The currency speculators are restless again. Many of them, including George Soros and Kyle Bass, are reportedly taking aim at the Hong Kong dollar (HKD). The HKD bears think that China’s renminbi (RMB) will lose value against the U.S. dollar (USD) as China’s economy slows down and capital flight from China continues. It has been asserted that this will put pressure on the HKD and force its devaluation, which would render the fixed rate of 7.8 HKD/USD null and void, and would pump profits into the pockets of those who bet on a devaluation of the HKD.
Like past speculative attacks against the HKD, this one will fail, and the bears will be forced back into hibernation after suffering large losses. It is remarkable how so many experienced currency speculators, George Soros among them, can be so ill-informed about Hong Kong’s monetary setup. This is far from the first speculative attack on the HKD. The most notable occurred during the Asian Financial Crisis of 1997-98. And we cannot forget hedge fund guru Bill Ackman’s well-advertised “bet the house” attack against the HKD in 2011. It failed badly.
The currency speculators aren’t the only ones who are ill-informed about Hong Kong. Financial journalists — even veterans with Hong Kong market experience — clearly don’t understand the currency board system that governs the course of the HKD.
So, why is there so much confusion about exchange rates, particularly fixed exchange rates delivered by currency board systems such as Hong Kong’s? To answer that question, we must develop a taxonomy of exchange-rate regimes and their characteristics. As shown in the table just below, there are three types of regimes: floating, fixed and pegged.
Prepared by Prof. Steve H. Hanke, The Johns Hopkins University.
In fixed and floating rate regimes, the monetary authority aims for only one target at a time. Although floating and fixed rates appear dissimilar, they are members of the same free-market family. Both operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a floating rate, a central bank sets a monetary policy, but the exchange rate is on autopilot. In consequence, a country’s monetary base is determined by the central bank. With a fixed rate, there are two possibilities: Either a currency board sets the exchange rate and the money supply is on autopilot or a country is “dollarized,” using the U.S. dollar or another foreign currency as its own, and the money supply is again on autopilot.
Under a fixed-rate regime, the monetary base is determined by the balance of payments, which moves in a one-to-one correspondence with changes in the country’s foreign reserves. With either a floating or a fixed rate, there cannot be conflicts between monetary and exchange-rate policies, and balance-of-payments crises cannot rear their ugly heads. Floating and fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of-payments crises.
Most people use “fixed” and “pegged” as interchangeable, or nearly interchangeable, terms for exchange rates. In reality, they are very different exchange-rate arrangements. Pegged-rate systems are those in which the monetary authority aims for more than one target at a time. They come in many varieties: crawling pegs, adjustable pegs, bands, managed floats and more. Pegged systems often employ exchange controls, and are not free-market mechanisms for international balance-of-payments adjustments. They are inherently disequilibrium systems, lacking an automatic adjustment mechanism. They require a central bank to manage both the exchange-rate and monetary policy. With a pegged rate, the monetary base contains both domestic and foreign components.
Unlike floating and fixed rates, pegged rates invariably result in conflicts between monetary and exchange-rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. When outflows become “excessive,” a central bank often attempts to offset the decrease in the foreign component of the monetary base by buying bonds, increasing the domestic component of the monetary base.
Balance-of-payments crises erupt as a central bank begins to offset the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange-rate and monetary policies, forcing a devaluation, interest-rate increases, the imposition of exchange controls or all three.
Let’s take a look at the HKD, which is linked to the USD via a currency board. In this case, the board’s monetary base (reserve money) must be backed by foreign reserves — 100% or slightly more. The currency board’s “backing rule” (or “stock rule”) is strictly followed in Hong Kong. As the following chart shows, the “flow rule,” according to which reserve money must change in a one-to-one relationship with changes in the currency board’s foreign exchange reserves, is also strictly followed in Hong Kong.
There has never been a system following currency board rules, like Hong Kong’s, that has ever been broken by a speculative attack. And Hong Kong’s is not destined to become the first. Indeed, its currency board is operating exactly as it should, which is why it can’t be broken.
So, what will happen? When the U.S. Fed embraced quantitative easing, USDs flowed into Hong Kong. Now that the Fed has started to notch up the Fed funds rate, the flows have reversed. As a result, the currency board is automatically tightening up, and both broad money and credit to the private sector are decelerating and are below their trend rates (see the chart below).
This is just what is supposed to happen. We should expect a slowdown in the Hong Kong economy. But the HKD will remain rock solid.
Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and Director of the Troubled Currencies Project, at the Cato Institute, in Washington, D.C.