Currency Board Complications: The AEL Model

for Hong Kong ? 

 Tsang Shu-ki

Department of Economics

Hong Kong Baptist University

9 February 1998

 

1.     Doubting the Classical Currency Board

        Currency boards originated in British colonies in the 19th century and seem to be enjoying a revival since the 1980s (Hanke, Jonung and Schuler 1993; Schwartz 1993; Williamson 1995). Present members of the "camp" include Hong Kong, Argentina, Estonia, and Lithuania, while Bulgaria began a "currency board arrangement" (CBA) on 1 July 1997. Actually, there have been significant changes in the setup and framework between the classical and the modern versions of currency boards, which have unfortunately eluded in-depth investigation. This short piece is both an attempt to focus researchers’ attention on the key issues, in particular those of arbitrage efficiency, and an advocacy that Hong Kong should adopt the model of Argentina, Estonia and Lithuania (the "AEL" model), all three countries being latecomers to the "camp" compared with Hong Kong.

        A classical currency board issues notes and coins with 100% foreign reserves backing at a fixed exchange rate. The exchange rate of broader money is supposedly anchored at the same level because of two processes. The first is the specie-flow mechanism, just like under the gold standard. An outflow of capital would contract the money supply, push up the interest rates, and induce a counter-flow. The whole chain of events would automatically take place, within a short time horizon and without any government intervention.

        In a modern and open financial economy, this presumed balance of payments mechanism is far from being reliable in the presence of expectations and uncertainty. Higher interest rates may not induce a counterflow of capital, if the exchange rate itself is in doubt. Exchange rate risk means that an interest rate premium is required, and higher interest rates might be interpreted as a sign of weakness, even leading to a vicious circle. The simultaneous occurrence of high interest rates and plunging exchange rates during the East Asian crisis is a case in point.

        Therefore, there is the need for the second mechanism of the currency board: arbitrage that technically binds the exchange rate. Since a currency board has foreign reserves that cover at least 100 % of cash in circulation, if the market exchange rate weakens from the official rate, people can convert their bank deposits into cash, go to the currency board to exchange the cash into foreign currency at the stronger official rate, and then sell the foreign currency in the market, fetching an arbitrage profit. Cash arbitrage appeals to the self-interest of market participants. The selling pressure on the foreign currency will bring the market exchange rate back to the level of its official counterpart.

        It is claimed that, with the two "stabilizers", the currency board system has had a "perfect record" of exchange rate stability. According to Steve Hanke, "since the first currency board was installed in Mauritius in 1849, not one has suffered a successful speculative attack".1

        The October 1997 attack on the currency of Hong Kong, the only territory in East Asia adopting a currency board system (other than tiny Brunei), might have jeopardized the prospect of the "perfect record". Hong Kong's authorities had to protect the fixed exchange rate by tightening liquidity, thereby pushing up interest rates, rather than relying purely on the two "self-adjusting" mechanisms. Into 1998, Hong Kong has had to cope with the unpalatable consequences of high interest rates. Some measures should obviously be implemented to restore the credibility of the link and to alleviate the cost of defending it.

        A clear lesson from the episode is that the Hong Kong link is a peculiar currency board system. There is actually no currency board, and HK$ notes are issued by three designated note issuing banks (NIBs), which alone could deal with the Exchange Fund at the fixed exchange rate. Notes-based arbitrage opportunities have therefore been highly restricted, undermining one of the two stabilizers (Tsang, 1996a; 1996b). Since the other stabilizer is highly dependent on the efficiency of arbitrage, it also has not functioned effectively.

  

2.     Modernizing the Arbitrage Mechanism

        A second, perhaps more important, lesson is that cash arbitrage is hopeless in defending a currency board regime in the modern context. In a banking system with fractional cash reserves, allowing depositors to covert deposits into cash for the sake of obtaining arbitrage profits is a hazardous business. The cash base in any financial economy has been mercilessly diminishing. By the end of 1997, the Hong Kong dollar cash-deposit ratio in all "authorized institutions" (including licensed banks, restricted-license banks, and deposit-taking companies) was less than 1%, while the territory-wide ratio of notes to deposits was only about 5.6%. Under such a situation, why should banks want to facilitate arbitrage activities that require first of all the conversion of deposits into currency notes? Actually, bank notes arbitrage rarely took place in Hong Kong, and certainly not during the attack in October 1997.

        Worse still, a cashless society is widely predicted to arrive some time in the 21st century. How would then a currency board be able to fix its exchange rate through cash arbitrage?

        The whole picture would of course be dramatically changed if arbitrage can be performed effectively without involving cash, e.g. through electronic transfer instructions. This however requires some important institutional changes. For a start, the coverage of foreign exchange reserves must go beyond the cash base.

        Hanke, Jonung and Schuler (1993, p.5) observe that "in some cases" a currency board "issues deposits" fully backed by foreign reserves, and in their recommended "model constitution" for a currency board in Russia (Appendix A), they also allow for such a possibility. Since they strongly argue against discretionary central banking and regard the self-adjusting currency board system as a superior alternative, it is not clear why a currency board should accept any deposits from commercial banks and then cover them with foreign currency. On the other hand, Balino and Enoch (1997) look at modern "currency board arrangements" (CBAs) in general. In quite a few of the CBAs in existence (which total about a dozen), there is a central bank. In several cases (including Argentina, Estonia and Lithuania), the central bank takes deposits from commercial banks and its foreign exchange reserves extend beyond the amount of notes and coins in circulation to cover those deposit liabilities (the monetary base or the central bank’s total financial liabilities).

        Neither Hanke, Jonung and Schuler (1993) nor Balino and Enoch have highlighted the operational differences between a CBA that guarantees the convertibility of only notes and coins and one that guarantees the convertibility of the total of banking reserves with it. In fact, there are significant implications, particularly with regard to arbitrage efficiency and the stability of the exchange rate.

        Tsang (1996a, 1996b) argues that the model of Argentina, Estonia and Lithuania (the "AEL model") overcomes the problems of cash-based arbitrage. These three countries adopted a currency-board type system in 1991, 1992 and 1994 respectively (Bennett 1993, 1994; Balino and Enoch 1997). Though latecomers compared with Hong Kong, they have used an improved arrangement which shows a much higher degree of arbitrage efficiency. In these three countries, banks have an account with the central bank, in which deposit reserves as well as other balances are kept. The central bank guarantees the full convertibility of these balances, at the fixed exchange rate. This setup bypasses the problem of moving cash around for arbitrage. The spot rate in the foreign exchange market has been invariably quoted around the official rate, despite political and economic turbulence in recent years (Tsang, 1996a, 1996b).

        A hypothetical example will illustrate how arbitrage can be done electronically, without involving cash or bank notes. Suppose we are in a country where the domestic currency, called peso, is pegged to the US dollar at parity under the convertible reserves scheme similar to the AEL model. Every bank then has no choice but to quote the official rate of 1 peso per US dollar. Suppose Bank A deviates and quotes an exchange rate of 1.1 peso. Bank B can sell US$1 million (or much larger amounts) to Bank A for 1.1 million peso, asking A to transfer the peso to B's account at the central bank. (B would of course transfer US$1 million to A's account there). The central bank is ready to convert the peso into US$1.1 million for Bank B, which then fetches an arbitrage profit of US$100,000. A, on the other hand, suffers a loss of 100,000 peso as its US$1 million at the central bank is worth only 1 million peso. If Bank A remains unrepentant, every other bank would be getting at it.

        No cash movements are involved, as the central bank plays the role of clearing the arbitrage transactions between the two banks (Tsang, 1997). In the above example, the central bank's foreign reserves would be reduced by US$100,000, only if Bank A is foolish enough to accept a correspondent fall (100,000 peso) in its assets.

        In reality, under this "convertible reserves" system, no banks would dare to deviate in quoting exchange rates. They are bound by the rule of the game to quote the official exchange rate, within a very narrow buying and selling spread that truly reflects petty transaction cost, or they will immediately be hit by their fellow bankers. In the end, no actual arbitrage needs to take place, and the central bank is in no fear of losing any foreign reserves.2

        As arbitrage activities are settled by accounting instructions through telephone calls and other electronic means, the transaction cost is reduced to an absolute minimum. This arrangement for "cashless" arbitrage is superior not only to the cash-based arbitrage mechanism under the classical currency board, but also to gold-point arbitrage where physical shipment of gold bullion was required (Officer 1989, 1993).

 

3.     The AEL Model for Hong Kong

        Hong Kong could have adopted the convertible reserves system as a much firmer defense, without invoking proactive liquidity manipulation and direct intervention in the foreign exchange market by the government. A central bank, the Hong Kong Monetary Authority (HKMA), came into existence on 1 April 1993. In late 1996, a real time gross settlement (RTGS) system was instituted. It is an accounting mechanism between the HKMA and all commercial banks, that allows the former to transact directly with the latter.

        On the basis of the RTGS infrastructure, it is a modest step to set up a system under which every bank has a direct reserve account with the HKMA. One top of the normal clearing balances, the HKMA could ask each bank to submit an equivalent amount of US dollar to it for obtaining notes from the NIBs.3 Concurrently or alternatively, the HKMA might impose a deposit reserve requirement on the banks. To overcome resistance from the banking sector, the ratio, which could be interpreted as a "financial tax", should be as small as possible. The idea is not to tax the banks, but to ensure that there is suitable liquidity in the reserve account to minimize any possible impact on the interest rate. As explained above, if the system works, no actual arbitrage needs to take place and the spot exchange rate will be fixed around the official rate. In that situation of benign equilibrium, the deposit reserve ratio may even be set at zero.4

        At US$92.8 billion at the end of 1997, Hong Kong’s foreign exchange reserves were the third largest in the world (after Japan and China). They represented more than seven times of the amount of bank notes in circulation and 40% of the HK$ M3, and were much larger, in absolute and relative sizes, than those of the AEL countries. The HKMA should easily host the arbitrage game among financial institutions. Adopting the AEL model would then require a lower degree of central banking activism, including the manipulation of liquidity and interest rates as well as market intervention to defend the Hong Kong dollar. The Hong Kong economy should face less unpalatable results in the case of a return of the speculators, as the latter would see that all banks are bound to quote around the rate of 7.80. In other words, they would be fighting the whole banking system, rather than the HKMA, in their bid to unsettle the link.

 

4.     Efficiency Risk, Systemic Risk and Exit Cost

        Although the spot exchange rate is "fixed", the forward rate is not so automatically. Local interest rates could still be higher than those of the foreign counterpart, along with weak forward exchange rates. The reason may be that market participants are not sure whether the convertible reserves system can really fix the spot rate. In other words, there is an "efficiency risk" and a risk premium is demanded. However, over time the fixation of the spot rate should lead to the return of confidence, and convergence in domestic-foreign interest rates and spot-forward exchange rates would take place as people engage in interest arbitrage and capital inflow exceeds outflow. That has been occurring in Argentina, Estonia and Lithuania, as analyzed by Balino and Enoch (1997, Appendix I).

        However, that convergence has not been perfect. This is due to the existence of "systemic risk". In other words, although market participants observe the "fixed-ness" of the spot rate, they are not sure that the "perfect" system that is working so well will not be abandoned in the future, perhaps not because of its own faults, but as a result of other political and economic factors. Any one familiar with the political situation in these three countries understands why some people at least might be nervous, justifiably or otherwise, about the possibility of coup d'etat or external invasion. Moreover, no matter how good an arbitrage mechanism is in anchoring the exchange rate, whether a fixed rate regime is optimal for the economy in the long run is always a controversial issue.

        Governments in the three countries have tried to contain the market perception of systemic risk by legal means (Tsang, 1996a; 1996b; Balino and Enoch, 1997). In Argentina and Estonia, it is enshrined in an act of the Congress and the Parliament respectively that the central bank can only revalue but not devalue the exchange rate. The latter decision can only be made through another parliamentary legislation. In Lithuania, according to the Law on Litas Credibility, the exchange rate can only be changed by the Bank of Lithuania, in consultation with the government, under extraordinary circumstances.

        In the case that Hong Kong adopts the convertible reserves system, the efficiency risk associated with the "fixed-ness" of the spot exchange rate should be eliminated rather quickly. As to the systemic risk, Hong Kong's political and economic situations are far more stable than theirs: no one here would seriously fear the possibility of coup d'etat or invasion, although re-pegging or re-floating out of optimality considerations can never be entirely ruled out.

        Enshrining the link in law may go some way in further reducing systemic risk and lead to an even higher degree of interest rate and exchange rate convergence. In any case, the convergence can never be perfect as the law itself is still open to some residual doubts. Moreover, it will actually increase the "dismounting cost" or the "exit cost" of the link, in case it is deemed optimal to abolish the fixed rate regime and re-float the Hong Kong dollar, or re-peg the currency at different levels, at some time point in the future.

        This also applies to any scheme under which the HKMA issues insurance instruments (e.g. put options) to market participants to foster confidence that the link rate of 7.80 will not be changed. The basic idea is "to put the money where the mouth is". If the HKMA devalues the Hong Kong dollar, it will have to compensate those holding the put options. This will presumably instill confidence and help to hold the link.5

        Without an effective currency (or exchange rate) arbitrage mechanism such as the AEL model, insurance instruments alone may not be able to fix the link because there will always be market participants and speculators who are not allotted the put options. The ability of the HKMA to issue insurance coverage is obviously not unlimited. The relative strength of holders of put options versus non-holders is difficult to predict in the globalized financial market. The non-holders may decide to have a go at the link. We will then be back to the problem of "efficiency risk".

        If an effective arbitrage mechanism is in place to bind the spot exchange rate (and hence to eliminate the efficiency risk), insurance instruments may help to reduce systemic risk. Their effectiveness will however depend on the insured amount offered to the market. If the amount is small, it will not add much to the defence of the link. If the amount is large, the exit cost (in terms of compensations to holders of the instruments) will escalate. One must note that the exit cost will eventually be borne by the local tax-payers.

        Overall, the Hong Kong government needs to strike a balance between the conflicting considerations of eliminating the systemic risk for the link and reducing the exit cost from it.

 

Notes:

  1. Steve H. Hanke, "The Solution: Autopilot for Hong Kong", Asian Wall Street Journal, 30 October, 1997.
  2. This game-theoretic set-up must be the basis of the gold standard and the currency board, which rely on the self-interested activities of market participants to cancel each other out, thereby holding the exchange rate. See Tsang(1984).
  3. This arrangement would be similar to the pre-1994 situation, although commercial banks then passed the US$ reserves to the NIBs rather than to any central monetary authority individually. See Tsang (1996a).
  4. According to Balino and Enoch (1997), Argentina replaced its deposit reserve requirements by liquidity requirements in August 1995.
  5. Credibility is a delicate subject. Which is more trustworthy: a law or a put option (remembering that both may be "defaulted")? A friend half jokingly proposed an alternative to me. Should a top givernment official declare that he or she will commit suicide if the fixed exchange rate is abandoned, the system may become "almost fully credible".

 

References

Balino, Tomas and Charles Enoch (1997) "Currency Board Arrangements: Issues and Experiences," IMF Occasional Paper, No. 151, August.

Bennett, Adam G.G. (1993) "The Operation of the Estonian Currency Board," IMF Staff Papers, 40 (2), June, 451-470.

Bennett, Adam G.G. (1994) "Currency Boards: Issues and Experiences," IMF Papers on Policy Analysis and Assessment, PPAA/94/18.

Hanke, Steve H., Lars Jonung and Kurt Schuler (1993) Russian Currency and Finance, London: Routledge.

Officer, Lawrence H. (1989) "The Remarkable Efficiency of the Dollar-Sterling Gold Standard, 1890-1906," Journal of Economic History, 49 (1), 1-41.

Officer, Lawrence H. (1993) "Gold-point Arbitrage and Uncovered Interest Arbitrage under the 1925-1931 Dollar-Sterling Gold Standard," Explorations in Economic History, 30 (1), 98-127.

Schwartz, Anna J. (1993) "Currency Boards: Their Past, Present and Possible Future Role," Carnegie-Rochester Conference on Public Policy, 39, 147-93.

Tsang, Shu-ki (1984) "On the Cash-based Fixed Exchange Rate System," in The Pearl in the Mouth of the Dragon: Collected Essays (in Chinese), Hong Kong: Wide Angle Press, 179-201.

Tsang, Shu-ki (1996a) A Study of the Linked Exchange Rate System and Policy Options for Hong Kong, a report commissioned by the Hong Kong Policy Research Institute, October.

Tsang, Shu-ki (1996b) "The Linked Rate System: through 1997 and into the 21st Century," in Ngaw Mee-kau and Li Si-ming (ed.), The Other Hong Kong Report 1996, Hong Kong: The Chinese University Press, chapter 11.

Tsang, Shu-ki (1997) "Currency Board the Answer to Rate Stability," Hong Kong Standard, 31 October 1997.

Williamson, John (1995) What Role for Currency Boards? US: Institute for International Economics.