A Timely Depreciation
We have no direct evidence that the Exchange Fund ever actually deviated from its official float policy. Our evidence is circumstantial and consists partly of the fact that in practice the exchange rate was somehow tied down even though, under the official policy, it should not have been. Our view is also based on the fact that the recent depreciation in the Hong Kong dollar was quite timely for the Hong Kong government. It came, that is, just when the government would have welcomed it.
Seeing why that is so requires a look at who gains and who loses from the depreciation of this currency. Changes in the exchange rate of the Hong Kong dollar affect the distribution of wealth among issuers and holders of Hong Kong dollar-denominated liabilities. As mentioned above. since the Exchange Fund's portfolio consists primarily of assets denominated in foreign currency while its liabilities are in Hong Kong dollars. its net worth varies inversely with the exchange value of the Hong Kong dollar (the lower the exchange rate, the greater the government's net worth). Offsetting this, in terms of a consolidated balance sheet, everyone else has a net worth that varies directly with the exchange value of the Hong Kong dollar. However, the effects on any particula asset holder depend on the holder's portfolio composition, namely, on the extent to which the holder is unhedged (exposed to risk) with respect to the exchange rate and the direction in which the holder is unhedged. It is primarily in terms related to such effects that we will explain why the au- thority might have welcomed a depreciation of the Hong Kong dollar.
We will do this by examining the balance sheet of a hypothetical Hong Kong financial firm as it experiences what some real Hong Kong firms may actually have experienced: first a substantial decline in real asset prices and then that decline joined by a substantial decline in the value of the Hong Kong dollar. Our financial firm has some assets in the form of loans. denominated in Hong Kong dollars, which have as collateral real Hong Kong assets and some liabilities. denominated in Hong Kong dollars, in the form of deposits. We will assume, as seems plausible. that the value of the real assets in terms of I foreign currency is determined in a world capital market. That is, their value measured in terms of foreign curren cies does not depend on the exchange value of the Hong Kong dollar.
Our hypothetical financial institution begins with the balance sheet in the first column of Figure 4 We measure
all entries in foreign currency so that entries denominated in Hong Kong dollars will vary with the exchange rate but those denominated in foreign currency will not. Note that this institution has initial net worth equal to 10 percent of total assets and that it is unhedged with respect to the exchange rate in only a minor way. That is, an exchange rate depreciation would lower net worth in an amount proportional to the initial net worth denominated in Hong Kong dollars, namely. 10 percent of x.
We now describe the effect on net worth of a sub- stantial decline in the value, in terms of foreign currency, of the assets which serve as collateral for the loans denominated in Hong Kong dollars. We will assume for the sake of argument a 50 percent decline in the value of these assets, measured in terms of foreign currency, and we will assume that initially the value of the assets was equal to 4,3 of the loans. (Put another way, the loans were equal to 75 percent of the value of the collateral.) In describing the firm's portfolio after the decline. we take the value of such loans to be the value of the collateral if the collateral is worth less than the initial value of the loans.
If the value of the collateral assets falls 50 percent and the exchange rate does not change. then these assump- tions imply that loans backed by Hong Kong dollars are defaulted on and the firm's balance sheet changes to that in the second column of Figure 4. A comparison of this column and the first shows that, because of the asset price decline. net worth declines. In fact, it becomes negative. implying bankruptcy, if x is sufficiently larger than y
If the value of the Hong Kong dollar falls at the same time as asset prices, however, the result is not as bad for the financial firm. Suppose that, along with the 50 percent decline in the value of real Hong Kong assets in terms of foreign currency, there occurs a decline of 1/3 in the exchange value of the Hong Kong dollar. (It takes 11⁄2 times as many Hong Kong dollars to buy one unit of foreign currency as originally.) Then, per Hong Kong dollar of loans originally granted, there is collateral worth (4/3)(1/2)(3/2), or one Hong Kong dollar. Thus, there need be no default on the loans. As the new balance sheet. the last column of Figure 4. indicates, the firm's net worth still declines somewhat from its initial value, but not as much as with just a decline in real asset values. When a depreciation accompanies the asset price decins, there- fore, the firm can stay in business
Individual depositors of the financial firm, of course. would not prefer this situation to the last, for & deprecia
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