TNAG-1347-FCO40-1777-Financial-policy-in-Hong-Kong-1984 — Page 65

Figure 2

Balance Sheet Effects of Issuing HK$ 100

Assets

Liabilities

Exchange Fund

Foreign exchange

85

Certificates of indebtedness

100

Hong Kong bank deposits denominated in Hong Kong dollars

15

Private Hong Kong Banks

Certificates of indebtedness

100

Hong Kong dollar notes

100

I

sell Hong Kong dollars for foreign currencies at market rates of exchange.

:

During the float period, the Exchange Fund mostly kept secret its portfolio composition and its strategy for shifting the composition of the portfolio between foreign currencies and domestic deposits. (The exception is that the amount heid in British pound sterling was revealed.) However, the guiding principle of the Exchange Fund's open market strategy seems to have been to hold all or most of its portfolio in foreign currencies. When the Hong Kong dollar was experiencing temporary weak- ness, the Exchange Fund might move temporarily into deposits denominated in Hong Kong dollars. Such moves were exceptional and temporary, though. The Exchange Fund professed no intention and acknowledged no ability to influence the basic direction of exchange rates. Ac- cording to government officials, the exchange rate was determined by fundamental market forces which the Exchange Fund should not, and could not, oppose for long.

An Indeterminate Exchange Rate?

We strongly suspect that the Hong Kong government did not actually follow its official float policy. A major reason for this suspicion is that, if the policy had been followed. then the exchange rate for the Hong Kong dollar would have been indeterminate. By indeterminate, we mean that there would have been a wide range of values of foreign exchange rates for the Hong Kong dollar that would have cleared markets. This indeterminacy is a consequence of the lack of any anchor in a system in

which both the exchange rate and the quantity of Hong Kong dollars float. It results under any theory of the demand for Hong Kong dollars. The indeterminacy is a product of the responses required of the Exchange Fund under the official policy.

To establish that result, let's first examine the options available to the Hong Kong government if it were to have pegged the exchange rate for its currency to one or sever- al foreign currencies. A government doing that simply announces that it is willing to buy and sell unlimited amounts of its currency at the chosen exchange rate. Then it must be prepared to cope with a run on its currency, or an attempt by holders of the domestic currency to convert their holdings into foreign currency. The government need not be concerned about high demands for its own currency, since it can always provide more if needed. This asymmetry produces a range of values at which it is feasible to peg the exchange rate.

To simplify the exposition, suppose that there is only one foreign currency and that at some time a monetary authority has a balance sheet consisting of units of foreign currency which it possesses as assets and h units of its own (home) currency outstanding which are its liabilities. Staning in this situation, it is feasible for the authority to fix the exchange rate, the value of its own currency in terms of foreign currency, at any value between zero and the ratioƒ h. That is because, with the

Here and elsewhere in this paper, our descriptions of the Hong Kong government's strategy rely heavily on Sargent's discussions with various Hong Kong economists in June 1983.

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