FACULTY OF ECONOMICS AND ADMINISTRATION

EEEE2314Monetary Economy ISemester 2, 2014/2015

Hong Kong first to feel the force of QE tsunami

Prepared by: Chin Yaw Hin (EEE130010)Chuah Kah Hooi (EEE130014)

Lecturer:Dr. Lim Kian Ping

Introduction Hong Kong currency often be the targeted to be attack by speculator, once a decade mostly since 1997 Asian financial crisis. In general, Currency speculation happen when ones buy foreign currencies, not because he want to buy foreign product or is investing in a foreign business, but wish to sell the currency at a higher rate in the future. Some speculation is needed to gain benefits or minimize loses in international trade. Lets take an example, theres a cloth manufacturer in China that export cloths to the United States. As the U.S. importer of China cloth, he will do his payment in U.S. dollar, the Chinese exporter receives dollar. The exporter has to pay his workers in RMB, and thus needs to exchange the Dollar into RMB. Someone has to buy U.S. dollars (U.S.$) so that she can buy RMB. Currency traders can make money from this process, buying the U.S.$ and charging transaction fees. But many also act as speculators, hoping that they can profit from selling the dollars at a higher price in the future. The risk of speculative attack that concern by Hong Kong government is due to QE tsunami from US, as after the injection have been given by the government of US but the unemployment rate and output remain unchanged. The managing director of Lycean Securities, Francis Lun, was quoted as saying that inflows of hot money are expected to continue. He recommended that Hong Kong consider linking its currency to the Chinese yuan instead of pegging it to the US dollar.

Therefore, speculative attack will surely affect a countrys economy and affect the peoples life like how the Asian financial Crisis impact the Malaysian, Thailand Indonesia and others.

What is speculative Attack and how it happen Many countries, small and large one, for example China, export is crucial for their economy, therefore, pegging their currency to a foreign currency, which called reserve currency.

There are 2 necessary conditions if a country wants to maintain afixed exchange ratewith another country: The pegging country need to have sufficient foreign reserves of the reserve currency to exchange it for the domestic currency on demand; The pegging country need to maintain inflation rates and interest rates that closely match those of the reserve country. If these 2 conditions are violated, then speculators might attack the pegged currency in order to gain to profit from its devaluation. In the real world, the most important factor is to have enough reserves of the reserve currency to satisfy any demand. Secondly, if the reserve country has higher interest rates or lower inflation rates than the pegging country, the capital will surely flow from the pegging country to the reserve country until the pegging country is depleted of its reserves and forced to abandon the peg by letting the exchange rate float freely, end up with the devaluation of the domestic currency, which might affect the countries economy in a bad way. Ifforex tradersuspect that thecentral bank does not have enough of the reserve currency for demand, they will launch speculative attack to make big profits within a short period of short time.Even though speculation should not be compared to gambling, it cant be considered as a traditional investment because the risk of involving is higher compare to others investment. Heres a simply explanation about speculative attack. According to most of the expert, Speculative attack refers to massive selling of domestic currency in the forex market caused by misleading info spread by speculators in order to profit from the process. In other words, it is a negative form of investing based on greed. Some speculators spread misinformation about a possible devaluation in the near future in keeping with the negative expectations and spread panic in the market. Before the attack these speculators buy and hold foreign currency and when the devaluation in the domestic currency takes place, they exchange their foreign currency for a higher sum and thereby profit from it.

How QE can be viewed as a potential threat ( What is QE and how is it dangerous)An uncommon monetary policy, which a central bank buys securities from the market in order to increase the money supply and decrease interest rates. Quantitative easing increase the money supply by flooding financial institutions with capital to promote lending and increase liquidity of money. Quantitative easing is considered when short-term interest rates are at or approaching zero, and doesnt involve the printing of new banknotes.Firstly, central banks target the money supply by buying or selling government bonds. When the central bank wants promote economic growth, the next step will be buying government bonds, which will decrease short-term interest rates and increases the money supply in the circular. This strategy will have no effects when interest rates at zero, forcing banks to try other ways for stimulating the economy. QE targeted commercial bank and private sector assets, and use it to increase economic growth by asking banks to lend money. However, if the money supply increases too drastically, quantitative easing can cause the rates of inflation to increase. This is because of the fact that there is still a fixed amount of goods for sale when more money is available in the economy. In addition, banks may decided to keep funds generated by quantitative easing in reserve rather than borrowing those funds to individuals and businesses. Experts nearly disagree about the terms - its meaning, its history of implementation, and its function as amonetary policytool. Popular media's define the quantitative easing just aims on the concept ofcentral banksto larger the size of their balance sheets to increase the amount of credit that available to borrowers. In order to make it happen, central bank issues new money and uses it to buy assets from other banks. Typically, the cash the banks receive for the assets can then be loaned to borrowers. This way is to make the loan will be easier to obtain, interest rates will decrease and buyers and businesses will borrow and spend. Therefore, the more spending will cause the increases in consumption, demand for goods and services will increase, fosters job creation and ultimately, creates economic vitality.Easy money created out of thin air at an almost zero-per-cent cost by the US Federal Reserve is flowing into the emerged markets for speculative attacks. The Hong Kong dollar has become one of the target. In a proxy war launched by the US Fed at the height of the US presidential campaign, the speculators appear to be circling Hong Kong's currency board system to test the water. We don't know yet whether the speculators whether want to tear apart Hong Kong's currency board in a repeat of the 1997 episode when they attacked Thailand's fixed-exchange-rate system. Don't forget that Hong Kong is the window to China, where the yuan is the ultimate target in this galactic currency war launched in parallel with the geopolitical confrontation between the US and China.Whether quantitative easing works is a subject of considerable debate. There are several notable historically examples of central banks to increase themoney supply. This process is likely related to as "printing money", even it's done by electronically crediting bank accounts.While aiminginflationto avoiddeflationis one of the goals of quantitative easing, too much inflation can cause a negative consequence. Germany (in the 1920s) and Zimbabwe (in the 2000s) engaged in what many scholars refer to as quantitative easing. In this two cases, the result washyperinflation. However, many modern scholars aren't convinced that the efforts of these countries qualify as quantitative easing.

There is also an discussion said that QE has psychological value. Experts can generally agree that quantitative easing is a last resort for desperate policy makers. When interest rates are near zero but the economy remains stalled, the public expects the government to involve in this situation. Quantitative easing, even if it is not functioning, shows action and concern on the part of policy makers. Even if they cannot solve the situation, they can at least demonstrate activity, which can help in the psychological boost to investors. By buying assets, the central bank is using the money it has created, and this will cause risk to occur. For example, the purchase ofmortgage-backed securitiesruns the risk of default. It also questioning about what will happen when the central bank sells the assets, which will take cash out of circulation and tighten the money supply.Effect of speculation attack to a countrys economy Appreciation caused by speculation attack Heres an example of speculation attack forcing the domestic currency to appreciate. Firstly, it will force the Domestic currency to appreciate in value in a short period of time, hurting domestic exports and its competitiveness in term of economic. Secondly, the speculation could force the domestic monetary authority to adjust its currency board or abandon the currency board. This properly will create disturbance in the regional financial markets. Thirdly, if the domestic monetary authorities insist on defending the currency board, they will have to print more the local currency en masse to cope with the foreign currency inflow. Fourthly, increased value domestic currency liquidity will drive up asset values, especially for stocks and properties, to create bubbles. Thus, create high risk for the happening of economic crisis.

Devaluation caused by speculation attack The danger is that devaluation can worsen inflation. When this happens, the government need to raise interest rates to control inflation, the will make economic growth grow become slower. Another risk of devaluation can be view in the psychological way. For the people, devaluation is viewed as a sign of economic weakness, the creditworthiness of the nation may be jeopardized, the people will soon realize their purchasing power have become weaker and loss confidence to the local currency. To be even worse, devaluation may dampen investor confidence in the country's economy and hurt the country's ability to secure foreign investment. The last possible consiquence is a round of successive devaluations. For example, trading partners may realized that a devaluation negatively affect their own export industries. Neighboring countries might devalue their own currencies to offset the effects of their trading partner's devaluation. Such "beggar thy neighbor" policies tend to exacerbate economic difficulties by creating instability in broader financial markets.

2.policy used to prevent speculation attack or react to minimize the damage of speculation attack (how to tackle by using policy to prevent, deal or after it)In the history of Hong Kong, a fixed exchange rate system has been a norm rather than an exception. This largely reflects the characteristics of Hong Kong as a highly externally-oriented economy, which desires a firm anchor for the external value of its currency.2 In this respect, Hong Kong differs from most other currency board economies that in recent years adopted the system as a strong commitment to halt hyper-inflation.

Hong Kong, under the linked exchange rate regime, uses a local monetary unit with its currency fully backed by the US dollar at a fixed rate.The situation is the reverse of 1997's events, when the HK dollar and other regional currencies in Asia came under speculative attacks. Then, hedge funds and money managers sold local currencies - the HK dollar, Thai baht, Malaysian ringgit, Indonesian dollar - in favour of the US dollar to knock down the value of these currencies or force their devaluation. The Hong Kong Monetary Authority was forced to rely on unconventional measures, such as printing money to inject liquidity into the financial system, and also to buy up equities in the Hang Seng stock market. TheBank of Thailanddefended the fixed exchange rate system until it ran out of its US-dollar reserves and was forced to seek a bail-out from the International Monetary Fund.The managing director of Lycean Securities, Francis Lun, was quoted as saying that inflows of hot money are expected to continue. He recommended that Hong Kong consider linking its currency to the Chinese yuan instead of pegging it to the US dollar.`TECHNICAL REFORMS TO STRENGTHEN THE CURRENCY BOARD ARRANGEMENTS The HKMA followed through the stock market operation with a package of technical reforms in September 1998 to strengthen the resilience of the currency board arrangements. These reforms can be broadly categorised into three planks: (a) making the commitment to the link even more explicit; (b) revamping the mechanism for providing liquidity assistance and (c) further improving the transparency of the currency board arrangements. a)Explicit commitment to the link While the HKMA had always stood ready to buy or sell Hong Kong dollars against US dollars at a rate close to 7.80 to ensure exchange rate stability, the precise exchange rate levels at which it operated were not disclosed. It was believed that a small degree of unpredictability would increase uncertainty faced by speculators. However, experience during the crisis suggested that the discretion was more apparent than real. As the HKMA had been defending at the 7.75 level, a withdrawal from this level could possibly be misread by the market as a retreat from the linked rate. Moreover, at a time when confidence had been shaken by external and domestic shocks, the absence of an explicit commitment was not conducive to public confidence. As part of the technical reforms, the HKMA has provided an undertaking to all licensed banks in Hong Kong to convert, at their initiative, Hong Kong dollar balances into US dollars at a prescribed convertibility rate. Taking into account the exchange rate prevailing at that time, the convertibility rate was set initially at 7.75. A 500-day transition took place between April 1999 and August 2000 when the rate was moved by 1 pip per day to converge to the linked rate of 7.80, where it has remained (Chart 5). On the strong side of the link, the HKMA has continued to retain some limited discretion in determining the exchange rate level at which it sells Hong Kong dollars for US dollars. Operationally, it responds at its discretion to bank offers, taking into account prevailing market conditions. Market feedback suggests that there is little 12 worry about the HKMAs ability to defend against speculative attacks on the strong side. It is also believed that a small degree of uncertainty will make it more difficult for speculators to calculate the cost of speculation. Nevertheless, the pros and cons of a formal two-way convertibility undertaking are re-examined from time to time in the light of changing market conditions.

Revamping the mechanism for providing liquidity assistance Experience During the crisis revealed the inadequacy of LAF in two aspects. First, it was mainly a mechanism to buffer liquidity shocks for the purpose of ensuring a smooth functioning of the interbank payment system. There was no built-in cushion to prevent an overshooting of interest rate response to portfolio shocks. Such a cushion would be useful to facilitate more orderly adjustments of interest rates to changes in the demand for Hong Kong dollar assets. The Aggregate Balance of the banking system has always been small, given the efficiency of the payment system and the absence of statutory reserve requirements. An outflow of funds could easily drain the pool of interbank liquidity, causing panic among banks. Secondly, while the HKMA had reserved the right to vary the LAF interest rates, conventionally, they had been set at fixed spreads from the US discount rate/Fed funds target rate. This explained the need to discourage repeated borrowers, particularly when the currency was under selling pressure.

n revamping the mechanism for providing liquidity assistance, the HKMA replaced the LAF by the Discount Window. Borrowing against Exchange Fund paper (which is fully backed by US dollars) is no longer subject to the repeated 13 borrowing restriction. The base rate for discount window borrowing is set with reference to a pre-announced formula that takes into account the US Fed funds target rate and Hong Kong dollar interbank interest rates. There is, in addition, a step-up structure under which individual banks that borrow in excess of 50% of their holdings of Exchange Fund paper are charged a higher interest rate. While seemingly complicated, this design aims at striking a fine balance between two objectives: ensuring the cost of discount window borrowing reflects the underlying fund flows situation on the one hand, and preventing excessive interest rate volatility on the other.

The outstanding amount of Exchange Fund paper currently stands at around HK$110 billion, and is allowed to expand over time along with the interest payments on the paper. Putting aside roughly HK$40 billion worth of paper that banks require for intra-day repos under the RTGS system, there is an estimated cushion of around HK$70 billion. Although the effectiveness of the discount window has not been tested by shocks as severe as the Asian financial turmoil, simulations run on models suggest that interest rate hikes during the turmoil would have been much more moderate had this facility been in place. Official reserves would have shown larger declines, however. Enhancing the transparency of currency board operations To enhance the transparency of currency board operations, the HKMA publishes the forecast changes in the Aggregate Balance on a real time basis, the monetary base and its components on a daily basis, and the currency board account on a monthly basis. A Subcommittee on Currency Board Operations has been set up under the Exchange Fund Advisory Committee to oversee the currency board operations, and to recommend measures to further strengthen the currency board arrangements. The Subcommittee consists of members from the HKMA and the private sector, and the minutes of its meetings are published.

Table 2 below summarises the main features of Hong Kongs currency board arrangements, following the implementing of various reforms over the past years.

The governments stock operation in August, and the package of technical reforms implemented in September, effectively fended off speculative pressure and stabilized the monetary situation. Helped also by developments in the external environment, the Hong Kong dollar risk premium narrowed substantially in 15 1999, and largely disappeared in 2000. Interest rate volatility also declined significantly, from 2.84 percentage points in 1998 to 0.45 percentage points in 2000.

ECONOMIC ADJUSTMENT IN THE POST-CRISIS PERIOD The return of monetary and financial stability has provided a sound foundation for economic activity to recover. Having experienced five consecutive quarters of negative year-on-year growth, the Hong Kong economy started to recover in the second quarter of 1999, and staged a distinct rebound in 2000, with real GDP growth of around 10%. Initially driving the recovery was an increase in net exports, resulting first from a compression of imports, and helped later by a revival in export demand. As the recovery has become more established, growth has broadened to domestic demand, with private consumption expenditure, and in more recent quarters, private investment, picking up from depressed levels in 1998 and early 1999. The unemployment rate has come down from a high of 6.3% early 1999 to the present 4.3%, although the latter is still considerably higher than the pre-crisis level (Chart 6).

Economic adjustments under the fixed exchange rate system have come about largely through internal price/cost adjustments and productivity enhancements. Chart 7 shows the movement of real effective exchange rate, which provides a summary indicator of Hong Kongs price competitiveness. Real effective exchange rate appreciated by about 12% between June 1997 and January 1998, as a result of the weakening of the Japanese yen and sharp falls of regional currencies. From August 1998, the index began to edge down, helped not only by a rebound of yen and regional 16 currencies, but more importantly, by declines in domestic prices, which help restore competitiveness. In the following paragraphs, we examine the adjustment efforts of the corporate sector, developments in the banking sector and fiscal policies to support the economic recovery.

Conclusion: Hong Kong, for instance, which pegs its Hong Kong dollar to the United States dollar, always maintained at least several times the amount of United States dollars as there were Hong Kong dollars in circulation. Nonetheless, this currency was attacked several times, because speculators believed that even though Hong Kong had the foreign exchange reserves to maintain the peg, they believed that the Hong Kong currency board was unwilling to take actions to maintain the peg. However, the speculators lost because the currency board successfully defended the peg by raising interest rates on the Hong Kong dollar, which brought in more United States dollars. When the speculative attacks ceased, Hong Kong lowered its interest rates to closely match interest rates in the United States. Hong Kong has maintained its dollar peg since 1983 and has successfully varied the interest rate by up to 1.5% from the United States rate while still being able to maintain the peg. Hence, interest rates do not have to be exactly equal. The greater the reserves and the shorter the time period, the more that the interest rate can deviate from the reserve country to effect a limited form of monetary policywhile maintaining the currency peg.References 1. Thanong Khanthong (2012 )- Hong Kong first to feel the force of QE tsunami Retrieved from :http://www.nationmultimedia.com/opinion/Hong-Kong-first-to-feel-the-force-of-QE-tsunami-30193022.html 2. Somchai Jitsuchon,Chalongphob Sussangkarn (2009) Thailand's Growth Rebalancing Retrieved from :http://www.adbi.org/working- paper/2009/10/06/3344.thailand.growth.rebalancing/lessons.from.the.1997.economic.crisis/1. Priscilla Chiu (2001)-Hong Kongs Experience in Operating the Currency Board SystemRetrieved from : https://www.imf.org/external/pubs/ft/seminar/2001/err/eng/chiu.pdf

2. Speculative Currency Attack-Retrieved from: http://thismatter.com/money/banking/speculative-currency-attacks.htm 5. Christian Weller (1998)- Currency Speculation How great a Danger? http://www.dollarsandsense.org/archives/1998/0598weller.html