Yam's Thick Peg
27 May 2005
On 15-Oct-03, in our article Destructive Ambiguity, we marked the 20th anniversary of Hong Kong's peg to the US dollar by criticising Hong Kong Monetary Authority Chief Executive Joseph Yam's doctrine of "constructive ambiguity". Mr Yam argued that the asymmetry in Hong Kong's currency board was a good thing. The HKMA undertook to convert Hong Kong dollars into US dollars at 7.80, but there was no undertaking to provide conversion in the opposite direction at 7.80 or at any other level. Consequently, when the HKD strengthened below 7.80, as it did in 2003, people were unwilling to convert HKD back into USD, in case the HKD was allowed to strengthen some more.
Mr Yam wrote in his column of 2-Oct-03:
"I am sure that the market will calm down soon. In the meantime, no doubt there will be critical comments again on the asymmetry in the manner in which we operate the Currency Board system, in that there is no formal convertibility undertaking on the strong side of the Link. But then there is no harm to have a bit of constructive ambiguity..."
There certainly were critical comments. We called then for the HKMA to introduce a two-way convertibility undertaking at a fixed rate of 7.80. We argued that ambiguity by definition constitutes uncertainty, that uncertainty attracts speculation, and that this was contrary to the objective of the peg which was to eliminate speculation on the value of the Hong Kong dollar.
In a rebuttal the following day, Mr Yam rejected these concerns. As a consequence, Hong Kong has spent the last 18 months with a continuation of record low interest rates even as US rates rose, and this has been a contributory factor (amongst other factors) in the inflation of local property prices by facilitating record low mortgage rates. In our opinion, we are in the midst of a new property bubble.
Now, in a U-turn, the HKMA has accepted that a two-way convertibility undertaking is needed, and on 18-May-05 it announced "refinements" to the operation of the "linked exchange rate system" (you will never hear them call it the peg). That's the good news. The bad news is that they put political considerations, namely jobs for bankers and profits for banks, ahead of common sense, and maintained a 10-cent spread between the convertibility rates, so you can have as many HKD as you like at 7.75, or as many USD as you like at 7.85. This range is what they call the "Convertibility Zone", or what we would call a "Thick Peg" - not a single point, but a range.
The real reasons for this were not spelt out in the recent announcement, but if you look back to a speech by Mr Yam on 19-Jan-04, he makes it clearer:
"There is a further consideration and this is the impact of a two-way convertibility undertaking on the jobs of all those employed in the dealing rooms of banks trading the Hong Kong dollar against the US dollar. Depending on whether there is a spread between the strong side and the weak side in the convertibility undertaking, market activity will be diverted to us and we would play the role as the market maker. In the extreme case when there is no spread and we buy and sell both at the level of 7.80, all buying and selling of Hong Kong dollar against US dollar will be diverted to us. We would be the counter-party to every deal and there would be much less a need for dealers that live on market volatility. Obviously, this is not something that any of us would wish to see..."
There you go, he said it..."dealers that live on market volatility". Mr Yam is essentially arguing that we should keep some uncertainty in the HKD/USD exchange rate so that people can be employed to speculate on it. Jobs for jobs' sake, and economic inefficiency for the sake of intermediaries. It's like arguing that we must keep some crime or there wouldn't be any jobs for the police.
In fact, there is another aspect to this, besides gratuitous job support. Banks currently make money by skimming a few tenths of a cent (or more) each way on conversions, and they are able to hide this by telling their customers that the exchange rate fluctuates, and that what they are offering is the "market rate". In the absence of a live quotation screen, or in a situation where the instruction is not negotiated in real time, most customers just accept what they are given as the market rate, and have no real choice, given that they cannot get a different counterparty without incurring the time and cost of moving money between banks. But if everyone knew that the peg was fixed at a two-way 7.80, then there would be virtually no scope for skimming these profits. Banks would compete and end up charging no more than the cost of taking your phone call or receiving your USD/HKD instruction on the internet. In short, the market would be more efficient. This would be great for everyone except those poor impoverished banks and bankers. But don't feel too sorry for them, because trades with all other currencies besides the USD would still carry risk and profit potential - Hong Kong's foreign exchange markets would continue, and you would still pay the bank a profit each time you switched other currencies.
Incidentally, Mr Yam is wrong to say that the HKMA would be the "counter-party to every deal" if the rate were fixed at 7.80. Only adjustments to banks' net positions would end up with the HKMA. When a customer decides to switch her HKD7,800 deposit into USD1,000, the bank wouldn't immediately convert HKD7,800 in its clearing account at the HKMA. Most of the time, as is currently the case, the bank would simply net that off against a trade they had made with another customer, or accept a tiny change in the bank's net HKD liabilities, particularly given that they would have no currency risk, since the rate of 7.80 would be fixed.
In the last week, the effect of the two-way convertibility undertaking has been what you would expect - investors now have the confidence to buy USD if the HKD is near the strong boundary of 7.75, and this prevents the massive build-up of HKD in the clearing system, and as a consequence, local interest rates have quickly adjusted upwards to close to the USD interest rate curve. However, by adopting a thick peg rather than a two-way conversion point of 7.80, we will all continue to pay more than we need to for foreign exchange, keeping a few bankers and their employers happy at our expense.
There is a second problem with adopting the thick peg rather than a single point, and that is that there is still foreign exchange risk attached to switching into the currency with the higher interest rate, so the interest rate arbitrage mechanism doesn't work as efficiently to level out the rates. By comparison, with a single exchange rate, the moment you are offered a higher interest rate in the other currency, it makes sense to switch, and so the rates are kept level. Already, the HKMA has had to intervene to create HKD within the range, rather than waiting to be hit at the boundary, and this has created further uncertainty about whether there is a boundary within the boundaries.
Some time in the next two years, but not yet, Mr Yam will probably admit to another error and move the boundaries to a fixed conversion point.
© Webb-site.com, 2005
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