would be averted, but because they would be allocated partly to depositors, thereby helping to preserve existing financial institutions.
Hong Kong's Other Options
With the exchange rate indeterminate under the official float policy, it is not surprising that the Hong Kong government should have departed from that policy in practice and revened to an unofficial policy of pegging the exchange rate. It did, however, have other alternatives.
One feasible alternative is to make its unofficial policy official: to adopt a fixed rate policy in which the Exchange Fund acts as a warehouse for foreign exchange. Then, if government budgets are balanced or in surplus (in a present value sense), it could not only peg but gradually appreciate the Hong Kong dollar. Appreciation could be engineered as a way of paying out all or part of the interest that is earned on the foreign securities that the Exchange Fund holds as reserves. (Singapore evidently manages its currency this way.) Such a policy would be feasible regardless of the fate of the wealth of Hong Kong, as determined by news about 1997 or other factors, as long as the government balanced its budget so that the portfolio available to back the Hong Kong dollar remained intact.
Another alternative that has been suggested is for the Hong Kong government to fix the quantity rather than the exchange rate of Hong Kong dollars and allow the exchange rate to float. (See the article Hong Kong's financial crisis, 1982). However, this proposal is not complete without specific rules governing the asset side of the monetary authority's balance sheet. Whether the proposal would work depends on whether the foreign exchange backing of the currency stock is to be eliminated or maintained.
In one version of this proposal, fixing the quantity of Hong Kong dollars is viewed as a substitute for maintain- ing backing. Advocates of a fiat money (or unbacked paper money) regime seem to have this view. They see the ability to dispense with backing as a one-time dividend for the monetary authority to spend. The size of this dividend is sometimes said to be a measure of the inefficiency of a backed system compared to a fiat system.
This sort of fiat system would probably not work in Hong Kong. For a fixed-quantity, no-backing regime to determine the exchange rate. there must be a stable demand function for unbacked Hong Kong dollars, in other words, a preference among Hong Kong residents for Hong Kong dollars over other currencies. However, it is
questionable that such a preference could exist for a fiat currency issued by the government of an economy as open to trade and capital transactions as is Hong Kong's economy. Foreign currencies circulate in Hong Kong now, and international transactions are not restricted. This suggests that extreme currency substitution poten- tially prevails in Hong Kong. If it does, then the exchange rate would not be determinate under a regime of a fixed quantity of unbacked Hong Kong dollars (Kareken and Wallace 1981.).
The other version of the proposal to fix the quantity of Hong Kong dollars would work, but it doesn't appear to be optimal. In this version, while the quantity of dollars is fixed, its backing is maintained, thus preventing Hong Kong dollars from becoming worthless. However, then there is no reason to fix the quantity. Indeed, when backing of the currency is maintained, it is desirable to allow the demand for Hong Kong dollars to determine their quantity for the same reason that it is desirable to let demand determine the quantities of other kinds of inter- mediary liabilities (Sargent and Wallace 1982).
Epilogue
On October 15, 1983, the government abandoned the official float policy and announced a policy of pegging the Hong Kong dollar at 7.80 Hong Kong dollars per U.S. doilar. Short-term interest rates denominated in Hong Kong dollars reacted by climbing sharply, to as high as 40 percent per annum for overnight money. Such high nominal rates can be interpreted as reflecting the market's expectation that the government would not long maintain the current peg and that it would soon devalue. This widespread public pessimism is likely due to a variety of political forces currently operating in Hong Kong which are likely to affect and restnet the government's actual choices in ways we have so far abstracted from.
We have analyzed the valuation of the Hong Kong currency by viewing the monetary affairs branch of the Exchange Fund as though it were managing a mutual
This argument rests on the same considerations that led Keynes to write this of France in March 1924 (p wi}
Polten argued that the Tran, cannot tellerova un no cause France is a wealthy thafty and industrous country, w because her bu unce of trade is prima luote satis:actory This springs from contusion as to the causes which ultimately govern the value of money A very rich country can have aven had currency and aven poor country a very good one The weath France and her balance of trade may render a casier for her authoriues 10 pursue a sound monetary pouss Butthes are not the same thing. The value of a country's monetas, unit is now a function of its wrath or even its trade balance
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