The Ever‐​Solid Hong Kong Dollar

This article appeared on Forbes.com on July 5, 2019.
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This week, turmoil gripped a usually dynamic, but well-ordered and calm, Hong Kong. Police stood by as young protestors stormed and sacked Hong Kong’s parliament building. Contrary to dire predictions by currency speculators, one thing that remained rock solid was the Hong Kong dollar (HKD).

The HKD’s exchange rate is the responsibility of the Hong Kong Monetary Authority (HKMA). The HKMA has many responsibilities. One of the most important ones is the management of Hong Kong’s currency board. A currency board issues notes and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. As reserves, it holds low-risk, interest-bearing bonds denominated in the anchor currency. The reserve levels (both floors and ceilings) are set by law and are equal to 100%, or slightly more, of its monetary liabilities (notes, coins, and deposits). A currency board generates profits (seigniorage) from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities.

By design, and unlike central banks, a currency board has no discretionary monetary powers and cannot engage in the fiduciary issue of money. It has an exchange rate policy (the exchange rate is fixed) but no monetary policy. A currency board’s operations are passive and automatic. The sole function of a currency board is to exchange the domestic currency it issues for an anchor currency at a fixed rate. Consequently, the quantity of domestic currency in circulation is determined solely by market forces, namely the demand for domestic currency.

Since the Hong Kong dollar’s anchor currency is the U.S. dollar (USD), the HKD is a clone of the USD, and Hong Kong is a part of a unified currency area with the United States. There is no better way to tell a financial story than with a balance sheet. For the HKMA’s currency board story, one needs to focus on the HKMA’s segregated currency board account. Unfortunately, many are confused by the HKMA’s consolidated accounts, which include many non-currency board accounts, such as the fiscal reserves the HKMA holds for the government. These are significant, and they are managed by the HKMA. Recall that, during the Asian financial crisis in 1998, the HKMA used those reserves to intervene in Hong Kong’s stock market on a massive scale.

So, with the HKMA, unlike a central bank, lacking any discretionary monetary powers, how is the money supply determined in Hong Kong? Well, it’s determined by the free market for Hong Kong dollars. The Hong Kong dollar chart below shows how the quantity of Hong Kong dollars (the monetary base, M0) is determined in a free market for Hong Kong dollars. The HKMA’s currency board sets the HKD/USD exchange rate at 7.8. That rate always remains fixed. So, the supply of HKDs is infinitely elastic (represented by the horizontal line). The demand for HKDs determines the magnitude of the monetary base (M0), which is the quantity associated with the point at which the supply and demand for HKDs are equated. At present, that quantity is HKD 1,627,905 million. If the demand for HKDs increases, the demand curve would shift to the right and move along the supply curve, resulting in an increase in the monetary base. The market, not the HKMA, determines the magnitude of Hong Kong’s monetary base.

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So, how has the market-determined money supply worked out in Hong Kong? Let’s take Hong Kong’s monetary temperature. To do that, we first determine the “golden growth” rate for the money supply, and then compare the actual growth rate in Hong Kong to the golden growth rate. To calculate the golden growth rate, I use the quantity theory of money (QTM). The income form of QTM states: MV=Py, where M is the money supply, V is the velocity of money, P is the price level, and y is real GDP.

Let’s use the QTM to make some bench calculations to determine what the golden growth rate is for the money supply. This is the rate of broad money growth that would allow the HKMA to hit an inflation target. But, the HKMA operates a currency board and has no monetary policy. So, the U.S. inflation target of 2%/yr is used.

According to my calculations, the average percent real GDP growth since 2006 was 3.06%, and the average change in the velocity of money was -3.25%. Using these values and the U.S. Federal Reserve’s inflation target of 2%, I calculated Hong Kong’s golden growth rate for Total Money to be 8.30% (see the chart below).

Calculations:
Golden Growth rate = Inflation target + Average real GDP growth – Average percent change in velocity
Golden Growth rate = 2.000% + 3.058% - (-3.246%) = 8.30%

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Since 2006, the average annual growth rate for the market determined money supply in Hong Kong is 9.15%, which is very close to Hong Kong’s Golden growth rate of 8.30%.

Hong Kong’s currency board works like a charm. Even with mayhem in the streets, the Hong Kong dollar is as solid as a rock. And, it will remain so. No currency board has ever been broken. That’s because they can’t be broken.

Steve H. Hanke

Steve Hanke is a professor of applied economics at The Johns Hopkins University and senior fellow at the Cato Institute.