DE 18-77
Mr Footman, HKD
My Part
CONFIDENTIAL
With a skim.
Reference
PA
103
Conchesi on seems right time.
HKC 100/1
HONG KONG: EXCHANGE RATE LINK
1/12
He does not expert one
Mr Broadbent o.r.
Mr Footman
Wright
5/12
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Dowe owe Mc
an answer to
22 W/2/12
Para 9?
1. The 'Economist' of 26 November carried an article (attached) which argues that the HK$ should be valued against a basket of currencies, a policy that would be similar to that practiced by Asian competitors. There is no call, in marked contrast to the
'leader' of December 1987, for an upvaluation of the HK$. Indeed, the analysis seems to accept that adjustment through inflation has worked in Hong Kong.
2.
Taking the article as an excuse, this note has two purposes. First to review the performance of the link thus far in 1988. Second, to consider briefly the specific proposal made in the Economist.
The link in 1988
3.
The attached graph shows movements in the HK$-US$ exchange rate between January 1987 and early November 1988, in terms of percentage premium from the 7.80 rate. This shows clearly the intense period of speculation in December 1987 and January 1988 when traders were prepared to accept less than HK$7.80 for US$1 in the expectation that a revaluation was likely. Since then the exchange rate has been trading at a minor discount. This appears to be, from casual observation, the 'normal' state of affairs.
4.
The exchange rate by itself only tells part of the story.
The
on holding a foreign currency is the sum of its expected rate of appreciation and the differential in the appropriate rates of interest. Simple economic theory suggests that, without barriers to trade, market forces will equalize the return over all currencies. That is, all currencies with an expected appreciation will have a compensating negative interest rate differential.
5.
The second graph shows the interest rate differential between Hong Kong and the US from January to July 1988. The choice of rates is somewhat arbitrary but a similar trend emerges with other measures. This trend is a movement from a strong negative to strong positive differential in HK interest rates. The negative period reflects the HK determination to resist upward pressure on the link and fits comfortably with the theory outlined above. Applying the same logic to the period since April would suggest that, if anything, a devaluation is expected. More generally this probably reflects some uncertainty about Hong Kong's future. Although this cannot be demonstrated, it seems likely that this premium would be MA 3AAA/1
CONFIDENTIAL