I. IntroductionThe financial crisis in the Asian economies in 1997 has created tremendous interests in the economic point of view. This report focuses on the economic situation of Hong Kong in 1997-98, which has some very special features among the economies in the region.
In the Asian Financial Crisis, the economy in Hong Kong did not sufferer from any banking or currency crisis like some of the Asian countries such as Indonesia, Malaysia, South Korea and Thailand, which their troubles began with a severe depreciation in their currencies. This triggered capital outflow and bankruptcy of many financial intermediaries and firms. The currencies of these countries have long been maintained at a relatively constant rate with the US dollar until 1995. Their depreciation is due to the central banks were unable to defend speculative attacks.
Regarding to this, the government of the Hong Kong Special Administrative Region of the People's Republic of China successfully supported the currency by paying the cost of having high interest rates.
Hong Kong dollar is pegged with the US dollar, at a rate of HK$7.8 to US$1 since 1983. This is due to the effort of the Hong Kong Government and the Hong Kong Monetary Authority (HKMA), the central bank of the Hong Kong. However, the economy is expected to enter one of the most severe recessions in the post-war period after the Asian Financial Crisis.
Section 2 in this paper will offer background information of the Linked Exchange Rate System. It defines how the monetary authorities defend the currency peg. Section 3 will summarize on how and why the Hong Kong dollar was under speculative attacks during the Asian Financial Crisis. Section 4 is a postscript on how the HK government reacts to the situation and the actions that was taken.
II. The Background of the Linked Exchange Rate SystemAs a small opened economy, the currency of Hong Kong was used to be backed by stronger currency, pound sterling at first and later, US dollar. There was only about nine years (1974 -1983) in which a floating exchange rate regime was adopted. By the end of 1983, under both external (speculative attacks) and internal (political uncertainty) factors, the authorities decided a fixed exchange rate regime and peg Hong Kong dollar with the US dollar at HK$7.8 to US$1. The latter is known as the "Linked Exchange Rate System", which is effective since October 17, 1983.
The Linked Exchange Rate System is in practice a modified version of a classical currency board. A "classical" currency board is a system where there is no place for a central bank. The current Hong Kong's currency board maintains certain functions of the HKMA as the central bank of the SAR. The rest of this subsection discusses their distinction.
In general, currency board refers to "a monetary institution that issues base money solely in exchange for foreign assets, specifically the reserve currency." (Williamson, 1995, p.2)With the currency board, the monetary authorities can not change money supply at will. If the currency board would like to issue new cash, it must first increase its stock of the chosen reserve currency given certain fixed exchange rate stipulated by law. Which means the supply of home currency can increase only when commercial banks puts an equal amount of reserve currency in the currency board. Usually, the foreign reserve is more than the monetary base (cash in circulation plus deposits from commercial banks), so there is a net worth on the liabilities side that equals to the excess amount of foreign reserve. With buying or selling domestic credits, the central bank can perform open market operations and sterilized intervention of exchange rate. The currency board can stabilize the value of the home currency to a stronger one. This is an attractive feature for small countries. With people having confidence in this monetary system and the fixed exchange rate, a stable economic environment will promote trade, and...
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