Commentary

A Lesson in the Virtue of a Stable Currency

If you believe everything you read in the financial press, the Hong Kong Monetary Authority, or HKMA, has its back against the wall. The Hong Kong dollar is supposedly under attack, forcing the HKMA to defend it. As a result, the authority burned through almost $2 billion of reserves, in U.S. dollars, in March alone. Sensing a devaluation, the bears have awoken from hibernation to speculate.

But we’ve seen this play before — plenty of times, in fact, over the past 35 years. It always ends the same way: with the Hong Kong dollar maintaining its fixed rate, linked to the U.S. dollar.

Speculators fail to distinguish between the linked rate maintained by Hong Kong’s currency board and the pegged exchange rates employed by more than 80 central banks around the world.

A currency board effectively maintains a monetary union with the anchor currency. For Hong Kong, that’s the U.S. dollar. Currency boards do not conduct discretionary monetary policy, as central banks do. They do not actively set or manage interest rates. Interest rates, like rates of credit and money growth, are set by local market responses to monetary conditions in the country of the anchor currency. Without any discretionary monetary-policy powers, a currency board steers clear of errors that result in devaluations and sticks to its sole objective—to maintain a fixed exchange rate.

Furthermore, a currency board holds anchor-currency reserves that equal or exceed the value of the currency it issues. Thus, it always has enough reserves to fulfill its obligation: to exchange local currency for its anchor currency passively (and vice versa) on demand at a fixed rate. The quantity of local money in circulation, as a result, is strictly a function of the demand for it, not a policy produced by a monetary authority.

This helps explain why fears about the Hong Kong dollar are overwrought. The foreign assets of the HKMA are predominantly U.S. dollars, with official foreign reserves of $435 billion—more than enough to cover 100% of the local currency issued and to meet any conceivable demand for U.S. dollars.

Moreover, the HKMA is required to purchase U.S dollars at the strong side of its narrow trading band (7.75 Hong Kong dollars per U.S. dollar) and sell U.S. dollars at the weak side (HK$7.85 to US$1). These transactions are triggered not by the HKMA, which is on autopilot, but by licensed banks in Hong Kong. The HKMA’s mandate allows for some variation, but not much. Accordingly, the Hong Kong dollar is best understood as a unit of the U.S. dollar equal to 12.8 U.S. cents. 

Trying to short the Hong Kong dollar against the greenback is therefore equivalent to shorting a U.S. dollar against itself. The Hong Kong dollar is a clone of the greenback—shorting won’t work.

Just as the U.S. dollar became a safe haven from 2008-09, so did the Hong Kong dollar. In Hong Kong, capital inflows pushed the exchange rate to the strong side of its trading band. The inflow of US$170 billion from 2008-11 swelled the HKMA balance sheet and the monetary base by HK$1.3 trillion. This mirrored the expansion of the Fed’s balance sheet.

As a result, the banks in Hong Kong built excess reserves that will eventually need to be run down. The HKMA will supply U.S. dollars to the market, thereby removing excess Hong Kong dollars. The exchange rate, meanwhile, will never move beyond the limit of HK$7.85 to US$1. At any rate beyond that, it becomes profitable for banks to obtain U.S. dollars from the HKMA rather than in the market. The mandated weak-side limit thereby functions as a stone wall. Contrary to popular belief, the HKMA is not “intervening to support the Hong Kong dollar.” It’s passively supplying U.S. dollars to the market in response to demand.

Since the HKMA does not operate a domestic monetary policy, Hong Kong’s interest rates tend to converge toward those in the U.S. Recently, Hong Kong’s lower interest rates, compared with U.S. rates, have enticed investors to use the Hong Kong dollar as a funding currency for the carry trade, driving the Hong Kong dollar toward the weaker end of its trading band. 

Consequently, the HKMA’s autopilot mechanism of passively providing U.S. dollars and absorbing Hong Kong dollars at its fixed limit has tightened the local money market, helping bring Hong Kong and U.S. interest rates into closer alignment. This automatic convergence of interest rates acts to take speculative opportunities off the table.

Like past speculative attacks against the Hong Kong dollar, the current one will fail. The bears will suffer losses and once again be forced back into hibernation, where they belong.

John Greenwood is chief economist at Invesco in London. Steve H. Hanke is a professor of applied economics at the Johns Hopkins University.