Creeping Dollarisation in HK
23 May 2000
One of the first pieces we ever published on Webb-site.com was the text of a Nov-98 speech "Booms, Busts and Dollarisation" on the advantages of dollarisation as a solution to the stresses in the Hong Kong monetary system. That followed in the wake of the Government's misguided intervention in the stock market in Aug-98, which in turn was a reaction to weaknesses in the currency board system known as the "peg".
Intervention need never have happened
The essence of what happened prior to the stock market intervention was that the Government was running a very "orthodox" currency board. They believed that if there was a shrinkage in the supply of Hong Kong Dollars (due to people switching into foreign currency) then they should allow short-term local interest rates to climb until money was attracted back into the system by the conversion of US Dollars into Hong Kong Dollars. Penal rates of interest were imposed on banks if they repeatedly tried to borrow HK$ from the HKMA. During the Oct-97 crisis, this strategy was demonstrated when overnight rates briefly rose to triple-digit levels as equities crashed.
The flaw in the orthodox currency board is that when rates climb too high, confidence in the currency begins to weaken, and at the same time equity markets slide, feeding the fear. Then the higher interest rates are not enough to compensate for the risk of a substantial devaluation in the currency.
For example, even if 1-month HIBOR (the inter-bank interest rate) rises by 12%, this is only an extra 1% per month. Imagine yourself back In crisis conditions, and suppose that you estimate there is a 50% probability of the peg breaking in the next month, and that if it did, there would be a 20% devaluation. The "expected return" on the Hong Kong Dollar is then a loss of 10% (a 50% chance of a 20% loss), which is ten times what you would be paid for holding it.
Although the peg had by then been in place for 15 years, it seems that the Government was unprepared for the situation when hedge funds discovered the flaw and put pressure on the interest rates, trying to benefit from the resulting confidence crisis by taking short positions in the stock market.
What followed was nothing more than a panic move in which the HK Government invested US$15bn of public money in the stock markets to squeeze out the short positions of the speculators. This approach was given a boost in the Autumn of 1998 by the global contraction of credit to hedge funds caused by the Russian debt crisis, which cut their firepower.
Following the intervention, the HKMA got their night-caps off and their thinking caps on, and realised that they should never have allowed rates to be squeezed in this way. They introduced the "7 measures" to modify the currency board, and effectively converted the HKMA into a central bank. A full discount window was introduced to which Government bills and notes from certain other issuers could be presented as security for short-term HK$ funds, greatly expanding the monetary base.
Behind the scenes, there may also be a use by the Government of the foreign reserves to cushion outflows by repatriating US Dollar deposits to HK banks and then converting them to HK Dollars, triggering the corresponding sales by the banks. This could be justified, if required, on the basis of the need to finance the budget deficit from these reserves.
While all this has made it much harder to cause any change in interest rates by market manipulation, there was still a concern that the sheer volume of transactions passing through Hong Kong and the expanding size of the Hong Kong Dollar capital markets could create opportunities for speculators.
Steps were taken, for example, to discourage supranational bodies or multinationals from issuing short-term Hong Kong Dollar debt, because they would naturally swap the borrowed HK$ for US$. Hedge funds could take the other side of the swap and then sell the resulting HK$ for US$, setting up an outflow.
In effect, the HKMA has set out to domesticate the Hong Kong Dollar further and limit its use by external parties.
The US Dollar clearing system
The HKMA is now introducing a domestic US Dollar clearing system, to be administered for the next 5 years by HSBC. This will be a full-blown counterpart to the Hong Kong Dollar clearing system, including Real-Time Gross Settlement (RTGS). Until now, US Dollar payments between banks and with non-bank counterparties had to be cleared through correspondent banks in the USA. The resultant time delay of up to 2 days made it impractical for many purposes.
The stated motivation of the new system is to allow trading and settlement of US Dollar-denominated transactions in equities and bonds, initially on GEM. However, it has much wider potential than that. There is no reason why trading of all securities could not then migrate to US Dollars. Take HSBC Holdings plc, for example - a stock that still comprises around 20% of the Hang Seng Index. That company, which is domiciled in the UK, recently listed on the New York Stock Exchange and its primary currency of accounting is the US Dollar (its accounts also include translations into Pounds Sterling and HK$). Even its shares are now denominated in US Dollars.
If all HK stocks were traded in US$, and produced their accounts in US$, then foreign investors would find it easier to assess them, and cross-listings of HK stocks on US stock markets would just become an extension of the trading pool, with pricing being in the same denomination.
For overseas issuers (including mainland PRC companies) it makes far more sense to raise US Dollars directly than to conduct offers in HK Dollars and then convert them. The widespread use of US Dollars in our capital markets would be a huge boost to Hong Kong's aspirations to be a global financial centre.
Unless it is artificially restricted, there is no reason why the US$ clearing system could not also be used in everyday life. The system will also allow individuals to operate regular US$ current accounts. Cheques would clear overnight, the same as they do in HK$. Soon, you could be carrying a dual-currency cheque book which will allow you to shop and settle bills in US$ so long as your counterparty agrees. Credit cards and debit cards (such as the EPS system) could work the same way.
People working for companies which already do a large part of their business in US Dollars might request their salaries in US Dollars, and the companies would be happy to oblige as this removes currency translation altogether, and no longer involves telegraphic transfers overseas. Such companies include airlines, investment banks and multinationals with national or regional headquarters in Hong Kong. In time, local banks would match the resulting growth in the US$ deposit base by offering residential mortgages in US Dollars.
You can see where this is heading. Under the Basic Law (unless amended), the Hong Dollar must remain legal tender, but there is no reason why we cannot reduce its role to pocket change and adopt the US Dollar for all "big ticket" transactions.
The final step in this process would be to make life simpler for everyone by consolidating every 7.8 Hong Kong Dollars into one "New Hong Kong Dollar", equal in value to a US Dollar. This would then allow goods and services to be priced in one single amount, but settled with the same number of Hong Kong Dollars or US Dollars if the vendor agrees. This would be a boon to tourists who could then shop till they drop effectively in US Dollars without having to perform mental arithmetic. A "parity peg" of one US Dollar for every New Hong Dollar would reinforce the psychological perception that the peg is permanent. At 7.8, it has always seemed up for discussion.
See what you can do when you try!
After the Oct-97 crash, the Government commissioned a "Report on Financial Market Review" (word format) which was released on 23-Apr-98.
In that report, the possibility of dollarisation was given short shrift. Sadly, we believe China would only allow Hong Kong to formally adopt a foreign currency as a second legal tender under extreme pressure (such as everyone panicking and swapping their HK$ deposits for US$, creating a currency mismatch in the banking balance sheet), which incidentally, is the worst time to attempt dollarisation. Never mind the fact that 12 countries in Europe have been happy to surrender currency sovereignty to the European Central Bank and the Euro.
Apart from the sovereignty problem, one of the primary reasons cited for dismissing dollarisation was the difficulty in clearing transactions. The report stated:
"Theoretically, it should be possible for the banks to maintain US Dollar clearing accounts with the HKMA for the purpose of settling interbank and other transactions. But it is doubtful whether the US authorities would allow US Dollar clearing to be conducted by a foreign monetary authority in another time zone"
The new US$ clearing system demonstrates that there was no difficulty in achieving this. Indeed, the HKMA is so relaxed about the matter that it has contracted out the system to HSBC.
It won't quite lead to dollarisation (since strictly speaking the US Dollar will not be legal tender), but it's the next best thing. The current timetable sees US$ stock clearing from Aug-2000 and US$ cheque clearing from Sep-2000. From thereon, expect a gradual transition over several years as creeping dollarisation takes its effect.
© Webb-site.com, 2000
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