HK Currency Board offers model to eurozone, says Invesco’s Greenwood
Invesco chief economist John Greenwood has said that precedents exist for setting up and managing a successful currency union, but a set of eight fundamental rules apply.
No-one is suggesting that a solution to the drawn out eurozone crisis is quick or easy, but Invesco Chief Economist John Greenwood says the region could draw some inspiration from refinements made to Hong Kong’s currency board system in recent years.
In the 1980s Hong Kong had its own currency crisis, prompting a solution which became known as a Currency Board mechanism, essentially the pegging of the HK$ to the US dollar at a fixed rate. since 1998, Greenwood has been a member of the Committee on Currency Board Operations of the Hong Kong Monetary Authority.
Under the system, Local banks had to pay US dollars to the Monetary Authority, so the local currency was 100% backed by the dollar, operating in the same way as the former Gold Standard.
Greenwood says the system provided early relief but over the years other measures had to be added, and the system tweaked to produce the required result. The European Monetary System started out with the Maastricht Treaty, and then added the Stability and Growth Pact to ensure currency stability.
“We in the currency board committee of HKMA had to do the same thing, until we reached the point we wanted to be. The last change was in 2005, and the measures we have taken have proved effective in recent crises,” he explained.
Distilling the experience of more than 30 years, he has evolved eight “rules” on how to operate a successful currency board, or currency union, and he feels the analogies between the situation of the HK$ over time, and the euro, are similar.
“Interest rates in Hong Kong follow the US very closely. There is an automatic adjustment to match the Fed Funds target rate, which means that especially at the short end of the yield curve, they are almost identical. (Further out they are more divergent as other factors come into play).”
Greenwood’s eight rules start with three necessary conditions for successful currency union, all of which the HK$ achieved, but, he adds, the euro did not : a high level of wage and price flexibility, a high degree of factor (capital and labour) mobility, and a limited welfare state. “The first two are simply essential for a modern market economy, but if they fall short or are not working, the third element of a transfer mechanism has to come into play,” explains Greenwood.
History demonstrates how the eurozone has attempted to reach that point, starting in 1994 with the Maastricht Treaty convergence criteria, which limited the national deficit to 3%, the debt to GDP ratio to 60% and 1.5% deviation from the inflation rate of other economies.
In 1999′ following the creation of the eurozone, those three factors – deficit, debt and price – were supplemented with the Growth and Stability Pact. But that too proved insufficient to support the currency union.
Hong Kong then added another set of measures relating to the overall financial health of the economy and to balance sheet strength. These focused on monetary requirements, fiscal rules, the capitalisation of banks, and managing debt for both households and non financial companies.
Hong Kong monetary authorities were mandated to maintain 100% foreign currency serve against the domestic monetary base. In fact, this built to four to five times the domestic base, meaning that in hard times, the government had reserves to tackle any crisis. Argentina was forced to abandon its plans for currency convertibility in the 1990s because it failed to secure that cushion.
The Hong Kong authorities are constitutionally obliged to maintain a government budget surplus through the business cycle. Hong Kong effectively has no sovereign debt, and only issues long Maturity debt to create a yield curve. There is no opportunity for elected officials to spend unwisely ahead of elections.
Hong Kong’s banks are “strongly. Capitalised and highly liquid” Greenwood notes. There is no written capital ratios requirement but in practice most banks have Tier 1 capital ratios of between 10% and 18%’ against a proposed 4% under Basel II regulations. The rule applies to all “authorised institutions”, and includes the provision to maintain a positive balance at e central clearing house at all times.
“Contrast that to the system in Europe where central banks and commercial banks are in debt to sovereigns,” commented Greenwood.