouldn't be so bad right
now", one cannot chop and change between regimes to suit short-term expedience. We acknowledge
that no system is perfect, but I have suggested that much criticism of the peg may be exaggerated, or
even unfounded. We would need to be well satisfied that an alternative would be unequivocally
superior, before ditching something which has been the cornerstone of internal financial stability and
external confidence for over 18 years.