How the peg makes Hong Kong special
and why the rule-based monetary system is the city's last institutional safeguard
Most nations have their currencies issued by the central banks. But it is not always the case. Before the 20th century, only the powerful nations had the legitimacy to issue currencies. Less developed societies often adopted the currencies of their major trading partners.
The capability to issue currency people trust is a matter of institutional strength. In the past, the monetary institution was backed by one thing and one thing only: the sovereign ability to honor payment, i.e., countries with persistent trade surpluses, wars and receiving reparations, and
Public finance for dummies
Before going further into the ABCs of the monetary institutions, let’s first look at how public finance functions.
The first rule of public finance is: Taxation is never an effective means of raising money. People evade taxes. Taxes distort incentives. It is just messy.
In feudal society, monarchs and their vessels make money by receiving rent. From an economic point of view, rent, like tax, is not efficient.
The advent of international trade and industrialization give rise to a new economic reality. Granting and running monopolies, domestic or overseas, became a much better way for the sovereign to make money. However, it also required a more sophisticated administration to manage the complex relationship between parties. The institutions of international trade and industrialization evolved into modern capitalism.
Amongst the most profitable monopolies is the right to issue money. There is even a word for it: “seigniorage.”
The linked exchange rate
The Hong Kong government issues small-denomination coins and ten dollar notes, which are cost-ineffective for commercial banks to undertake. Otherwise, most currencies in circulation are issued by three commercial banks.
For every 7.8 HKD issued, the banks surrender 1 USD to the Hong Kong Monetary Authority in an instrument called a Certificate of Indebtedness. Note-issuing banks do not profit from “printing money.” Having their logos printed on the city’s money gives people more confidence in the banks. Some erroneously believe that note-issuing banks cannot go bankrupt. Or perhaps the government will consider them too big to fail. In reality, there is no such guarantee. Nevertheless, should any note-issuing banks cease to operate, the banknotes should remain valid legal tender for it is fully backed.
Unbeknown to most, Hong Kong has been using USD. As mentioned above, it has been quite common for societies to adopt the currencies used by their trading partners. Hong Kong has always been using foreign currencies since the 19th century.
After the Second World War, Hong Kong’s dollar was pegged to the pound sterling until the United States unilaterally closed the gold window and forced the United Kingdom to end the Sterling Area. From 1972 to 1974, the Hong Kong dollar was pegged to the USD. Then Hong Kong dollar remained free float until 1983.
Therefore, except for the nine years from 1974 to 1983, Hong Kong had a fixed exchange rate regime, and the institution had been ingrained in the fabrics of the city’s commercial practices. There is no evidence domestic consumer prices were under better control in those nine years when Hong Kong set its discretionary monetary policy.
Nonsensical calls for abolishing the peg
Since the change of sovereignty, from time to time, there have been calls for abolishing the HKD peg for the following reasons:
Hong Kong is part of China. China has a more significant influence on Hong Kong than the United States. There is no reason why we are not using China’s RMB.
The peg limits Hong Kong’s ability to set its own fiscal and monetary policy.
The USD is no longer as powerful as it was. Instead of pegging to one currency, we should peg to a basket of many currencies.
The case against pegging to RMB
How could the Hong Kong dollar remain freely convertible if it is pegged to non-convertible RMB?
When the HKD was pegged to the pound sterling, from 1949 to 1972, there was an exchange control in the sterling area. However, Hong Kong neglected the restrictions, and HKD remained almost freely convertible. In the 1960s, Hong Kong became a loophole for the flight of sterling to USD.
Should the HKD is pegged to China’s RMB while Hong Kong remains an open economy, Hong Kong will be a proxy for speculation and a destabilizing factor to the RMB.
Another argument for ditching the HKD-USD peg for the RMB peg was Hong Kong’s economic cycle corresponds more closely with China, especially after the 2000s when China became more powerful and active internationally. However, a closer look at both the asset and consumer prices in Hong Kong, China, and the United States reveals that the whole global economy is more synchronized than ever. The cyclical price movements between China, the United States, and Hong Kong are becoming more correlated. Therefore, leaving the peg will not help flatten the boom-bust cycle in Hong Kong.
The case against discretionary fiscal and monetary policy
Discretionary fiscal and monetary policies are good on paper. But there is no evidence any government achieved anything by either going the Keynesian or monetarist ways.
On the contrary, people overlook the benefit of a strictly rule-based monetary regime. Hong Kong has maintained a disciplined fiscal regime for almost half a century because of the peg. Since World War II, Hong Kong persistently ran a surplus budget, which is an exceptionally rare case.
Article 107 of the Basic Law states:
The Hong Kong Special Administrative Region shall follow the principle of keeping the expenditure within the limits of revenues in drawing up its budget, and strive to achieve a fiscal balance, avoid deficits and keep the budget commensurate with the growth rate of its gross domestic product.
Most people do not see the linkage between this article with the peg. However, fiscal discipline is precisely what the peg requires. Most currency board regime fails because their government cannot maintain a balanced budget.
The secret of Hong Kong’s fiscal health lies in the entanglement of government revenue with asset prices. Besides income and profit tax, the most crucial revenue sources in Hong Kong were land premiums and stamp duties.
There is undoubtedly a downside to this model. The Hong Kong government will inevitably run into a deficit budget during recessions. In addition, there is an inherent interest in the Hong Kong government to maintain a restrictive land-use policy, hence leading to astronomical house prices
But we must bear in mind that all cosmopolitan cities have the same problem. At least Hong Kong can capture asset price inflation for delivering general welfare. Hong Kong’s public expenditure is on par with international standards. Our public infrastructure is amongst the best. Our public education, healthcare, housing, and various welfare are reasonably generous. Yet, Hong Kong has a fairly simple and low income and profit tax regime.
The case against a basket of currencies
In investment, diversification helps mitigate risks. But a basket of currencies approach increases the arbitrariness and the uncertainties. It is not as adaptive as free-float and not as disciplined as a peg based on resolute but straightforward rules.
Pegging to a basket of currencies satisfies the busybodies who thought the central bank must actively manage something.
Conclusion
Instead of asking how the peg could be broken, the important question is under what circumstances the peg had to be broken.
First and foremost, if the government cannot maintain a structural surplus, or a balanced budget, in the long term the deficit will lead to debt financing, and in turn an inclination to devaluate and artificially expand the Central bank balancesheet.
When the peg is broken and the currency devaluated, people who incurred foreign currency-denominated debt will suffer the most. In fact, a considerable amount of commercial financing in Hong Kong is denominated in USD.
Often when a nation devaluates, the shock to the financial system triggers a vicious cycle of liquidity crisis and further monetary easing and devaluation. In a word. it is the bankruptcy in the public sector that leads to massive insolvency in the private sector.
The currency board arrangement has served us well as a simple, rule-based institution. Without the peg, there will only be more arbitrariness, uncertainty, and idiosyncrasy.
I do not want to speculate why there have been calls for ending the peg in Hong Kong. But I hope more people can see why this monetary system is still the best for our city.