A WAVE of currency depreciation has swept through East Asia, from Thailand to Taiwan. Only the Hong Kong dollar has clung on to its peg to the American greenback. Hong Kong is also the only economy in the region to operate a currency board. In the past week, speculators have attacked the Hong Kong dollar and the stockmarket has swung wildly. Will the currency board prove more durable than other Asian exchange-rate pegs?
That question matters elsewhere. Although the trend in emerging economies is towards more flexible exchange-rate mechanisms, several countries—including Argentina, Bulgaria, Estonia and Lithuania—have introduced currency boards in recent years. But as a recent IMF paper* points out, currency boards have costly drawbacks as well as benefits.
A country that introduces a currency board commits itself to converting its domestic currency on demand at a fixed exchange rate. The Argentine peso, for instance, has been convertible into one American dollar since the currency board was introduced in 1991. The Hong Kong dollar has been officially fixed at HK$7.80 per American dollar since the board was introduced in 1983. To make this commitment credible, the currency board holds reserves of foreign currency (or gold or some other liquid asset) equal at the fixed rate of exchange to at least 100% of the domestic currency issued.


Unlike a conventional central bank, which can print money at will, a currency board issues domestic notes and coins only when there are foreign-exchange reserves to back it. Under a strict currency-board regime, interest rates adjust automatically. If investors want to switch out of domestic currency into, say, dollars (as they have been doing in Hong Kong), then the supply of domestic currency will automatically shrink. This will cause interest rates to rise, until eventually it becomes attractive for investors to hold local currency again.
The predictability and rule-based nature of a currency board are two of its biggest advantages. Like any fixed exchange-rate system, a currency board offers the prospect of a stable exchange rate, which can promote both trade and investment. Its strict discipline also brings benefits that ordinary exchange-rate pegs lack. Profligate governments, for instance, cannot use the central bank's printing presses to fund large deficits.
But discipline has its drawbacks. Like other fixed exchange-rate systems, currency boards prevent governments from setting their own interest rates. Hong Kong's interest rates are in effect set by America's Federal Reserve. Because its inflation rate has been higher than in America, this has resulted in low—and sometimes negative—real interest rates in the 1990s. In turn, this cheap money fuelled a bubble in property and share prices.
If local inflation remains higher than that of the country to which the currency is pegged, the currencies of countries with currency boards can also become overvalued and uncompetitive. Governments cannot use the exchange rate to help the economy adjust to outside shocks, such as a fall in export prices or sharp shifts in capital flows. Instead, domestic wages and prices must adjust. In countries where these prices are sticky, such as Argentina, the risk of currencies becoming overvalued is high.
A currency board can also put pressure on banks and other financial institutions if interest rates rise sharply as investors dump local currency. For emerging markets with fragile banking systems, such as Bulgaria, this can be a dangerous drawback. Also, a classic currency board, unlike a central bank, cannot act as a lender of last resort. A conventional central bank can stem a potential banking panic by lending money freely to banks that are feeling the pinch. A classic currency board cannot. But most currency boards have more freedom than the classic description implies. Hong Kong's, in particular, is in a strong position.
After big depreciations in other Asian countries, it is the fear that the Hong Kong dollar is now overvalued that triggered much of the current panic. That fear is probably overdone. Hong Kong has very flexible wages and prices. And two other factors also suggest Hong Kong's currency board will weather the storm.

Your flexible friend

First, it has a massive armoury of reserves. At $85 billion, Hong Kong has enough reserves to cover the entire M1 narrow measure of the money supply (currency in circulation plus demand deposits) almost four times over. If China's reserves are added (its government has promised to support the Hong Kong dollar), narrow money is covered ninefold (see chart). Such huge reserves make Hong Kong the soundest currency board in the world and should bolster investors' confidence about the country's ability to maintain its exchange-rate peg.
Second, Hong Kong's banks are well regulated and well capitalised. This puts them in a strong position to cope with the high interest rates that might be needed to defend the currency board.
With such strong economic and financial fundamentals it is hard to see why Hong Kong's currency board is under such attack. One reason may be that the board has begun to look a bit too much like a central bank. Hong Kong, and some other countries with currency boards, such as Argentina, intervene in money markets to smooth swings in interest rates the same way central banks do. Hong Kong's Monetary Authority can inject or withdraw money from the interbank lending market to push up or lower interest rates. On October 23rd, for instance, it drove up overnight interest rates to 300% to punish speculators. The following day it injected money into the system to push rates down.
This kind of intervention undermines the advantages of a currency board. Instead of regarding the system as automatic, speculators are left to wonder about the government's motives. Does money-market intervention, for instance, imply that the government is worried about high interest rates? If so, will Hong Kong cling to its currency peg, no matter the cost to its economy that higher interest rates might bring? These kinds of uncertainties are the cause of speculative attacks. Truly credible currency boards can avoid them.


* “Currency Board Arrangements: Issues and Experiences.” IMF Occasional Paper 151. August 1997.