Sunday March 18, 2018

Hong Kong dollar will be rock solid, currency bears should beware: Steve Hanke

By Asantha Sirimanne

Mar 02, 2016 07:56 AM GMT+0530 | 0 Comment(s)

INTEREST FLOAT:  Hong Kong's monetary base (reserve money) moves in step with dollar inflows and outflows. During the 2009 turmoil there were large inflows into Hong Kong while regional currencies took a beating.

ECONOMYNEXT - The Hong Kong dollar, backed by complementary monetary and exchange rate policy of its currency board will remain rock solid, and speculators who are trying to bring down the currency will get hurt as they have before, Steve Hanke, a top US economist has warned.

There have been media reports that George Soros, the man who failed to break the Hong Kong currency board during the East Asian Crisis and other hedge fund managers like Kyle Bass are trying once again to speculate against the currency.

"Like past speculative attacks against the HKD, this will fail and the bears will be forced back into hibernation, suffering large losses," Hanke, professor of Applied Economics at The Johns Hopkins University in Baltimore wrote in Globe Asia magazine.

"What is fascinating is how so many experienced currency speculators, like George Soros, can be so ill-informed about Hong Kong’s monetary setup."

"This is far from the first speculative attack on the HKD; the most massive occurred during the Asian Financial Crisis of 1997-98.

"We cannot forget hedge fund guru Bill Ackerman’s well-advertised 'bet the house' attack against the HKD in 2011. It failed badly.

"Like past speculative attacks against the HKD, this will fail and the bears will be forced back into hibernation, suffering large losses."

Spurious commentary and misguided attempts to 'short' the currency are based on widespread if not total ignorance of how currency boards work.

Hanke says even financial journalists and analysts do not understand currency boards, as shown by an exchange between John Greenwood, the architect of Hong Kong's currency board and Jake van der Kamp, a columnist at South China Morning Post newspaper and former analyst at Morgan Stanley, an investment bank.

"Greenwood politely took van der Kamp to the woodshed and told him that he didn’t know what he was talking about, and van der Kamp had the good sense to admit that he had sinned," Hanke said.

The Hong Kong dollars has not moved since 1983 when it was created in the wake global monetary turmoil after the US and UK tightened monetary policy.

Neither has any orthodox currency board which does not print money (generate liquidity against domestic currency assets like Treasury bills) and allows domestic money supply to be driven by the balance of payments.

All currency boards including in Sri Lanka in 1951, have been legislative action in a mistaken belief that monetary policy can drive growth.

Under a currency board, the exchange rate is fixed or hard pegged and interest rates float.

Many commentators and economists do not make a distinction between ordinary or soft-pegged currency arrangements with a policy rate and hard pegged arrangements like Hong Kong.

Balance of payments crises are created in (soft) pegged arrangement because the monetary authority simultaneously targets both the exchange rate and interest rate and fails on both counts.

In a country with a curency board there is no central bank to conduct monetary policy (print money to manipulate interest rates), all money is created by forex inflows, there are no exchange controls, no conflicts between exchange and monetary policy and therefore no balance of payments crises.

In a soft pegged arrangement, money is created both by forex inflows and by acquiring domestic assets (printed), generating a conflict between money and exchange rate policies, and a balance of payments crisis.

Exchange controls are also usually found in such countries.

"Under a fixed-rate regime, a country’s monetary base is determined by the balance of payments, which move in a one-to-one correspondence with changes in its foreign reserves," Hanke says.

"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."

But when there is an outflow of money, a soft-pegged central bank will create new domestic money to off-set the tightening effect of the outflow (sterilize a forex sale), generating new money, driving credit and giving ammunition for speculators to hit the peg.

"They are inherently disequilibrium systems, lacking an automatic adjustment mechanism," explains Hanke.

"Balance-of-payments crises erupt as a central bank begins to offset more and more of 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 and force a devaluation, interest-rate increases, the imposition of exchange controls, or all three."

As the Fed started to raise interest rates, Hong Kong's credit system also started to tighten and both broad money growth and credit to private sector are below trend growth, he says.

"This is just what is supposed to happen. We should expect a slow-down in the Hong Kong economy. But, the HKD will remain rock solid," says Hanke.

Though Hong Kong has a de facto policy rate for overnight liquidity, money is loaned only against currency board paper (which is fully backed by forex reserves) and only a limited quantity can be borrowed by each bank before interest rates start to move up.

If speculators try to borrow more Hong Kong dollars, including through swaps, interest rates will move up sharply, squeezing them as they had been before, which is why bears should beware.


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