Ground-zero of the currency crisis that has infected one Asian country after another was the floating of the Thai baht on July 2. Since then, in a spreading contagion, the currencies of Thailand, Malaysia, Indonesia, and the Philippines have fallen 30 to 50 percent in value. Now currency speculators have zeroed in on the Hong Kong dollar.
The origins of Thailands currency crisis go back to 1992-94 when the Federal Reserve maintained the federal funds rate at an unusually low rate of 3 percent to enable U.S. banks to work their way out of their bad loan problems. The Thai baht was officially pegged to a basket of currencies, but because the dollar accounted for about 80 percent of the basket, the baht was effectively tied to the dollar. Convinced of the permanence of the exchange rate, banks in Thailand took advantage of the attractive spread between U.S. and Thai interest rates to borrow tens of billions of dollars, converting them into baht, and then loan the funds to Thai businesses and property developers at far higher rates. The result was a flood of funds into Thailand which fueled an asset bubble, especially in real estate. Property prices soared, and the national bird of Thailand unofficially became the building crane.
The underpinnings of the Thai boom unraveled when the dollar began to appreciate against other currencies, especially against the Japanese yen. As the dollar rose from 80 yen in April of 1995 to 125 yen in early 1997, the Thai baht suddenly became seriously overvalued, clobbering Thai exports. Thailands trade deficit shot up to over 8 percent of GDP in 1996 causing foreign investors to think twice about lending even more. Speculators launched a series of attacks on the Thai currency in March. After losing $7 billion dollars of reserves in the spot market and committing $23 billion to the forward market in an attempt to defend the baht, the Bank of Thailand finally gave up on July 2 and allowed the baht to float.
In short order, the Philippine peso, the Malaysian ringget, and the Indonesian rupiah followed suit. Only the Hong Kong dollar and the Taiwan dollar remained linked to the greenback. With their enormous reserves (Hong Kong had foreign exchange reserves of $86 billion and Taiwan, $87.6 billion), the media proclaimed them invulnerable to speculative attack. But Taipei decided it would be a waste to spend its huge reserves defending what had become an uncompetitive exchange rate and threw in the towel on October 18, allowing the Taiwan dollar to float. Taiwans capitulation to the speculators proved to be a key factor in provoking the current speculative attack on the Hong Kong dollar.
Since 1983 the Hong Kong dollar has been pegged to the U.S. dollar at an exchange rate of 7.8 to 1 (plus or minus 1 percent). The Hong Kong Monetary Authority prints money when foreign-exchange reserves increase and reduces the supply of the local currency when they are spent. In the run up to the hand over of the British Crown Colony to China at midnight on June 30, property values soared on visions of thousands of mainland Chinese flooding Hong Kong and requiring housing. The inflow of funds to finance the real estate boom, in turn, fueled an explosion in money and credit. Because financial markets considered the convertibility of Hong Kongs currency into the greenback at the official exchange rate sacrosanct, Hong Kong had a virtually unlimited credit line from the worlds banks at the U.S. federal funds rate of 5.25 - 5.5 percent. Because of the inflation generated by the monetary expansion, these interest rates were far less than the rate of inflation. Real rates of interest were negative, justifying almost any asset value. But that could not be a sustainable equilibrium. Foreign investors became increasingly wary of lending to a bubble economy and feared that if they collectively tried to repatriate their investments, the Hong Kong authorities and their Chinese partners would abandon the official peg as so many other Southeast Asian Tigers had done.
On Red Thursday, October 23, just five days after the floating of the Taiwan dollar, foreign investors decided the risk of continued investment in Hong Kong was too great, and tried to dump their Hong Kong assets. Foreign investors can reduce their holdings of Hong Kong assets and repatriate these funds only by converting Hong Kong dollars into greenbacks. The Hong Kong Monetary Authority must then use foreign-exchange reserves to meet the demand for dollar, causing an equivalent drop in the supply of the local currency. As Hong Kong banks scrambled for remaining reserves, overnight rates reached 300 percent before they fell back and finished the day at 150 percent. The soaring interest rates triggered a plunge in the Hong Kong stock market. The Hang Seng index of stock prices fell over ten percent, the worst one-day decline in over a decade. But the loss of foreign- exchange reserves was contained because the currency board mechanism provides an automatic brake on capital outflows. While central banks can, and usually do, use open-market operations or lending through the discount window to replace bank reserves lost by the sale of foreign-exchange, sterilizing capital outflows, Hong Kongs Monetary Authority cannot. Currency boards are intentionally set up as a sort of doomsday device. There is no way foreign investors can repatriate their funds without creating a liquidity crisis.
The terrible truth is Hong Kongs property boom is over. Clearly, Hong Kong has the resources to maintain its currencys link to the dollar if it has the political will. But the cost will be a contracting money supply, deflation, and periodic speculative attacks with their associated financial crises as speculators test Chinas resolve . Property values will tumble, and Hong Kongs economy will suffer from an uncompetitive manufacturing sector. Of course, Hong Kong is basically a service economy, so its manufacturing sector may not matter as much to policy makers as it does in Malaysia, the Philippines, or Taiwan. Still, it seems preferable to abandon the peg and float the Hong Kong dollar. The currencys value would drop substantially against the dollar, but deflation could be prevented. Existing property values in local currency terms would seem less expensive to the rest of the world, and manufacturing exports more attractive in world markets.
The worst scenario would be maintaining the pegged rate without convincing speculators that the exchange rate will be successfully defended. Lack of credibility would make the monetary contraction even more severe and require even higher interest rates. A similar monetary situation occurred in the United States during the interregnum of despair (the long interval between the defeat of Hoover in the 1932 presidential election and the inauguration of Roosevelt on March 4). President Hoover, who was now a lame duck, kept the dollar linked to gold while the president-elect hinted that he would take the country off the gold standard. The uncertainty led to a run on the U.S. gold stock which caused the collapse of the entire banking system. By the time Roosevelt was inaugurated, all the banks in the United States had closed. Hong Kong policy makers take note.
Mac Williams
Cosmos Mariner
Destination Unknown
© November 4, 1997