Position Paper on Linking the "Hong Kong Dollar to the SDR"


Question Description

Position papers should be from 4-5 pages in length with an 11-size font, 1.5-line spacing, and 1" margins.

They should be prepared in the following format with the following subheadings.

Summary: Prepare a concise summary of the topic and recent reference articles, including a citation

from an article from a peer reviewed journal. (Recent articles are no more than four years old). Briefly

discuss why you selected this issue.

Position of the Author(s): State the position of the author(s) of the article you selected that relate to

your issue.

Analysis of the Issue: Using critical thinking skills, analyze the articles, including a discussion of the

areas in which you agree and disagree. Discuss what you agree AND disagree with keeping in mind

that it should be applicable to international business. You may address specific issues or apply the

principles involved in the issue.

Relation to Class Material: Discuss the relation of the articles to applicable topics of interest from our

textbook, including the text content and mini lectures located in Course Documents.

Key Contribution to International Business: Identify and discuss the contribution this topic/issue and

articles make to the field of international business. Implications for international managers and /or

entrepreneurs should be thoroughly discussed.

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Linking the Hong Kong Dollar to the SDRAuthor(s): Matthew Harrison and Geng Xiao Source: China Review , Vol. 19, No. 4 (NOVEMBER 2019), pp. 33-54 Published by: Chinese University Press Stable URL: https://www.jstor.org/stable/10.2307/26838912 REFERENCES Linked references are available on JSTOR for this article: https://www.jstor.org/stable/10.2307/26838912?seq=1&cid=pdfreference#references_tab_contents You may need to log in to JSTOR to access the linked references. JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at https://about.jstor.org/terms Chinese University Press is collaborating with JSTOR to digitize, preserve and extend access to China Review This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms The China Review, Vol. 19, No. 4 (November 2019), 33–54 Linking the Hong Kong Dollar to the SDR: An Increasingly Attractive Option Matthew Harrison and Geng Xiao Abstract Since 1983, the Hong Kong dollar has been linked under a modified currency board mechanism to the US dollar. This arrangement has maintained confidence in the Hong Kong dollar’s value, and is generally regarded as a success. Yet this confidence has been bought at the cost of volatility vis-à-vis other currencies and volatility in the economy as a whole. Geopolitically, as a Special Administrative Region of China, Hong Kong may find a link to the US dollar unsustainable, particularly if US-China tensions worsen. However, linking to China’s RMB will not be a sensible option as long as convertibility of the RMB remains restricted. Linking the Hong Kong dollar to the IMF’s SDR, which includes the RMB, would be a possibility in the future—the more attractive if by then there is wider use of the SDR. Since October 1983, the Hong Kong dollar has been linked to the US dollar under a modified currency board mechanism. This arrangement is widely felt to have served Hong Kong well, putting an end to the lack of confidence that had previously plagued the currency. The downside of the linked rate mechanism is that Hong Kong cannot operate an independent monetary policy, having in effect to Matthew Harrison is Senior Researcher in Hong Kong Institution for International Finance. Geng Xiao is Professor in Peking University HSBC Business School. Correspondence should be sent to xiaogeng@phbs.pku.edu.cn. This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms Matthew Harrison and Geng Xiao 34 accept the monetary policy of the US Federal Reserve. Because of Hong Kong’s divergence from US economic performance, it experiences periods of inflation or deflation, of which extended asset price inflation following the global financial crisis (GFC) is the most recent example. Moreover, the US dollar is volatile, resulting in sharp movements in the Hong Kong dollar exchange rate with other currencies. There have been calls from time to time to review the US dollar linked rate mechanism, for example linking the Hong Kong dollar instead to a basket of currencies or to the RMB. However, these have never been taken forward, and there has been little public discussion of possible future arrangements for Hong Kong’s currency. The present article puts forward the option of linking the Hong Kong dollar to a particular currency basket, namely the Special Drawing Rights (SDRs) of the International Monetary Fund (IMF), under a similar linked rate mechanism to the present one. While conditions for exercising this option are not yet present, they may be drawing closer. It is time for more active discussion of the possibilities. The article, an earlier version of which appeared in Caijng (財經),1 reviews the history of arrangements for the Hong Kong dollar, and describes the modified currency board under which parity with the US dollar is currently maintained. The drawbacks as well as the advantages of the current arrangements are discussed. Options for change are set out, and the costs and benefits of change explained. Background on the SDR is presented, and the option of re-linking the Hong Kong dollar to the SDR is elaborated, with its pros and cons. 1. The Existing Linked Rate Mechanism2 a. Previous Systems Hong Kong became a British colony in 1842. In the nineteenth century, China traders adopted the monetary system then operating in China, the silver standard. When Hong Kong introduced its own currency, it was based on silver—silver coins and banknotes exchangeable for silver. This system lasted until 1935, when China abandoned the silver standard. The monetary arrangements Hong Kong adopted thereafter were in effect a currency board based on sterling. The sterling-based currency board continued, with an interruption during the Japanese occupation. However, the base currency, sterling, This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms Linking the Hong Kong Dollar to the SDR 35 proved unstable. In 1967 when sterling devalued, Hong Kong did not follow it down but re-pegged at a new rate which maintained the preexisting cross-rate with the US dollar. Following a further sterling crisis in 1972, which led to a substantial drop in the value of Hong Kong’s largely sterling-based international reserves, Hong Kong cut its link with sterling and abandoned the currency board. The Hong Kong dollar was now free-floating. Without a central bank of its own, Hong Kong was reliant on the commercial banks, in particular Hongkong Bank (now HSBC). This worked reasonably well until negotiations began for the handover of Hong Kong to China. The negotiations impacted confidence in the Hong Kong dollar, resulting in severe pressure on the currency. The commercial banks did not feel justified in using their depositors’ money to defend the exchange rate, and so left it to fluctuate. A new monetary system was needed. Since Hong Kong had no central bank or other infrastructure necessary to manage a currency, there was no alternative to a currency board. Accordingly, the decision was taken in October 1983 to link the Hong Kong dollar to the US dollar at the rate of 7.80 under a quasi-currency board mechanism administered by the Exchange Fund. b. The Linked Rate Mechanism Historically, a currency board was based on physical currency. Initially, this was the approach taken in Hong Kong: from 1983 to 1988, the mechanism focused on physical cash only. Certificates of indebtedness (which backed the banknotes issued by the then-two note-issuing banks) were bought and sold by the Exchange Fund in accordance with a convertibility undertaking against payment of US dollars at the rate of 7.80. No other parties had access to the arrangement. Intervention by the authorities, mostly in the foreign exchange market, was needed to ensure that the market rate converged on 7.80 (at that time, the authorities did not possess the means to conduct unsterilized intervention). Thus, Hong Kong departed from the textbook version of the currency board relying wholly on arbitrage. In 1988, the authorities extended the mechanism to include the reserve balance of the banking system, via an account established for Hong Kong Bank at the Exchange Fund. Subsequently, with the introduction of real time gross settlement (RTGS) in 1996, all banks were obliged This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms 36 Matthew Harrison and Geng Xiao to maintain settlement accounts with the Exchange Fund. This gave the authorities the ability to conduct unsterilized intervention. However, they gave no convertibility promise for the reserve balance. The authorities concentrated on managing bank liquidity or interest rates, often via money market intervention. This focus may have raised doubts about the authorities’ commitment to the linked rate. From 1990, Exchange Fund bills were issued, followed by longer-dated Exchange Fund notes (together, EFBN); these widened the options for managing liquidity in the banking system and so influencing the exchange rate. Another tool was the Liquidity Adjustment Facility (LAF) introduced in 1992. In 1993, the Hong Kong Monetary Authority (HKMA) was formed, taking charge of the Exchange Fund and its responsibility for the currency. In March 1994, the HKMA announced that it would henceforth target short term interest rates rather than banking liquidity, with a view to keeping the former from going outside the LAF range, which in turn was set with reference to US interest rates. This objective would appear to contradict the functioning of the currency board which should see interest rates diverging from US rates in order to attract funds into or deter funds from the Hong Kong dollar and so maintain the target exchange rate by arbitrage. In March 1994, the HKMA began admitting article other than EFBN as collateral for the LAF, which may again be seen as a departure from currency board philosophy.3 Whether or not these measures weakened confidence in the linked rate mechanism, in August 1998 the Hong Kong dollar came under pressure. The HKMA intervened in the stock and futures market to head off alleged attacks—an example of sterilised intervention. In September 1998, reforms to the linked rate mechanism were enacted. Future issuance of EFBN was to be limited, albeit that following the Global Financial Crisis (GFC) from 2008 onwards EFBN issuance increased, reaching HK$1,071 billion at June 2019.4 The HKMA issued a firm convertibility undertaking for banks’ balances with the Exchange Fund on the weak side. The LAF was abolished, replaced by a discount window where the HKMA would provide funds set by reference to local interbank interest rates (not by US rates). These reforms removed a considerable portion of the discretion that the HKMA had formerly exercised. However, the HKMA continued to exercise discretion on the strong side. This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms Linking the Hong Kong Dollar to the SDR 37 In May 2005, the HKMA announced that the weak side convertibility undertaking would be moved by steps to 7.85, and a new strong side undertaking set at 7.75. The HKMA would retain discretion to intervene within the band. It thus took the authorities almost twenty-two years to arrive at the present largely rule-based system. Since 2005, there have been no further changes to the mechanism. However, as US interest rates began to rise in late 2017, Hong Kong interest rates did not follow suit. Speculators engaged in a carry trade by selling Hong Kong dollars and buying US dollars, weakening the Hong Kong dollar towards its lower limit. To counter this, the HKMA made a number of interventions to buy US dollars, so helping to bring both the exchange rate and the interest rates into line. Overall, the linked rate mechanism has maintained the Hong Kong dollar’s value against the US dollar within a tight range over a long period, 36 years at time of writing—such period covering quite severe monetary and economic challenges. The mechanism is generally regarded as a success. 2. Issues with the Linked Rate Mechanism Given that the link to the US dollar is seen to work, what, if any, are issues with the current mechanism? a. Loss of Monetary Autonomy The main disadvantage of a fixed exchange rate mechanism is that Hong Kong cannot conduct an independent monetary policy but must accept the policy of the jurisdiction of its base currency, namely the USA. In monetary terms Hong Kong is effectively the USA’s fifty-first state. If Hong Kong were to try taking an independent monetary path—for example unduly diverging from US interest rates or expanding or contracting its money supply—it would quickly attract arbitrageurs seeking to make riskless profits from the divergence, which would in turn threaten the linked rate. Hong Kong could not sustain such divergence for very long while maintaining a freely convertible currency—and without free convertibility Hong Kong could hardly remain an international finance and trade center. This is an example of the monetary trilemma—a jurisdiction cannot simultaneously have open capital markets, a fixed exchange rate and an autonomous monetary policy; only This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms 38 Matthew Harrison and Geng Xiao two out of the three may be pursued successfully.5 Hong Kong has chosen the first two, and so cannot have the third. The implications for Hong Kong of following US monetary policy have at times been quite dramatic. The 1985 Plaza Accord by which the leading world economies sought to drive down the value of the US dollar brought the Hong Kong dollar down with it, which led to a surge of economic growth for the territory (13.4% in 1987) and inflation.6 In the aftermath of the 1997/98 Asian Financial Crisis, Hong Kong experienced prolonged deflation (negative Consumer Price Index changes during each of the years 1999–2004).7 After the GFC, low interest rates and quantitative easing pursued by the US Federal Reserve to stimulate the US economy led to asset price inflation in Hong Kong, particularly of property, with social as well as economic repercussions. Given the very different economic structures of Hong Kong and the US, it is to be expected that from time to time US monetary policy will be inappropriate for Hong Kong’s position in the economic cycle. The US and Hong Kong together do not constitute an ‘optimal currency area’. Nonetheless, Hong Kong is generally felt to possess the necessary conditions for success in operating under a currency board mechanism. As summarized by Latter, these include, “ … sufficiently flexible costs and prices, a sound banking system, adequate fiscal discipline and the requisite foreign exchange reserves to back the monetary base, preferably free of other encumbrance.”8 Hong Kong wages and prices are regarded as flexible enough to adjust to changing conditions—thus the adjustment can be made through internal prices rather than the external price (the exchange rate). Hong Kong has large reserves to deal with residual turbulence and, if necessary, to ease the social consequences of adjustment—at end-June 2019 the Exchange Fund’s foreign exchange reserves amounted to US$434 billion,9 while the Government’s fiscal reserves amounted to HK$1,176 billion.10 The banking sector is prudently regulated by the HKMA and has high capital ratios—as at March 2019, the total capital ratio of locally-incorporated institutions was 20.4%.11 Nonetheless, the linked rate mechanism has contributed to marked social and economic stress, especially during the deflationary and more recent asset-price-inflationary eras. Hong Kong currently has the world’s highest residential property prices,12 for which the forced adoption of low post-GFC US interest rates is a factor (albeit that other factors such as This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms Linking the Hong Kong Dollar to the SDR 39 government land supply policy, and inflows of Mainland money have also been important). Inequality has risen, with the Gini coefficient rising to 0.539.13 The Hong Kong government has the resources to ameliorate social problems but has generally preferred to build reserves or spend on infrastructure. Nor should the continuing flexibility of the workforce be taken for granted as Hong Kong ages. At least the question should be raised—would another regime serve Hong Kong better? b. Departures from Currency Board Discipline A second reason for questioning the optimality of the present linked rate mechanism for Hong Kong is that in practice the authorities have not accepted the discipline of the currency board working on a fully ‘automatic’ or self-balancing basis. From the beginning they have sought to soften the impact of the mechanism by various discretionary interventions. However, these interventions are not costless but risk encouraging speculation or introducing distortions of their own. In the text book version of a currency board,14 parity with the anchor currency is maintained wholly by arbitrage; the currency board is, “ … a rule-based money-changing machine”.15 If holders of the operating currency sell, say because of lack of confidence that parity will hold, they will create a scarcity which will cause the price (interest rate) to rise, which in turn will attract holders back into the currency; the reverse will hold when parties initially buy the currency. The authorities need merely ‘hold the ring’ by insisting that each unit of the operating currency be backed by the requisite deposit of the target currency; the undirected actions of traders do the rest. The linked rate is maintained, at the cost of occasional sharp movements in interest rates. In the Hong Kong context, given the large financial sector and the highly financialized property market, interest rate spikes are particularly sensitive (albeit that currency board-related arbitrage would normally affect short-term interest rates, which are less sensitive for property). Arguably in this respect, Hong Kong may lack ideal conditions for the operation of a currency board. Historically, the authorities have managed the mechanism actively in various ways as described in Section 1b above, and have shown particular sensitivity to sudden movements in interest rates – especially in the massive stock market interventions of August 1998. Recently, there have been repeated if more modest interventions in the currency market in accordance with the convertibility undertaking.16 This content downloaded from on Tue, 11 Feb 2020 01:05:41 UTC All use subject to https://about.jstor.org/terms 40 Matthew Harrison and Geng Xiao Another departure from pure currency board principles is that the convertibility undertaking is restricted to banks, rather than open to traders at large. This limits the pool of players available to conduct arbitrage, raising the possibility of manipulation by players in that smaller pool. The HKMA combines a number of functions with that of operating the currency board—managing government deposits, regulating banks, operating payments infrastructure, and managing liquidity through EFBN issues. These other functions could potentially conflict with the operation of the linked rate mechanism. Hong Kong’s currency board mechanism and the linked rate itself are not enshrined in law, but are merely undertaken within the wide provisions of the Exchange Fund Ordinance. How serious are these potential defects? Latter considers that the HKMA’s exercise of discretion in the pre-1998 period, “rather than helping to settle markets, ... may at times have disturbed them.”17 However, he feels that by 2005 the HKMA’s discretion had been reduced to intervention within the 7.75–7.85 band, which he sees as unnecessary but of no great concern. Ho argues that in the modern era, the functions of liquidity management, government deposit-acceptance and so on are necessary and not incompatible with operating a currency board; these functions can be distributed among separate institutions, but combining them into one is not wrong and may have advantages. Given the interest rat ...
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Hong Kong Dollar to SDR




Hong Kong Dollar to SDR
The selected article for this study is “Linking the "Hong Kong Dollar to the SDR,” by
Harrison and Xiao. The authors reflect on the transition of the Hong Kong dollar (HKD) to the US
dollar through the mechanism of a modified currency board. The process has been considered as
a success because it has restored the confidence of the HKD (Harrison & Xiao, 2019). However,
the authors criticize the move because the region lost its independence on monetary policy.
Today, Hong Kong has to accept the policies that are enacted by the US Federal Reserve.
It also makes Hong Kong susceptible to a series of deflation and inflation since it does not operate
under the US fiscal policies. Besides, HKD is not stable in the foreign exchange market, which
has contributed to the urge for reviewing the linkage of the currency with the US dollar (Harrison
& Xiao, 2019). The article identifies issues with the linked rate mechanism, which also includes
the acceptability of the US dollar.
Proposals have been made to consider the use of the renminbi (RMB). These proposals
have not been initiated, and they even receive little public participation. This makes the future
arrangements for linking HKD to RMB unexplored (Harrison & Xiao, 2019). The authors continue
to explore the alternative of RMB and the US dollar, which is the Special Drawing Rights (SDR).
The alternative may become evident, although it is not presently available. The article explores the
origin and nature of the SDR in details, and the purpose of its establishment, which is to claim a
currency under the International Monetary Fund (IMF). They also address the possibility of Hong
Kong to experiment on cryptocurrency in the form that is SDR-enhanced to make the currency
This article was chosen because it provides an innovative proposal that could be adopted
by many nations and not Hong Kong alone. The region has lin...

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