WHY WE INTERVENED

(Published in The Asian Wall Street Journal on 20 August 1998)

Joseph Yam
Chief Executive
Hong Kong Monetary Authority

[Reprinted by permission of The Asian Wall Street Journal
@1998 Dow Jones & Company, Inc.
All rights reserved worldwide.]

There has been a mixed response to Hong Kong Financial Secretary Donald Tsang's decision to intervene in the local stock and futures markets to deter currency manipulation by those who have built up large short positions in the Hang Seng Index futures. While there has been much support for this decision, expressed quietly through the many telephone calls and letters we have received from a wide spectrum of our community, vehement criticism has also been forthcoming.

The critics accuse the government of becoming dangerously interventionist and portray the action as a major departure from the free market philosophy of Hong Kong. They also interpret the intervention as a demonstration of weakness, because they think it reflects our unwillingness to bear the pain of economic adjustment under a currency board system. They further argue that the linked exchange rate system has, as a result, become more vulnerable. I would like to respond to these criticisms.

I have no doubt that there has been manipulation of our currency to engineer extreme conditions in the interbank market and high interest rates in order to reap profits from large short positions in stock index futures. We have no objection to anybody, including hedge funds, taking short positions in stock index futures. If they take the view that asset-price adjustment in Hong Kong requires the stock market going down to a particular level, they are free to take a corresponding position. If the market indeed falls to that level and they benefit from the short position I would even congratulate them for having excellent foresight.

But this is not the case. The manipulators have been repeatedly engaging in the double market play, with little regard to the economic fundamentals of Hong Kong and the extent of the market adjustments that have already taken place. This presents serious risks of markets overshooting, with asset markets ratcheting down on every occasion the manipulators engage in this activity. This can be highly damaging to the stability of the whole financial system of Hong Kong. It also undermines general confidence in our currency.

Furthermore, in my opinion, the manipulators' action is now responsible for a significant part of the interest-rate premium in the Hong Kong dollar over the U.S. dollar. This premium has been unfairly attributed to the possibility of government losing its nerve in seeing through the economic adjustment imposed upon Hong Kong by financial turmoil in the region, operating under a currency board system. I do not know how many times we expressed the view that we have to stick it out and bear the inevitable pain, and that a fixed exchange rate under our currency board system is the best option for Hong Kong. But it is unfair to ask the community to put up with excessive pain inflicted upon it by those engaging in this double play of the currency and stock futures markets.

We fully accept that, under a currency board system, capital outflow will lead to a shrinkage of the monetary base and therefore higher interest rates. But available statistics on some of the components show our current account balance of payments position has been stable to improving, even though our currency has been significantly stronger than many of our trading partners. Yet the extent of the selling of Hong Kong dollars in the three days from Aug. 5 to Aug. 7, and on previous occasions, was so clearly out of proportion to economic reality that it could only be attributable to currency manipulation as part of this double market play.

The question then is whether it is in the best interest of Hong Kong to continue to leave it to the free play of market forces and risk markets overshooting, with the pain of economic adjustment exacerbated and confidence in our currency undermined. Clearly it is not, and the alternative is to intervene to frustrate this double market play. We agonized over this difficult decision. We were acutely aware of the possibility of our action being misunderstood. But to us the balance of advantage, having gone through the positive process of weighing up carefully the arguments for and against this act of intervention, is to intervene. Although this is the first time the Hong Kong government has intervened in this manner, in either the stock or the futures markets, the intervention is not a departure from the traditional policy of "positive non-interventionism" that has served Hong Kong so well in the past.

The aim of the intervention is not to prop up the stock and futures markets. Our action is targeted at currency manipulation that took advantage of the automatic adjustment mechanism of our currency board system to produce extreme conditions in the interbank market and high interest rates, in order to profit from a short position in stock index futures. We wish to send the very clear message to those manipulating our currency for this purpose that they may stand to lose money instead. But if there were no currency manipulation, there would be no such intervention.

Turning to the currency board system, our resolve in adhering to it has never been stronger. The experience of many of our neighbouring economies in the past year or so says it all. There simply is no better alternative for Hong Kong. Financial liberalization and the globalization of financial markets have left little scope for a small open economy to pursue flexible exchange rates. It has become increasing clear, at least in central banking circles, that either the currency is firmly fixed to a major currency through the adoption of a currency board system or it has to be freely floating. I would even go further to say that floating is not really a viable long term alternative.

The Hong Kong Monetary Authority strictly observes the monetary rule of a currency board system. This requires any change in the monetary base to be brought about only by a corresponding change in foreign reserves in the specified currency, i.e. the U.S. dollar, at the fixed exchange rate. Any accusation that we have done otherwise will need to be substantiated by proof that we have allowed the monetary base to be altered without a corresponding change to our foreign reserves. We have been entirely transparent in the operation of our currency board arrangements. We even publish the aggregate balance in the clearing accounts of our banks, that crucial component of the monetary base non-existent in currency boards of the old days, almost on real time, and subject ourselves to the scrutiny of all concerned.

But adherence to the monetary rule does not preclude the government funding a budget deficit by drawing down its fiscal reserves that are held in foreign assets in the Exchange Fund. The fact that this was done at a time when speculators were manipulating our currency may have caused some annoyance and surprise to them. But they only have themselves to blame for not doing their homework and for manipulating our currency in the first place. Adherence to the monetary rule also does not preclude a portfolio shift outside the balance sheet of the currency board from other assets into Hong Kong stocks for whatever purpose considered to be in the best interest of Hong Kong.

Our currency board system is as robust as ever and our determination to maintain it is as firm as ever. There has been no weakening of resolve and our action in the stock and futures markets is not a "desperate defense" of our linked exchange rate system.

Let me close by indulging further in what will appear to some as blasphemy. If the market cannot be wrong and governments are generally wrong, why are we witnessing the emerging markets shaking themselves to bits? If emerging markets continue to devalue their currencies, which some commentators still suggest is inevitable, the costs will be borne either through massive deflation in the developing world or bubbles in the developed markets, or both. Success or bubble, call it what you will, built upon the collapse of emerging markets, cannot be fundamentally sound.

The burden borne initially by the loss of jobs and recession in the emerging markets will ultimately be borne by the G-7 economies. Even speaking as an official of the freest economy in the world, I think there is now a need to get a message to the G-7 that abstaining from intervention to maintain global financial stability, particularly currency stability, may no longer be a viable option. They will ultimately bear the costs of adjustments when they either have to recapitalize the international financial institutions and engage in Brady Bond-type adjustment mechanisms, or are sucked into a global deflationary process through a collapse of demand for their exports.

Whether we like it or not, governments have a role in protecting the level of income and employment of their people. The Hong Kong economy has the lowest level of government intervention in the world, the strongest economic fundamentals, and no debt. And yet, manipulative speculative activities threaten to undermine the fabric of this model economy. And if Hong Kong's strongest fundamentals can be threatened by such speculation, what hope is there for the rest of the non-industrial and emerging markets?

We need to provide a more balanced picture of the dangers of panicking markets leading to widespread contagion, rather than promoting the unrealistic view that devaluation (and by implication volatile markets) is the solution to the global crisis. Competitive devaluation is adding to the deflationary pressure in the world. We are already witnessing how panicking markets have sent some of the strongest economies in Asia to crisis and distress. We have an obligation to present a balanced picture of the situation.

Updated on 20 Aug 1998