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Hong Kong's durable currency board

Earlier this month Hong Kong passed a milestone: 30 years since it re-established a currency board system. The 99 years since the start of World War I have been quite turbulent in terms of monetary policy. Not many places have stuck with the same exchange rate, or, if on a floating rate, the same policy behind the float, for 30 years. The Bretton Woods system did not last so long. Nor has any floating rate system since that I know of stuck with monetary base targeting, inflation targeting, or some other readily identifiable policy for 30 years. And of course Hong Kong's system has lasted 30 years longer than nominal GDP targeting, given that the latter is still merely a proposal on paper.

A century ago, Hong Kong had free banking. Banks issued notes redeemable in silver, which was the monetary standard of China. In the early part of the Great Depression, China's adherence to silver saved it from the mistaken policies that the Federal Reserve and the Bank of France in particular were transmitting internationally through gold. Then, though, the United States began buying large amounts of silver as one of the ill-considered special-interest sops of the New Deal. China's exchange rate appreciated, exports drooped, and the Chinese government decided to abandon the silver standard de facto in 1934 and officially in 1935. Hong Kong followed China off in 1935. Rather than simply change the exchange rate anchor and allow free banking to continue, the government of Hong Kong created a currency board to go with the change to the pound sterling as the new anchor. Unlike currency boards elsewhere, though, Hong Kong's Exchange Fund, as it was called, did not monopolize note issue directly. Rather, the note-issuing banks continued to issue, but they were reduced to agents of the Exchange Fund and with wrinkle the system operated on currency board lines. (Three banks issue notes today: HSSBC, Standard Chartered, and Bank of China.)

Hong Kong floated the exchange rate and thereby abandoned the currency board system in 1972, during the volatility of the collapse of the Bretton Woods system. Because the government was not really aware of what it was doing, Hong Kong wound up with a curious and historically rare system that had neither an exchange rate nor a monetary base of limited quantity as an anchor. In principle, the note-issuing banks could have created assets without limit and raised the monetary base as they did so. This poorly understood arrangement was weak, but about the only person who understood its weakness was John Greenwood, an economist at the Hong Kong office of the mutual fund company GT Management (Asia) Ltd. Greenwood wrote a number of articles in the company publication, the Asian Monetary Monitor, and elsewhere criticizing the existing system. He propose that to fix it, Hong Kong return to a currency board or adopt central banking. He did not get much of a hearing until a political crisis struck. When Britain and China were negotiating over Hong Kong's future after the 99-year British lease on most of the territory in the colony expired in 1997, a Chinese official bellicosely suggested that China might take Hong Kong back before then. A currency panic ensued, with some merchants refusing to sell goods except for foreign currency. Hong Kong's government suddenly became willing to listen to Greenwood, who briefed them on his proposals. The government opted to return to a currency board, with the U.S. dollar as the anchor.

The system has since stood repeated tests, including the East Asian currency crisis of 1997-98 and the world financial crisis of 2008-09. Even so, the government of Hong Kong has repeatedly instituted measures to depart in some measure from the robust simplicity of an orthodox currency board, only to move back towards orthodoxy when the chips are down. (For my views on this pattern in 1998 and my suggestion of one solution, see here; here is an even earlier paper by Steve Hanke on a similar theme.)

I became interested in currency boards in late 1988 while doing research on the history of free banking and seeing seeing how many free banking systems had had currency boards as a step to central banking. At the time there were only a few people who knew much about currency boards. Fortunately, I had the chance to learn a lot about them from John Greenwood during an internship the next summer. That led me to wonder whether it might be possible to go in the other direction and use currency boards as a step to free banking. It hasn't happened, but I think it has contributed to an awareness that there are choices other than central banking.

John Greenwood's criticisms of Hong Kong's monetary system before the 1983 crisis, his proposals for change, and his analysis of the post-1983 system have been collected in a book that is essential for those who want to understand how Hong Kong's somewhat idiosyncratic monetary system works. Another worthwhile book on the subject is by Tony Latter, a government official in Hong Kong during the crisis. Greenwood's is one of the few cases in monetary policy combining a diagnosis that proved to be correct with a cure that proved to be highly beneficial, both well before the fact. In recognition of his services to Hong Kong, the British government later granted him the honor of an OBE.

  • JP Koning

    Interesting post, Kurt.

    "Because the government was not really aware of what it was doing, Hong Kong wound up with a curious and historically rare system that had neither an exchange rate nor a monetary base of limited quantity as an anchor. "

    Trying to get my head around this. Did it effectively become a central bank then, albeit with no inflation targets?

    This link didn't work for me:

    However, this one did:

    Off topic, but what do you think of the book "The Battle of Bretton Woods" by Ben Steil?

  • Kurt Schuler

    See my next post. Thanks for the correction about the link. I found Benn Steil's book worthwhile. He however had it almost finished when I sent him the manuscript of my book (which was published first) and so I he takes a more U.S.-centric view than I do. (He also makes use of some previously underused material, in his case transcripts of the strategy sessions of the U.S. delegation in the Morgenthau Diaries.) You may be interested to know that Eric Helleiner is working on a book about Bretton Woods more from the perspective of what later came to be called the Third World.