A survey of exchange rate systems with focus on currency boards and on Hong Kong's experience in particular

The choice of an exchange rate regime can make or break a regional economy. While a stable currency is useful to businesses, exchange rate flexibility also has its proponents. This thesis will first describe a brief history of exchange rate systems. Then, it will provide a survey and analysis of the benefits and drawbacks of different exchange rate systems. I will focus in particular on currency board arrangements. Some of them experience remarkable success, while others fail. The factors that contribute to the success of a currency board arrangement will be investigated. I will consider in particular the experience of Hong Kong, which has a mature experience in having a currency board to maintain a linked exchange rate system and stabilize its currency. This thesis studies Hong Kong's linked exchange rate system and discusses whether the system will continue to be optimal for Hong Kong. Finally, I will discuss the feasibility of alternative exchange rate systems in Hong Kong.

  A SURVEY OF EXCHANGE RATE SYSTEMS WITH FOCUS ON CURRENCY BOARDS AND ON HONG KONG’S EXPERIENCE IN PARTICULAR by Ka Ho Chan A Senior Honors Thesis Submitted to the Faculty of The University of Utah In Partial Fulfillment of the Requirements for the Honors Degree in Bachelor of Science In Finance Approved: ____________________ Hendrik Bessembinder Supervisor ____________________ Uri Loewenstein Chair, Department of Finance ____________________ Elena Asparouhova Department Honors Advisor ____________________ Dr. Sylvia D. Torti Dean, Honors College May 2014     ABSTRACT The choice of an exchange rate regime can make or break a regional economy. While a stable currency is useful to businesses, exchange rate flexibility also has its proponents. This thesis will first describe a brief history of exchange rate systems. Then, it will provide a survey and analysis of the benefits and drawbacks of different exchange rate systems. I will focus in particular on currency board arrangements. Some of them experience remarkable success, while others fail. The factors that contribute to the success of a currency board arrangement will be investigated. I will consider in particular the experience of Hong Kong, which has a mature experience in having a currency board to maintain a linked exchange rate system and stabilize its currency. This thesis studies Hong Kong’s linked exchange rate system and discusses whether the system will continue to be optimal for Hong Kong. Finally, I will discuss the feasibility of alternative exchange rate systems in Hong Kong.       ii   TABLE OF CONTENTS ABSTRACT ii INTRODUCTION 1 A BRIEF HISTORY OF EXCHANGE RATE SYSTEMS 3 CLASSIFICATION OF EXCHANGE RATE SYSTEMS 7 PROS AND CONS OF DIFFERENT EXCHANGE RATE SYSTEMS 12 CURRENCY BOARD ARRANGEMENT 18 HONG KONG’S LINKED EXCHANGE RATE SYSTEM 27 NOTES 49 REFERENCES 50       iii 1     INTRODUCTION The linked exchange rate system, an exchange rate regime that links the Hong Kong dollars to the United States dollars at a fixed rate, has contributed to Hong Kong’s monetary stability for more than thirty years, and has created an environment that fosters Hong Kong’s economic prosperity. However, the United States economy has not performed very well in recent years. John Greenwood, Chief Economist at Invesco Perpetual, commented in a BBC article that the “US interest rates - which are transmitted to Hong Kong by the peg - are currently too low for the vibrant economic conditions in Hong Kong” (2011). In addition, the former head of the Hong Kong Monetary Authority, Professor Joseph Yam, attributes inflation and asset bubbles in Hong Kong to the policy of quantitative easing the United States implemented after the global financial crisis (Liu, 2012). According to these economic experts, the United States’ efforts to stimulate its economy, such as setting low interest rates and quantitative easing, mismatch Hong Kong’s needs. Hong Kong’s inflation is among the highest of its major trading partners and housing prices have recently been at an all-time high. Hong Kong citizens have a hard time affording their living and daily expenses. This can be a result of the appreciation of the Chinese yuan against the US dollar. Since the value of the Hong Kong dollar is linked to the value of the United States dollar, the Hong Kong dollar depreciates against the Chinese yuan. Hong Kong’s commodities, and even housing, are now very attractive for Chinese consumers and investors. This high demand may be a reason for high inflation, since adjustments to economic conditions are made through internal adjustments such as prices and wages rather than exchange rate.   2     This situation has prompted a debate on whether or not the linked exchange rate system still serves the best for Hong Kong. As described by Want China Times, individuals such as Joseph Yam, former chief executive of the Hong Kong Monetary Authority, and Raymond Yeung, a senior economist at ANZ Banking Group, doubt if a review of the linked exchange rate system is needed or not (2012). To fix the current condition by using the exchange rate as a tool, Hong Kong can choose to change the nominal exchange rate, change the anchor, or even change the exchange rate system. To determine in which direction Hong Kong is heading, I will first discuss the history of exchange rate regimes and offer an analysis on the benefits and drawbacks of each exchange rate system. I will further focus on the understanding of a currency board arrangement and discuss Hong Kong’s experience in particular.     3     A BRIEF HISTORY OF EXCHANGE RATE SYSTEMS In ancient times, people used gold as currency since it was beautiful and rare. Through the passage of time, the use of gold has been extended and used as collateral to back up coins, notes, and other currencies. Similarly, silver and other precious metals, were used by some countries as their currency or the collateral of their currency. In the nineteenth century, many countries adopted bimetallism. These countries used both gold and silver as their currency (Eichengreen, 2008, p.8), with gold and silver linked to each other at a fixed rate. However, using both metals as currency was difficult. As the change in the exchange rates were different in the local and world markets, fixed prices created rooms for arbitrage. Whenever there were differences between the local and world markets and the differences excessed the cost of shipping and brassage, arbitragers imported silver and exported gold, or vice versa, in order to earn the difference between those two rates until one of the currencies was driven out of circulation (Eichengreen, 2008, p.9-10). It was difficult to keep the local and world exchange rates the same, or even similar, and therefore bimetallism was hard to maintain. Many countries returned to the gold standard in the third quarter of the nineteenth century; accurately speaking, many countries adopted the classical gold standard in the 1870s (Eichengreen, 2008, p.8). Different from previous monometallic monetary systems, the classical gold standard has the following two distinguishable features: it (1) “relied upon banknotes that were fully convertible into gold at a stable exchange rate” and (2) “allowed a relatively free movement of the capital” (Knafo, 2006, p.81). Because of these two important characteristics, the exchange rate between different currencies     4     could be calculated by comparing the amount of gold that they could purchase. This implied that the exchange rate was known as the mint parity rate (Robin, 2010, p.86). In 1930s, the world experienced the Great Depression. Country after country suspended the exchange of fiat money into gold. This caused a collapse of the global trade and capital flows occurred between countries (O'Driscoll, 2012, p.440). The Great Depression ended the classical gold standard. Later in 1944, 44 countries sent their representatives to the Mount Washington Hotel in Bretton Woods in the hope to rebuild the international monetary system. In the Bretton Woods Conference, countries agreed to create a “monetary system envisioned fixed exchange rates with a gold linkage” (O'Driscoll, 2012, p.444). Ashok J. Robin (2010), a Professor of Finance at the Rochester Institute of Technology, summarized five key provisions of the Bretton Woods Agreement of 1944: • The United States currency was linked to gold at a fixed rate of $35 per ounce and became the key international currency; • The U.S. central bank had to use gold reserves to back up the value of USD and allowed free conversion of USD into gold; • Other central banks had to reverse gold and other key currencies to support the value of their own currencies; • International Monetary Fund was established to oversee the international monetary markets and be responsible for financing countries who experience temporary difficulties in balance of payments resulting from trade imbalances;     5     • Periodic assessment and adjustment of currency values had to be carried out so as to maintain the international monetary system in balance (p.88). Since the United States was a major creditor of many other countries, the United States dollars became one of the key international currencies. The United States dollars were supported by gold, and other countries used gold and key international currencies to support the value of their own currency. By doing so, exchange rate markets were restored. The Bretton Woods Agreement created a new international monetary system which enabled international trading and capital flows. However, by the 1960s, the United States realized that the US dollar was overvalued. As recorded by the U.S. Bureau of Public Affairs, “a surplus of U.S. dollars caused by foreign aid, military spending, and foreign investment threatened this [the Bretton Woods] system, as the United States did not have enough gold to cover the volume of dollars in worldwide circulation at the rate of $35 per ounce; as a result, the dollar was overvalued” (2013). Eventually, shortage of gold compared to the US dollar forced the United States to terminate the conversion of United States dollars to gold on August 15, 1971. This caused the breakdown of Bretton Woods System. In order to resolve this problem, according to the Smithsonian Agreement, the US dollar was devalued to US$38 per ounce (Robin, 2010, p.89) and with a margin of ±2.25 percent around the new fixed rate (Madura, 2011, p.58). Even the exchange rate was adjusted and allowed to fluctuate more under the new agreement, governments still could not maintain exchange rates within the boundaries due to speculative activities. During 1972, speculators put upward pressures on many European currencies; the respective central banks intervened the exchange rate markets and accumulated excessive huge amounts of     6     United States dollars, which caused inflationary pressure in the U.S. (Humpage, 1971). Under this situation, the US government could no longer maintain the fixed rate of US$ 38 per ounce. Though the United States devalued its currency to US$42 per ounce on February 12, 1973, the dollar was still overvalued, again due to the uncontrolled speculative activities. By March 1973, many currencies were allowed to float freely under the market influence (Madura, 2012, p.58). As history developed, exchange rate regimes also developed from a very rigid system to a more flexible system, and finally to a relatively free one. Meanwhile, governments became more actively involved in exchange rate regimes.     7     CLASSIFICATION OF EXCHANGE RATE SYSTEMS There are many ways to classify exchange rate regimes. In particular, the International Monetary Fund (IMF) provides a systematic way to define and classify different exchange rate systems. IMF generalizes exchange rate regimes into the following categories: Exchange arrangements with no separate legal tender Countries that exercise exchange arrangements with no separate legal tender, also known as exercising dollarization, use another country’s currency as the only legal tender or share the same currency with a monetary union.1 For example, the twelve countries in the Euro area such as Greece, Italy, and France share Euro as their currency. These countries give up their control over domestic monetary policy (International Monetary Fund [IMF], 2006). Currency board arrangements Countries that exercise currency board arrangements have an explicit legislative commitment to issue their domestic currency against reserves of a foreign currency at a fixed exchange rate, hence the currency of these countries is fully backed by foreign reserves. For example, Hong Kong links its currency to the United States dollar under a currency board arrangement. These countries have little room for flexible monetary policy and completely surrender traditional central bank functions (IMF, 2006). Conventional fixed peg arrangements     8     Countries that exercise conventional fixed peg arrangements maintain their currency at a fixed exchange rate to the currency of another country for at least three months. Under this arrangement, the fixed exchange rate has to be either within margins of ±1%, or the maximum and minimum rates must stay within a margin of 2% relative to the currency of another country. Instead of having a fixed exchange rate with a sole currency, countries can also peg their currency with a basket of currencies which is a composition of weighted currencies of major trading countries. For example, the Chinese currency is linked to a basket of currencies. These countries maintain a fixed exchange rate through direct intervention and indirect intervention. They have limited flexibility of monetary policy and the right to adjust the exchange rate, albeit rarely (IMF, 2006). Pegged exchange rates within horizontal bands Countries that exercise pegged exchange rates within horizontal bands maintain their currency fluctuating at certain margins relative to another country’s currency or a currency composite; the margins are greater than ±1% or the maximum and minimum exceeds 2% relative to the anchor. Demark and Hungary are examples of countries implementing this system. These countries have limited control over their monetary policies (IMF, 2006). Crawling pegs Countries that exercise crawling pegs slightly alter their fixed exchange rate according to economic indicators such as inflation. Tunisia is an example. These countries have limited control over their monetary policies (IMF, 2006).     9     Exchange rates within crawling bands Countries that exercise exchange rates within crawling bands have exchange rates fluctuating at certain margins greater than ±1% or the maximum and minimum exceeds 2% relative to an anchor. These exchange rate fluctuations are triggered by economic indicators such as inflation. Belarus is the only country that adopts exchange rates with crawling bands. Having such a system allowed government to have limited control over its monetary policy (IMF, 2006). Managed floating with no predetermined path for the exchange rate Countries such as Egypt, Thailand, and Vietnam which exercise managed floating with no predetermined path for the exchange rate manage their currency’s exchange rate without a particular stated direction. These countries can use a wide variety of indicators. The choice of indicators is somewhat subjective, and changes in exchange rate may not follow these indicators automatically. These countries maintain their exchange rate regime through direct intervention and indirect intervention (IMF, 2006). Direct intervention entails government reductions or increases in foreign reserves, and converse actions in domestic currency reserves. By exchanging the country’s local currency in the currency market, the country’s government adjusts the local currency’s value. Indirect intervention includes governmental actions that influence inflation, interest rate, income level, government controls, and expectations of future exchange rates, with the goal of adjusting their currencies’ value. Independently floating     10     Countries like Japan and the United States that exercise independently floating system let the market determine the exchange rate of their currency. These countries make use of official foreign exchange market intervention to moderate the exchange rate and avoid unnecessary rises and falls in the exchange rate (IMF, 2006). IMF classified its members into different categories according to the above definitions, and Figure 1 shows the percentages of countries in implementing different exchange rate systems in 2008. Other  conventional  8ixed  peg   arrangement     Managed  8loating  with  no  pre-­‐ determined  path  for  the  exchange   rate     Independently  8loating     Currency  board  arrangement     Exchange  arrangement  with  no   separate  legal  tender     Crawling  peg     Pegged  exchange  rate  within   horizontal  bands     Figure 1. Percentages of countries in implementing different exchange rate systems in 2008. From International Monetary Fund, 2006,  in  De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks, retrieved September 25, 2013, from http://www.imf.org/external/np/mfd/er/2008/eng/0408.htm.     11     Among the eight exchange rate systems, most countries implement conventional fixed peg arrangements, managed floating with no predetermined path for the exchange rate, and independently floating. There is no one exchange rate system that fits most countries. To determine the reasons why countries choose to implement different exchanges rate systems, I categorized the above eight systems into three buckets according to their similar features. In the next section, I discuss the pros and cons of the three categories. Table 1 shows how I grouped exchange rate systems into three categories. Table 1 Three Generalized Categories of Exchange Rate Systems Categories Fixed exchange rate system Exchange Rate Systems Exchange arrangements with no separate legal tender Currency board arrangements Intermediate Conventional fixed peg exchange arrangements rate system Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling bands Floating Managed floating with no exchange predetermined path for the rate system exchange rate Independently floating     Monetary Exchange rate policy policy Little to Applied no flexibility Source of monetary base Foreign Limited Applied flexibility Both foreign and domestic Flexible Domestic Not applied 12     PROS AND CONS OF DIFFERENT EXCHANGE RATE SYSTEMS For simplicity, when examining the advantages and disadvantages of different exchange rate systems, I assumed that they are operated ideally according to their principles and definitions. In fact, usually governments are not playing by the book for many reasons such as political pressures, better economic performances, different government objectives, etc. Pros of Fixed exchange rate systems Under a fixed exchange rate system, the foreign exchange rate of a currency is relatively stable. When a currency is anchored to a strong currency at a fixed exchange rate, no sudden exchange rate changes occur. This facilitates global trade and foreign investments as foreign exchange rate risk is reduced. Hence, the fixed exchange rate system promotes economic stability and prosperity. In addition, fixed exchange rate is a credible tool for lowering local inflation. Anchoring the local currency to the currency of a low inflationary country “may serve as a commitment technology allowing the government to resist and even forestall subsequent temptations to follow excessively expansionary macroeconomic policies” (Obstfeld and Rogoff, 1995, p.6). There is a strong link between a fixed exchange rate system and low inflation due to a “discipline effect (the political costs of abandoning the peg induce tighter policies) and a confidence effect (greater confidence leads to a greater willingness to hold domestic currency rather than goods or foreign currencies)” (Ghosh, A.R., Gulde, A., Ostry, J. D.,& Wolf, H. C., 1996). Without excessively expansionary macroeconomic policies, the original high inflation rate is adjusted to a lower one.     13     Furthermore, a currency with a fixed exchange rate has higher creditability. Since the local currency is fully backed by foreign reserves, by linking the local currency to a credible foreign currency, people have confidence in using the local currency. They know that the local currency will not be worth nothing. If people have no confidence in a certain currency, it is useless because it loses its functions as a medium of exchange, store of value, and measure of value. Finally, a fixed exchange rate system limits government intervention. As the value of a local currency is linked to a foreign currency, there is little room for a government to use monetary policies to affect the value of its currency. This diminishes the currency risk by reducing the effect of government objectives. Cons of Fixed Exchange Rate Systems Maintaining a fixed exchange rate system is painful and expensive for an economy (Beker, 2006, p.316). The mechanism for absorbing economic shocks is to utilize interest rates rather than exchange rates. When a currency faces depreciation pressures, the government raises the interest rate through different means such as open market operation. The increase in interest rate attracts capital flowing into the country. Market participants buy the local currency and the supply of that currency decreases. The currency then appreciates and the exchange rate restores. However, raising the interest rate is a double-edged sword. While a high interest rate can attract capital inflow and restore the fixed exchange rate, it hinders the economic development of a country. In addition, using a fixed exchange rate system makes a country lose monetary sovereignty. If a country pegged its currency to another currency at a fixed rate, there is     14     little room, if any, for the country to make decisions on its monetary policy. The government is unable to use its own monetary policy to adjust the local economy. Moreover, if the economic cycles between the country using a pegged currency and the country which the currency is pegged to, are different, the mismatch hurts the economic development of the country using a pegged currency. Pros of Intermediate Exchange Rate Systems An intermediate exchange rate system has moderate flexibility and credibility. This “half-independent” monetary policy with a “half fixed” exchange rate is “more viable, and thus becomes more credible, if policymakers adopted some degree of management of capital inflows and outflows” (Kaltenbrunner and Nissanke, 2009, p.1). While a currency is linked to another currency, a government has some freedom to adjust the exchange rate through limited monetary policy. This way, the currency is supported by foreign reserve, though not fully, and monetary policy fits more the local economic conditions, though not totally. The system gives up some creditability in exchange for some flexibility in terms of monetary independence, and vice versa. Cons of Intermediate Exchange Rate Systems An intermediate exchange rate system, through observation, is the most susceptible to speculative attacks among all exchange rate systems, which causes currency crises. Whenever a pegged currency faces depreciating pressure, the government tries to maintain the fixed exchange rate by reducing its foreign reserve and buying its currency. The diminishing foreign reserve signals the weakness of the country     15     to defend the peg, hence inducing speculative attacks to take place. Andrea Bubula and Inci Otker-Robe confirm the above argument statistically, in an International Monetary Fund working paper, by finding that “the frequency of crises was significantly higher for intermediate regimes than both for hard pegs [fixed exchange rate systems] and floating regimes” (2003, p.19). Figure 2. Number of speculations happens under different exchange rate systems over 1990-2001, from Bubula and Otker-Robe, 2003, Are Pegged and Intermediate Exchange Rate Regimes More Crisis Prone?, p.12, retrieved February 18, 2014 from http://www.cgu.edu/include/ Bubula2.pdf Pros of Floating Exchange Rate Systems A floating exchange rate system is an efficient tool to absorb shocks. Edwards and Yeyati in the National Bureau of Economic Research Working Paper, flexible exchange     16     rates as shock absorbers, provide evidence indicating that floating exchange rate systems are able to adjust negative shocks smoothly through depreciations in the real exchange rate (2003, p.16). With a flexible real exchange rate, shocks have a reduced amount of impact on the economy. Moreover, floating exchange rate systems allow governments the autonomy of monetary policy. Since governments can have independent monetary policy, they manage to use their currency’s value as a tool to accomplish government objectives or adjust the local economic conditions such as inflation. By doing so, the macroeconomic policy matches the needs for economic development. Furthermore, a floating exchange rate system is market-driven. Though government intervention still takes place, the exchange rate is largely determined by the market. This is a natural mechanism that drives the exchange rate to an appropriate number according to the supply and demand of a currency. This prevents the presence of an overvalued or undervalued currency in the long run. Cons of Floating Exchange Rate Systems The most significant disadvantage of a floating exchange rate system is the unpredictable volatility due to the fluctuations of the nominal exchange rate. Investors have to assume much more risk when investing or trading in a currency under a floating exchange rate system. For example, in a sudden currency depreciation, investments in that currency are worth less and become a loss for investors. Even worse, if investors hold liabilities in foreign currency, investors have to use a larger amount of local currency than before in exchange for enough foreign currency to pay off debts. For     17     another instance, in a sudden appreciation in currency, investors who hold foreign assets suffer a loss as the foreign assets can now exchange for a lesser amount of local currency than before. A country which has a currency with high volatility in exchange rate yields higher foreign exchange risk, which in turn deters investors from investing or trading with that country and discourages the economic development of that country. Even if investors can hedge the foreign exchange rate risk, a cost is associated with the hedge. In the same sense, importing and exporting businesses, companies with foreign subsidiaries, and multinational firms are also facing a high exchange rate risk under a floating exchange rate system. A volatile exchange rate may deter businesses from operating and hence adversely affect economic activities.     18     CURRENCY BOARD ARRANGEMENT A currency board arrangement is a rules-based monetary system in which a government expresses its commitment in law that its currency maintains a fixed exchange rate with a specific foreign currency, and is fully convertible and supported by that foreign currency through the supervision from an independent currency board. Under an orthodox currency board arrangement, the monetary base of a country, which is supported by foreign reserve, changes according to the capital movements into or out of the country. As a result, the interest rate changes and drives the exchange rate back to the nominal exchange rate. Figure 3 illustrates when there is a capital inflow to Country A which adopts a currency board arrangement, the demand of its currency increases from D to D1 and thus creates an upward pressure in the value of its currency from P to P1. To maintain the nominal exchange rate, monetary base is then increased and interest rate falls. The increase in supply of the currency from S to S2 drives the value of the currency back to the original price P. In the same sense, when the is a capital outflow from the country, the contraction in monetary base and increase in interest rate drives the value of the currency back to the nominal exchange rate. Hence, equilibrium at the nominal exchange rate can be achieved.     19     Figure 3. Currency board arrangement mechanism. Suitability A currency board arrangement is especially suitable for small and open economies, as Professor John Williamson from Boston College explains the seigniorage cost “is likely to be zero or minimal for open, and therefore for small, economies” and “small countries find it more natural to keep a high level of reserves relative to the money supply” (1995, p.32). Countries which look for adopting a currency board arrangement usually have a desperate need of stable money and an institution that would deliver a hard budget constraint (Hanke, 2000, p.52). Besides that, small countries that want to launch new local currency would like to adopt a currency board arrangement in order to get a quick start and earn credibility. Requirements In order to maintain a currency board arrangement, countries have to meet the following requirements. First of all, countries need to have adequate reserves. By having     20     adequate reserves, local currency is fully backed by foreign reserve assets. In other words, no local currency is issued without putting the equivalent amount of the anchor currency or assets into foreign reserves. Since the value of a local currency is fully supported by foreign assets, the credibility under a currency board arrangement can be upheld. Moreover, in case of speculative attacks over a local currency, adequate reserve provides government the ability to expend or contract the monetary base in order to maintain the nominal exchange rate. In addition, countries also need to have a sound legal basis for a currency board arrangement (Enoch and Gulde, 1998). The adoption and operation of a currency board arrangement must be explicitly stated in the law. By having the rules of law, government’s commitment to the currency board arrangement is more rigid and further enhances the credibility of the system. Therefore, the credibility of a legal system and the legal definition of a currency board system together derive the credibility of a currency board system. Moreover, operating an effective currency board arrangement requires a government to have fiscal discipline. There should be an “acceptable balance between government receipts and expenditures support both the economy and the currency” (Kopcke, 1999, p.21). A fiscally disciplined government does not need to use the exchange rate as a tool to make up for fiscal deficit; hence the fixed nominal exchange rate under a currency board arrangement can be maintained. Furthermore, a successful currency board also requires a strong and well managed financial system. Under a sound financial system, the banking system “should be able to manage the volatility of interest rates, assets’ values, and financing that can result from     21     the monetary authority’s maintaining a fixed rate” (Kopcke, 1999, p. 31). To construct a well-developed financial system, banks should “maintain adequate capital, proper reserves for losses, full disclosure of their financial conditions, and access to credit aboard when necessary” (Kopcke, 1999, p. 31). Last but not least, having an efficient currency board arrangement requires choosing an appropriate anchor with an appropriate exchange rate. When countries try to pick a stable anchor, they consider the strength and international usability of a currency, as well as the trading activities with the anchor country (Enoch and Gulde, 1998). If the economic cycle of the anchor country is not well matched with the country with a currency board arrangement, this may restrict the development of that country. The Rise and Fall: the Case of Argentina There are only few successful examples of currency board arrangement. The International Monetary Fund considers the Argentinian currency board being one of them (IMF, 1999, p.7) though it failed in 2002. In the years before Argentina adopted its currency board arrangement, Argentina suffered hyperinflation, low or even negative GDP growth, and lack of capital investments. With the announcement of a currency board arrangement, all these bad situations disappeared. As shown in Figure 4, the inflation rate dropped from more than a 1000% in 1990 to almost zero in 1995. Figure 5 also shows that the GDP growth became positive after the introduction of the currency board arrangement. Besides that, Figure 6 also illustrates that people were more confident in investing in Argentina after having the currency board arrangement as foreign direct investment went up.     22     Figure 4. Inflation in Argentina in years before and after the introduction of the Argentine currency board arrangement. From Balino,J.T. and Enoch, C., 1997,   in   Currency board arrangements: issue and experiences, p.8. 15   10   5   0   1980  1981  1982  1983  1984  1985  1986  1987  1988  1989  1990  1991  1992  1993  1994   -­‐5   -­‐10   Figure 5. Argentina annual GDP growth rate. From The World Bank, 2014, in Argentina GDP growth (annual %), retrieved February 14, 2014, from http://data.worldbank.org/ indicator/NY.GDP.MKTP.KD.ZG/countries/1W-AR?display=default     23   Millions     5000   4500   4000   3500   3000   2500   2000   1500   1000   500   0   -­‐500   1980  1981  1982  1983  1984  1985  1986  1987  1988  1989  1990  1991  1992  1993  1994   Figure 6. Foreign direct investment in Argentina in USD. From The World Bank, 2014, in Argentina foreign direct investment, net inflows (USD), retrieved February 14, 2014, from http://data.worldbank.org/indicator/BX.KLT.DINV.CD.WD/countries/1W-AR?dis play=default Though Argentina enjoyed the benefits from its currency board arrangement for years, it could not maintain the system because it violated several requirements of a currency board arrangement. Argentina had a robust banking system (Hanke, 2003, p.54) which provided a feasible environment for operating a currency board arrangement. However, four out of the five requirements listed above were not met by the Argentine currency board arrangement. First of all, the Argentine currency board retained the ability to adjust reserve requirements. This allowed both foreign and domestic assets to support its currency and the exchange rate system started with only 66.6% in true foreign reserve (Spiegel, 2002, p.1). This violated the requirement of adequate reserve. In fact, the Argentinian currency     24     board sterilized or offset changes in its foreign reserves so aggressively after 1994 (Hanke, 2003, p.48). Inadequate reserve weakens the ability of a currency board arrangement to respond to crisis and also hurt the credibility of the system since people may worry the value of foreign reserve is no longer enough to support the value of peso. In addition, the Argentinian government broke its legal commitment to the currency board arrangement. It enacted new legislation that “change[d] the peso’s anchor from the dollar to a euro-dollar basket, and [ruled] the prohibition of internal convertibility” (Hanke, 2003, p.49). Change in government commitment in a currency board arrangement seriously hurt its credibility because people may doubt that if the government will change the rule someday. By doing so, the currency board arrangement may also be more attractive to speculations. Moreover, the Argentine government had bad fiscal discipline. It had fiscal deficits almost every year. For the years before 2002, the time Argentina gave up its currency board arrangement, the fiscal deficit increased as a percentage of GDP and reached 15.87% in 2002 (see table 2). This hurts the credibility of the currency board arrangement as people doubt that the government will someday modify the exchange rate system and monetize the deficit. The uncertainty also attracts speculative activities.     25     Table 2 Argentina Fiscal Deficit from 1999 to 2012 Note. Adapted from Argentina Government budget deficit, by countryeconomy.com, 2014, retrieved February 14, 2014, from http://countryeconomy.com/deficit/argentina Last but not least, the fundamental problem that led to the dismissal of the currency board agreement was the inappropriate nominal exchange rate. The peso linked to the US dollar at a one-to-one exchange rate caused an overvaluation of the peso (Hanke, 2003, p.47). As a result, Argentina became uncompetitive international trading and ran a trade deficit under the currency board arrangement (see Figure 7). An overvalued currency cannot be sustained by all means and eventually contributes to the breakdown of the improper fixed exchange rate.     26     Figure 7. Argentina balance of trade from 1986 to 2002 in USD million. From Trading Economics, 2014, in Argentina Balance of Trade, retrieved February 14, 2014, from http://www.trading economics.com/argentina/balance-of-trade     27     HONG KONG’S LINKED EXCHANGE RATE SYSTEM In 1960, 38 countries were adopting currency board arrangements, but by 1970, there were only 20 and by the late 1980s, only 9 remained (Enoch and Gulde, 1998). While there were many countries which failed to maintain a currency board arrangement and fewer and fewer countries choose to adopt such a system, Hong Kong has maintained its linked exchange rate system, which is a currency board arrangement, for more than thirty years. The system is so successful that the International Monetary Fund regarded the system as the most prominent among a handful of successful currency board arrangements (IMF, 1999, p.7). Milton Friedman, a Nobel Prize winner in economic science, commented that “the currency board system that was introduced in 1983 has worked very well for HK and I believe it is desirable that it be continued” (1994, p.1). Brief history of Hong Kong’s exchange rate system In 1841, Hong Kong used multiple currencies. People used Chinese currency silver ingots and copper cash - for domestic transactions and Spanish and Mexican silver dollars for international trade. The British government attempted to make the British pound Hong Kong’s legal tender, but it failed to do so because the British pound was unpopular in Hong Kong (HKMA, 2000, p.5). In 1863, the colonial government in Hong Kong declared the only legal tender was the silver dollar and issued the Hong Kong dollar in 1866. During the time Hong Kong used the Silver Standard as its exchange rate regime, the price of silver against gold was very unstable and therefore contributed to the economic crisis in the 1890s (HKMA, 2000, p.7).     28     By November 1935, the price of silver had surged in the United States. The more attractive silver price in the United States led to a huge outflow of silver from China. Hong Kong followed China to give up the silver standard. The colonial government declared that the Hong Kong dollar would become the local monetary unit with an exchange rate of HK $16 per pound (HKMA, 2000, p.7). The Hong Kong government enacted the Currency Ordinance of 1935, which stated that banks have to surrender their silver bullion to an Exchange Fund in order to get certificates of indebtedness to issue banknotes. A currency board system was established at this time. In 1967, the exchange rate of the Hong Kong dollar was still linked to the pound, but the rate became HK $14.55 per pound. Under the Sterling Exchange Standard, Hong Kong faced an unstable financial system because of the depreciating pound due to Britain’s deteriorating economic power (HKMA, 2000, p.9). The Hong Kong government linked the HK dollar to the US dollar with ±2.25% bands around HK$5.65 per USD in 1972 and linked to the US dollar at HK$5.085 per USD in 1973. In response to the weakening US dollar, the Hong Kong government decided to let the Hong Kong dollar float freely in 1974. Under the free floating exchange rate regime, Hong Kong’s economy developed well in the first two years but deteriorated afterwards as the existence of trade imbalance, currency depreciation, and high level of inflation attributed to the explosion in money growth and credit supply (HKMA, 2000, p.9). In 1983, the Hong Kong dollar depreciated to HK $9.6 per USD. Hong Kong was challenged by a currency crisis. In response to the crisis of 1983, the Hong Kong Government announced a Linked Exchange Rate System, one type of currency board arrangement, to stabilize it     29     currency. Since then, the Hong Kong dollar has been linked to the US dollar at the fixed rate of HK $7.8 per USD. Hong Kong government promised to fully back its currency with its US dollar reserve. After Hong Kong returned to China, the Basic Law of the Hong Kong Special Administrative Region Article 1112 rules that (1) the Hong Kong dollar continues to be the legal tender and circulate in Hong Kong, (2) the authority to issue Hong Kong currency belongs to the Hong Kong government and the government can authorize designated banks to issue the Hong Kong dollars, (3) the issue of Hong Kong currency must fully backed by reserve, and (4) the issue of currency and the reserve fund system are prescribed by law. The linked exchange rate system continues to benefit Hong Kong’s monetary stability and economic development.     30     Table 3 History of Hong Kong’s Exchange Rate Regimes Note. Adapted from HKMA Background Brief No. 1 Hong Kong's Linked Exchange Rate System (Second edition), p.33, by Hong Kong Monetary Authority, 2005, retrieved December 23, 2013 from http://www.hkma.gov.hk/media/eng/publication-and-research/ background-briefs/hkmalin/full_e.pdf     31     Mechanism of Linked Exchange Rate System Hong Kong’s banknotes are mainly issued by three note-issuing banks – Bank of China (Hong Kong) Limited, The Hongkong and Shanghai Banking Corporation Limited, and Standard Chartered Bank. In order to issue banknotes, the three note-issuing banks have to buy Certificates of Indebtedness from the Hong Kong Monetary Authority by surrendering an equivalent amount of US dollars at the rate of HK $7.8 per USD. Therefore, the Hong Kong dollars are fully backed by the US dollars. On the contrary, in order to remove the Hong Kong dollars from circulation, the Hong Kong Monetary Authority buys back the Certificates of Indebtedness with an equivalent amount of US dollars at the rate of HK $7.8 per USD. The Hong Kong Monetary Authority converts the US dollars into the Certificates of Indebtedness, or vice versa, between HK $7.75 per USD on the strong side and HK $7.85 per USD on the weak side. Therefore, the exchange rate bounces around the rate of HK $7.8 per USD. Under the linked exchange rate system, capital inflows or outflows affect the interest rates rather than the exchange rates. When capital inflows exist, market participants purchase Hong Kong dollars and the Hong Kong dollar exchange rate faces an upward pressure. The three note-issuing banks will then buy Certificates of Indebtedness from the Hong Kong Monetary Authority and issue Hong Kong dollars. In other words, the Hong Kong Monetary Authority will sell Hong Kong dollars. As a result, the monetary base will expand. Since the currency supply increases, the interest rate decreases. The low interest rate discourages capital inflows and the exchange rate remains stable.     32     On the other hand, when capital outflows exist, market participants sell Hong Kong dollars and the Hong Kong dollar exchange rate faces a downward pressure. The three note-issuing banks will then sell Certificates of Indebtedness to the Hong Kong Monetary Authority and reduce the circulation of Hong Kong dollars. In other words, the Hong Kong Monetary Authority will buy Hong Kong dollars. As a result, monetary base will contract. Since the currency supply decreases, the interest rate increases. The high interest rate discourages capital outflows and the exchange rate remains stable. Figure 8. The mechanism of Hong Kong Linked Exchange Rate System. From Hong Kong Monetary Authority, 2005, in HKMA Background Brief No. 1 Hong Kong's Linked Exchange Rate System (Second edition), p.39, retrieved December 23, 2013 from http://www.hkma.gov.hk/media/eng/publication-and-research/background-briefs/ hkmalin/full_e.pdf     33     In both buying and selling Certificates of Indebtedness, the three note-issuing banks earn the difference between the market exchange rate and the fixed exchange rate of HK $7.8 per USD. For example, when Hong Kong dollars appreciate, say HK $7.77 per USD, the three note-issuing banks can buy Certificates of Indebtedness from the Hong Kong Monetary Authority at the fixed exchange rate of HK $7.8 per USD. Therefore, when they issue money, they earn HK $0.03 for every US dollar they use to exchange Certificates of Indebtedness with the Hong Kong Monetary Authority. For another instance, when Hong Kong dollars depreciate, say HK $7.83 per USD, the three note-issuing banks can sell Certificates of Indebtedness from the Hong Kong Monetary Authority at the fixed exchange rate of HK $7.8 per USD. Therefore, they earn HK $0.03 for every US dollar they get from the Hong Kong Monetary Authority by selling Certificates of Indebtedness. As a result, every time there are any capital inflows or outflows, the three note-issuing banks compete to earn the difference between the market exchange rate and the fixed exchange rate of HK $7.8 per USD. The exchange rate will drive back to the rate of HK $7.8 per USD automatically. In order to reduce excessive fluctuation in the interest rate, the Hong Kong Monetary Authority provides temporary liquidity to banks through the Discount Window. Banks can borrow overnight liquidity from the Hong Kong Monetary Authority by using Exchange Fund paper or other eligible securities as collateral to reach repurchase agreements. Since foreign reverse backs Exchange Fund paper, the money created through these overnight liquidities does not violate the principal of the currency board system (HKMA, 2005, p.39).     34     Suitability of the Linked Exchange Rate System Among the different types of exchange rate systems, Hong Kong mainly chose to adopt one of the fixed exchange rate systems with the most successful experience in the Linked Exchange Rate System. The Linked Exchange Rate System fits Hong Kong because Hong Kong possesses the following features: • Without changing the exchange rate, the flexible and responsive economic structure allows adjustments in internal prices and costs which cause the adjustments to external competitiveness. • The healthy banking system is capable of handling the fluctuations in interest rates. • The Hong Kong government has a large number of fiscal surpluses, therefore the exchange rate is not likely, if any, to be affected due to monetary financing of government expenditure. • Hong Kong has a huge foreign reserve compared to the amount of currency in circulation which can fully support the linked exchange rate system. At the end of October 2013, the foreign reserve has US $309.586 billion which is more than 7 times the amount of currency in circulation (HKMA, 2014). Since the adoption in 1983, the linked exchange rate system plays an important role in Hong Kong’s monetary stability, even in periods of financial crisis or other external shocks (see Figure 9). IMF, in its annual Article IV Consultation with Hong Kong, affirmed that the linked exchange rate system is “a simple, credible, transparent and widely understood exchange rate system which has contributed immensely to the maintenance of monetary and financial stability in Hong Kong” (HKMA, 2012, p.48).     35     Figure 9. Hong Kong dollar exchange rate from 1981 to 2009 under different economic shocks. From Hong Kong Monetary Authority, 2011, in Milestones of Monetary Reform, retrieved December 23, 2013 from http://www.hkma.gov.hk/eng/key-functions/monetary -stability/milestones-monetary-reform.shtml Limitations of the Linked Exchange Rate System Every coin has two sides. Though Hong Kong has prosperous economic development because of the Linked Exchange Rate System, the system, at the same time, limits Hong Kong’s potentials to develop in the following ways: • Under the Linked Exchange Rate System, the exchange rate is not free to adjust. In response to economic shocks, unlike the rapid response in exchange rate, additional internal cost or price adjustments are needed (HKMA, 2005). Inability to adjust the exchange rate may results in imbalance trade.     36     Figure 10. Hong Kong balance of trade in USD million. From Trading Economics, 2014, in Hong Kong balance of trade, retrieved February 14, 2014, from http://www.trading economics.com/hong-kong/balance-of-trade • The Linked Exchange Rate System ties Hong Kong to United States monetary policy. The inability to use independent interest rate may result in unsuitable interest rate for the local economic condition. Since the economic cycles may be different in Hong Kong and the United States, following the US interest rate trend may hurt Hong Kong (HKMA, 2005). Figure 11. Hong Kong interest rate and the United States interest rate. From Trading Economics, 2014, Hong Kong interest rate, retrieved February 14, 2014, from http://www.tradingeconomics.com/hong-kong/interest-rate     37     Alternative Exchange Rate Systems Whenever there is a financial distress, people may think about a better exchange rate system to serve the best of the economy. People may ask if there is any other exchange rate system better than the current Linked Exchange Rate System. The following are some possible alternatives: A. Using the Linked Exchange Rate System with a new nominal exchange rate Using a linked exchange rate system implies that the country agrees to have internal adjustments, such as change in prices and wages, rather than changing its exchange rate. Setting a new nominal exchange rate in a linked exchange rate system therefore becomes a self-contradictory action. In addition, the credibility of the linked exchange rate system significantly depends on the government’s commitment over the system. Any change in the system will likely destroy the credibility including setting a new nominal exchange rate. This may cause a capital outflow because of the lack of confidence in the system. Under such a situation, investors are more cautious in investing and speculators become more active in finding opportunities. Moreover, to adjust the high price that Hong Kong is currently suffering, setting a new exchange rate means an appreciation in the Hong Kong dollar, which will place a burden on the trade balance. Hong Kong’s trade balance has already been negative for the last five years (see Figure 12). If Hong Kong dollars appreciate, Hong Kong’s competitive strength will further diminish and further hurt the trade imbalance.     38     Figure 12. Hong Kong balance of trade (HK$ million). From Trading Economics, 2014, in Hong Kong balance of trade, retrieved February 14, 2014, from http://www.tradingeconomics.com/ hong-kong/balance-of-trade B. Using the Linked Exchange Rate System with a new currency anchor When switching to a new currency anchor, the government must find a currency from its major trading partners that is stable, strong, and frequently used internationally. As shown in table 4, Hong Kong’s five major trading partners are China, the United States, Japan, Singapore, and Taiwan. For these five candidates, the Chinese yuan and the United States dollars are considered to be relatively stable (see Figure 13). Hong Kong has already used the United States dollar as an anchor. That means that if there is a switch of anchor currency, the Chinese yuan is the only choice. The Chinese yuan has an increasing presence in international trade. Yet, it is still not a dominant currency compared to the United States dollar. In addition, the Chinese yuan is not fully convertible and is not a key reserve currency in Hong Kong. Without a fully convertible anchor, the amount of foreign reserve may not be adequate due to the restrained convertibility. Therefore, the Chinese yuan is not a suitable currency anchor for Hong     39     Kong at this time. As the Chinese yuan is continuously strengthening to a large degree, along with improvements in the Chinese banking system, it is possible that the Chinese yuan will become the most suitable anchor for the Hong Kong dollar in the future. Table 4 Hong Kong’s Major Trading Partners in 2012 Note: Adapted from Hong Kong's Principal Trading Partners in 2012 by the government of HKSAR Trade and Industry Department, 2013, retrieved February 14, 2014, from http://www.tid.gov.hk/english/trade_relations/mainland/trade.html     7.00%   6.00%   5.00%   4.00%   3.00%   2.00%   1.00%   0.00%   -­‐1.00%   -­‐2.00%   -­‐3.00%   -­‐4.00%   -­‐5.00%       7/1/2012   10/1/2012   1/1/2013   4/1/2013   7/1/2013   10/1/2013   1/1/2014   1/1/2013   4/1/2013   7/1/2013   10/1/2013   1/1/2014   1/1/2014   10/1/2013   7/1/2013   4/1/2013   1/1/2013   10/1/2012   7/1/2012   7/1/2012   1/1/2012   10/1/2011   7/1/2011   4/1/2011   1/1/2011   10/1/2010   7/1/2010   4/1/2010   1/1/2010   10/1/2009   7/1/2009   4/1/2009   10/1/2012   Japan   4/1/2012   -­‐1.00%   4/1/2012   1.00%   4/1/2012   US   1/1/2012   10/1/2011   7/1/2011   4/1/2011   1/1/2011   10/1/2010   7/1/2010   4/1/2010   1/1/2010   10/1/2009   7/1/2009   -­‐2.00%   1/1/2012   10/1/2011   7/1/2011   4/1/2011   1/1/2011   10/1/2010   7/1/2010   4/1/2010   1/1/2010   10/1/2009   0.00%   4/1/2009   -­‐1.00%   7/1/2009   0.00%   4/1/2009   40     China   1.00%   41     Singapore   4.00%   3.00%   2.00%   1/1/2012   4/1/2012   7/1/2012   10/1/2012   1/1/2013   4/1/2013   7/1/2013   10/1/2013   1/1/2014   1/1/2012   4/1/2012   7/1/2012   10/1/2012   1/1/2013   4/1/2013   7/1/2013   10/1/2013   1/1/2014   10/1/2011   7/1/2011   4/1/2011   1/1/2011   7/1/2010   10/1/2010   4/1/2010   1/1/2010   -­‐2.00%   10/1/2009   -­‐1.00%   7/1/2009   0.00%   4/1/2009   1.00%   -­‐3.00%   -­‐4.00%   Taiwan   3.00%   2.00%   10/1/2011   7/1/2011   4/1/2011   1/1/2011   7/1/2010   10/1/2010   4/1/2010   1/1/2010   -­‐2.00%   10/1/2009   -­‐1.00%   7/1/2009   0.00%   4/1/2009   1.00%   -­‐3.00%   -­‐4.00%   Figure 13. Volatility in value of different currencies from Hong Kong’s major trading partners. From OANDA, 2014, in Historical exchange rate, retrieved February 14, 2014, from http://www.oanda.com/currency/historical-rates/ C. Linked to a basket of currencies Linked to a basket of currencies violates two important features of the linked exchange rate system in Hong Kong – simplicity and transparency. These two elements     42     contribute to the high credibility of the linked exchange rate system. If the Hong Kong dollar is linked to a basket of currencies, its value will depend on a portfolio of currencies with different weight on each currency. The current mechanism of the linked exchange rate system is so simple that it cannot cope with interactions between multiple currieries. The basket of currencies is too complicated to be operated by a government as well as too complicated to be understood by investors. As a result, people have less confidence in the currency without fully understanding how it operates. In addition, the government has more control over the exchange rate by using a basket of currencies such as adjusting the portfolio weights. The government’s discretionary actions to adjust the exchange rate make the exchange rate regime less transparent. The government may not adjust the exchange rate only to match the nominal exchange rate but to accomplish other government objectives. As a result, the predictability and transparency of the link is reduced by using a basket of currencies. This hurts the credibility of the exchange rate system. D. Dollarization When Hong Kong considers adopting dollarization, the United States dollar will be the first choice since the Hong Kong dollars is fully backed by the US dollars. For other currencies, they may not have enough presence in Hong Kong to replace all the Hong Kong Dollars. However, is there actually a need to replace the Hong Kong dollar with the United States dollar? The Hong Kong dollar has been used for about 46 years. During the period, the circulation of the Hong Kong dollar has increased by more than HK$ 388 billion (see Figure 14). This shows that the Hong Kong dollar is playing an     43     increasingly important role as a currency to store value, exchange for value, and measure value. People have confidence and demands in using the Hong Kong dollar. Many local businesses, as well as individuals, are used to pricing goods and services in Hong Kong dollars. If Hong Kong changes to the United States dollar, people have a hard time, at least in the short term, to Figure out an appropriate value of a product or service when they buy it or sell it. For business reporting, the original measuring unit, the Hong Kong dollar, has to change to the United States dollar. This may create confusion for some investors. Figure 14. Hong Kong’s Legal tender notes and coins in circulation (HK$ million). From Hong Kong Monetary Authority, 2014, in Monthly Statistical Bulletin (February 2014 Issue No. 234), retrieved December 23, 2013 from http://www.hkma.gov.hk/ eng/marketdata-and-statistics/monthly-statistical-bulletin/table.shtml Besides that, the Hong Kong dollar has already been linked to the United States dollar. Hong Kong enjoys most of the benefits, if not all, of a fixed exchange rate system. Is there a need to go to a more rigid fixed exchange rate system? The linked exchange     44     rate system is already very rigid in its nature that the government has its explicit commitment to the link in law. However, this rigid system provides Hong Kong an opportunity to develop a more appropriate exchange rate system for itself with its own currency. Without having its own currency, the government can do nothing in terms of monetary policy if it finds any mismatch in the local economy and the United States economy. Dollarization is over-rigid which prevents the government from gaining control over the monetary system to serve the best for its local economy. In addition, giving up the local currency also means to give up the credibility of the currency at the same time. Building the credibility of a currency it no easy task. Therefore, once a country chooses to adopt dollarization, it is difficult to go back to a less rigid system. E. Independently floating As Hong Kong features a small, open, and free economy, its economy is easily affected by other countries. If there are any events which cause a huge amount of capital, relative to this small economy, flowing into or out of Hong Kong, the floating exchange rate is largely affected because Hong Kong virtually has no capital controls. As a result, the exchange rate becomes very volatile, which can adversely affect the economic development. Investors do not want to invest in such a place that gives them a high exchange rate risk. Even though there are hedging tools available for investors to minimize foreign exchange risk, investors have to bear the additional cost for using those hedge tools. In addition, the Hong Kong government has inadequate experience in managing a floating exchange rate system. Throughout Hong Kong’s history in exchange rate systems, it largely operated fixed exchange rates with only nine years in a floating     45     exchange rates. It may not do well in moderating the exchange rate through the use of official foreign exchange market intervention. It may also takes time for the government to design a definite objective for it monetary policy. There is no room for the government to have a try or a test in carrying out a floating exchange rate system. Once the linked exchange rate converts to a floating exchange rate, Hong Kong has to accept the impacts no matter if they are good or bad. They are probably bad due to the nature of the economy and the inexperienced government. At this point, if the government wants to go back to the linked exchange rate system, it will be difficult to regain credibility because people do not know when the government will change the exchange rate system again. The Hong Kong government needs to seriously consider and have a thorough plan before making any changes. Let us not forget the failure of running an independent floating exchange rate in Hong Kong during 1974 to 1983. As shown in Figure 15, the real GDP growth rate fluctuated hugely during the period. Figure 16 also shows that inflation shot from a near zero point in 1975 to above 15% in 1980. Besides that, Figure 17 shows that the balance of trade deteriorated and the Hong Kong dollars depreciated continuously under that floating exchange rate. With the currency crisis in 1983, the Hong Kong dollar reached its lowest record of HK$9.60 per USD which caused a drop of 13% in two days. The banking system was going to collapse if the government did not announce the implementation of linked exchange rate system. Hong Kong had fluctuating growth rate, high inflation, negative and deteriorating balance of trade, and continues currency depreciation. Learning from the history, a floating exchange rate is not suitable for Hong Kong. Some may argue that the economic structure has been changed since 1983 and a     46     floating exchange rate may work today. However, can Hong Kong people stand with such a risky bet? Figure 15. Inflation, economic growth and the Hong Kong dollar exchange rate during the floating years (1974-1983). From Hong Kong Monetary Authority, 2005, in HKMA Background Brief No. 1 Hong Kong's Linked Exchange Rate System (Second edition), p.34, retrieved December 23, 2013 from http://www.hkma.gov.hk/media/eng/publicationand-research/background-briefs/hkmalin/full_e.pdf Figure 16. Real GDP growth and inflation in Hong Kong during the floating years (19741983). From Chiu, P., 2001, in Hong Kong’s experience in operating the currency board     47     system, p.4, retrieved February 13, 2014, from http://www.imf.org/external/pubs/ft/ seminar/2001/err/eng/chiu.pdf Figure 17. Hong Kong dollar exchange rate and balance of trade during the floating years (1974-1983). From Trading Economics, 2014, in Hong Kong currency, retrieved February 14, 2014, from http://www.tradingeconomics.com/hong-kong/currency Recommendation Every exchange rate regime has its own benefits and drawbacks. Countries have to sacrifice something in order to enjoy the others. In the international economy, the impossible trinity, also known as trilemma (Obstfeld and Taylor, 1997), is a famous theory that describes the imperfection in all exchange rate systems. The theory basically states that no one exchange rate system can provide monetary stability, monetary independence, and free capital movement at the same time. All exchange rate systems only satisfy two of the three objectives.     48     Monetary   Stability   Monetary   Independence     Free  Capital   Movement   Figure 18. Impossible trinity For Hong Kong, a place that has been the freest economy for 20 years (The Heritage Foundation), free capital movement is essential. The Hong Kong government tries not to intervene in the market as much as it can. Therefore, intermediate exchange rate systems, which have frequent government involvement, is not suitable for Hong Kong. In choosing monetary stability and monetary independence, Hong Kong prefers stability more because of its small and open economic features. Hence, free floating exchange rate systems which offers monetary independence but are volatile in nature are not suitable for Hong Kong. I recommend Hong Kong to keep its linked exchange rate system as it provides monetary stability and free capital movement which are essential to Hong Kong’s economy. Unless a more appropriate anchor presents itself and the United States dollar becomes irrelevant to Hong Kong’s development, any changes in the current system are not worthwhile. Let us not make the perfect the enemy of the good.     49     NOTES 1. Not only a country can issue its own currency, some cities may also print their own legal tender. In this paper, for the reason of simplicity, country may refer to a state, a city, or a place. 2. Basic Law of the Hong Kong Special Administrative Region Article 111 can be retrieved from http://www.basiclaw.gov.hk/en/basiclawtext/chapter_5.html     50     REFERENCES Balino,J.T. and Enoch, C. (1997, August). Currency board arrangements: issue and experiences. Washington, DC: International Monetary Fund. Beker, E. (2006). Exchange rate regimes choice. Retrieved January 15, 2014, from http://www.doiserbia.nb.rs/ft.aspx?id=1452-595X0603313B Bubula, A. and Otker-Robe, I. (2003, November). Are Pegged and Intermediate Exchange Rate Regimes More Crisis Prone?. Retrieved February 18, 2014, from http://www.cgu.edu/include/Bubula2.pdf Chiu, P. (2001). Hong Kong’s experience in operating the currency board system. Retrieved February 13, 2014, from   http://www.imf.org/external/pubs/ft/ seminar/2001/err/eng/chiu.pdf Countryeconomy.com. (2014). Argentina Government budget deficit. Retrieved February 14, 2014, from http://countryeconomy.com/deficit/argentina Edwards, S. and Yeyati, E.L. (2003, July). Flexible exchange rates as shock absorbers. Retrieved February 18, 2014, from http://www.nber.org/papers/w9867 Eichengreen, B. (2008). Globalizing Capital: A history of the international monetary system. New Jersey: Princeton University Press. Enoch, C. and Gulde, A. (1998, December). Are Currency Boards a Cure for All Monetary Problems?. Finance & Development, 35(4). Retrieved January 26, 2014, from https://www.imf.org/external/pubs/ft/fandd/1998/12/enoch.htm Friedman, M. (1994). Do we need central banks?. Retrieved January 26, 2014, from http://0055d26.netsolhost.com/friedman/pdfs/other_commentary/HKMA.1994.pd f     51     Ghosh, A.R., Gulde, A., Ostry, J. D., and Wolf, H. C. (1996 September). Does the exchange rate regime matter for inflation and growth?. Retrieved March 1, 2014, from http://www.imf.org/external/pubs/ft/issues2/ Greenwood, J. (2011, April 5). Hong Kong dollar's future uncertain as yuan dominates. BBC. Retrieved January 28, 2014, from http://www.bbc.co.uk/news/business12958377 Hanke, S.H. (2000). The disregard for currency board realities. CATO Journal, 20(1), 4959.  Retrieved January 26, 2014, from Academic Search Premier database. Hanke, S.H. (2003). The Argentine straw man: a response to currency board critics. CATO Journal, 23(1), 47-57.  Retrieved January 26, 2014, from Academic Search Premier database. Hong Kong Monetary Authority. (2000, November). Money in Hong Kong: A Brief Introduction. Retrieved December 23, 2013 from http://www.hkma.gov.hk/media/ eng/publication-and-research/reference-materials/monetary/1-1.pdf Hong Kong Monetary Authority. (2005). HKMA Background Brief No. 1 Hong Kong's Linked Exchange Rate System (Second edition). Retrieved December 23, 2013 from http://www.hkma.gov.hk/media/eng/publication-and-research/background- briefs/hkmalin/full_e.pdf Hong Kong Monetary Authority. (2011). Milestones of Monetary Reform. Retrieved December 23, 2013 from http://www.hkma.gov.hk/eng/key-functions/monetarystability/milestones-monetary-reform.shtml     52     Hong Kong Monetary Authority. (2014). Monthly Statistical Bulletin (February 2014 Issue No. 234). Retrieved December 23, 2013 from http://www.hkma.gov.hk/ eng/market-data-and-statistics/monthly-statistical-bulletin/table.shtml Humpage, O. (1971, December). The Smithsonian Agreement. Retrieved February 20, 2014, from http://www.federalreservehistory.org/Events/DetailView/34 International Monetary Fund. (1999, October). World economic outlook. Retrieved February 18, 2014, from http://www.imf.org/external/pubs/ft/weo/1999/02/ index.htm International Monetary Fund. (2006, July 31). De Facto Classification of Exchange Rate Regimes and Monetary Policy Framework. Retrieved September 25, 2013, from http://www.imf.org /external/np/mfd/er/2006/eng/0706.htm International Monetary Fund. (2009, February 25). De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks. Retrieved September 25, 2013, from http://www. imf .org/external/np/mfd/er/2008/eng/0408.htm. Kaltenbrunner, K. and Nissanke, M. (2009, May). Why developing countries should adopt intermediate exchange rate regimes: examining Brazil’s experience. Retrieved February 28, 2014, from http://www.soas.ac.uk/cdpr/publications/dv/ file51290.pdf Knafo, S. (2006, February). The gold standard and the origins of the modern international monetary system. Review of International Political Economy, 13(1), 78-102. Retrieved November 7, 2013, from http://www.jstor.org/stable/25124062     53     Kopcke, R. W. (1999). Currency Boards: Once and Future Monetary Regimes?. New England Economic Review, 21-38. Retrieved January 26, 2014, from Academic Search Premier database. Liu, J. (2012, June 20). Hong Kong debates its currency's peg to the US dollar. BBC. Retrieved January 26, 2014, from http://www.bbc.com/news/business-18516467 Madura, J. (2011). International corporate finance. Kentucky: Cengage Learning, Inc. OANDA. (2014). Historical exchange rate. Retrieved February 14, 2014, from http://www.oanda.com/currency/historical-rates/ Obstfeld, M. and Rogoff, K. (1995, July). The mirage of fixed exchange rates. Retrieved January 20, 2014, from http://www.nber.org/papers/w5191 Obstfeld, M. and Taylor, A.M. (1997). The great depression as a watershed: international capital mobility over the long run. Retrieved March 2, 2014, from http://www. nber.org/papers/w5960 O'Driscoll Jr., G. P. (2012). Toward a global monetary order. CATO Journal, 32(2), 439448.  Retrieved February 28, 2014, from Academic Search Premier database. Robin, J.A. (2010, January 21). International Corporate Finance. New York: The McGraw-Hill Companies, Inc. Spiegel, M. (2002, August 23). Argentina's Currency Crisis: Lessons for Asia. (Cover story). FRBSF Economic Letter, 2002(25), 1. Retrieved January 26, 2014, from Academic Search Premier database. The government of HKSAR Trade and Industry Department. (2013). Hong Kong's Principal Trading Partners in 2012. Retrieved February 14, 2014, from http://www.tid.gov.hk/english/trade_relations/mainland/trade.html     54     The Heritage Foundation (2014). 2014 Index of Economic Freedom. Retrieved March 2, 2014, from http://www.heritage.org/index/ranking The World Bank. (2014). Argentina Foreign direct investment, net inflows (USD). Retrieved February 14, 2014, from http://data.worldbank.org/indicator/ BX.KLT.DINV.CD.WD/countries/1W-AR?display=default The World Bank. (2014). Argentina GDP growth (annual %). Retrieved February 14, 2014, from http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG/ countries/1W-AR?display=default Trading Economics. (2014). Argentina Balance of Trade. Retrieved February 14, 2014, from http://www.tradingeconomics.com/argentina/balance-of-trade Trading Economics. (2014). Hong Kong balance of trade. Retrieved February 14, 2014, from http://www.tradingeconomics.com/hong-kong/balance-of-trade Trading Economics. (2014). Hong Kong currency. Retrieved February 14, 2014, from http://www.tradingeconomics.com/hong-kong/currency Trading Economics. (2014). Hong Kong interest rate. Retrieved February 14, 2014, from http://www.tradingeconomics.com/hong-kong/interest-rate U.S. Bureau of Public Affairs. (2013). Nixon and the End of the Bretton Woods System, 1971–1973. Retrieved February 20, 2014, from http://history.state.gov/milestones /1969-1976/nixon-shock Want China Times. (2012, October 29). Debate surrounding Hong Kong's linked exchange rate system renewed. Retrieved http://www.wantchinatimes. cnt.aspx?id=20121029000059&cid=1102     March 11, 2014, from com/news-subclass- 55     Williamson, J. (1995, January 1). What role for currency boards?. Washington, DC: Peterson Institute.