Rules Versus Discretion in Managing the Hong Kong Dollar, 1983-2006

Abstract

This paper examines the way in which Hong Kong's currency board has operated since its re-introduction in 1983. It discusses currency board design and the extent to which Hong Kong has conformed to particular principles. The core of the paper is an assessment of the rules-versus-discretion question. From 1983 to 1988 the currency board convertibility obligation applied, in effect, to physical cash only. Arbitrage could not be relied upon to ensure that the market rate converged to 7.80, so intervention - mostly in the foreign exchange market - played a significant role. In 1988 the authorities acquired the means to apply currency board principles also to the reserve balance of the banking system, but over the next ten years they did not exploit that to full advantage in the currency board context. They gave no convertibility promise for the reserve balance and seldom allowed foreign exchange transactions to trigger currency-board-type adjustment. They concentrated instead on managing bank liquidity or interest rates, very often via money market intervention, albeit subject to the overriding goal of a stable exchange rate. But the range which defined that stability was never revealed. Although this exercise of discretion and the departures from strict currency board principles were not obviously damaging, they may have complicated official procedures unnecessarily, and may have raised doubts as to the authorities' long-term commitment to 7.80. In other words, rather than helping to settle markets, the tactics may at times have disturbed them. Reforms in 1998 included a weak-side convertibility undertaking for banks' reserve money at 7.80 (after transition), but left strong-side intervention to the discretion of the Monetary Authority. It was only in 2005 that a firm strong-side undertaking was introduced at 7.75, with the weak side bound being moved to 7.85 in order to provide symmetry. Now, only one minor element of discretion - for intrazone intervention - remains. Whereas discretionary interventions were probably very necessary in the early years after 1983, the authorities could have moved more quickly after 1988 to reach the almost completely rule-based status of today. But the stability of the exchange rate over the entire period speaks for itself, and it is not obvious that stricter adherence to currency board principles would have delivered a materially different outcome.