The Credibility of Hong Kong's Currency Board System: Looking Through the Prism of MS‐VAR Models with Time‐Varying Transition Probabilities
| DOI | http://doi.org/10.1111/obes.12148 |
| Published date | 01 December 2016 |
| Date | 01 December 2016 |
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©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 78, 6 (2016) 0305–9049
doi: 10.1111/obes.12148
The Credibility of Hong Kong’s Currency
Board System: LookingThrough the Prism of
MS-VAR Models with Time-Varying Transition
Probabilities*
Boris Blagov† and Michael Funke†,‡
†Department of Economics, Hamburg University, Von-Melle-Park 5, 20146 Hamburg,
Germany (e-mail: boris.blagov@gmail.com)
‡CESifo Munich, 81679 Munich, Germany (e-mail: michael.funke@uni-hamburg.de)
Abstract
This paper employs a Markov regime-switching VAR model to describe and analyse the
time-varying credibility of Hong Kong’s currency board system. The endogenously esti-
mated discrete regime shifts are made dependent on macroeconomic fundamentals. This
enables us to determine which changes in macroeconomic variables can trigger switches
between the low and high credibility regimes. We carry out extensive testing to search for
the most appropriate specification of the Markov regime-switching model. We find strong
evidence of regime switching behaviourthat por traysthe time-varying nature of credibility
in the historical data.
I. Introduction
In order to overcome financial crisis episodes, currency board exchange rate regimes have
been implemented with success in countries such asArgentina, Bulgaria, Estonia, and Hong
Kong as a tool to safeguard external financial stability. Hong Kong introduced a currency
board system in 1983. Against the background of severe crises, Argentina and Estonia
adopted currency board systems in 1991 and 1992 respectively, and Bulgaria in 1997.
Under the arrangement the monetary base is fully backed by foreign currency reserves.
Typically, changes in the monetary base are fully matched by corresponding changes in
foreign reserves at the fixed exchange rate of the reserve currency, i.e. there exists 100%
reserve backing.
The recent revival of interest in currency board systems originates from the ‘hollowing
out of the middle’ exchange rate regime literature (Fischer, 2001), as well as the experi-
JEL Classification numbers: C11, C32, F31, F41
*We thank Franseco Zanetti, two anonymous referees, the seminar participants at the University of Z¨urich and
the Bank of Finland, and the conference participants at the 23rd Symposium of the Society of Nonlinear Dynamics
and Econometrics (2015), the Swiss Society of Economics Annual Congress: Post-Crisis Macroeconomics (2014),
and at the Annual Summit of the German Economic Association (2015) for helpful comments and suggestions.The
usual disclaimer applies.
896 Bulletin
ence of the global financial crisis. The rationale for the bipolar view is that corner solutions
such as free floats and super-strict pegs are preferable to intermediate regimes because
they are less crisis-prone in the context of today’s volatile financial markets, on the as-
sumption that investors will otherwise sooner or later overwhelm intermediate regimes
like band systems. Bluntly, the exchange rate regime policy options were assumed to
have hollowed out to the point where the only choices left to policymakers were whether
to let exchange rates float or fix them permanently via a currency board or a monetary
union.1
The Hong Kong government adopted the currency board system on 17 October 1983
during the ‘Black Saturday Crisis’. Under the board, the money supply in Hong Kong is
fully backed up by US dollars (USD), and the HK dollar (HKD) is effectively fixed at
the rate of USD/HKD 7.80. Any one of the three note-issuing commercial banks wishing
to print HKD notes would have to surrender an equivalent amount of USD (at the offi-
cial rate) to the Hong Kong Monetary Authority (HKMA) in exchange for the so-called
‘Certificates of Indebtedness’, which entitle the bank to print a corresponding amount of
HKD. Conversely, note-issuing banks can use their certificates of indebtedness in HKD to
redeem an equivalent amount of USD from the HKMA.A distinctive feature of the system
up to May 2005 was that no strong-side boundary existed, i.e. the currency board system
was asymmetric. In May 2005, however, there was a sweepingtransfor mation.The HKMA
introduced a symmetric target zone with a narrow HKD/USD band of [7.75, 7.85].2While
exchange rate interventions at the boundaries of the band are automatic, the HKMA also
reserves the right to inject or withdraw liquidity intra-marginally.
The default view on a currency board system is that it lends credibility to the exchange
rate and monetary policy by relinquishing the devaluation option. However, this is not
always the case, as one can point to numerous historical episodes where currency boards
fail to enhance the credibility of the monetary authority. This is because the government
retains its right to abandon the scheme and renege on its institutional commitments. In
other words, political uncertainty about the preferences of current and future governments
can erode credibility. With respect to Hong Kong’s currency board system, we illustrate
this by drawing on financial market information captured by the behaviour of interest rates
in the US and Hong Kong. Because currency board rigidity ties the hands of HKMA, the
system aligns Hong Kong’s interest rates to the US ones.
Figure 1 reveals that interest rates have been on equal levels in normal periods, but the
interest parity has broken down in turbulent times. The task, therefore, is to account for
a succession of higher credibility periods, followed by sub-periods of lower credibility.3
It is apparent that the stock market crash at the end of the 1980s put severe pressure on
Hong Kong’s currency board. The system was again put to the test by the Asian financial
1Williamson (1995) explainswhat a currency board is and discusses the pros and cons of the exchange rate regime.
The author emphasizes that currency board systems may be quite attractive to small, open economies and a useful
monetary arrangement for countries emerging from a very deep macroeconomic crisis, but that their disadvantages
outweigh these advantages in large open economies.
2For a thorough reviewof the advancement towards a symmetric system see Chen, Funke and Glanemann (2013).
3The empirical research investigating the credibility of pegged exchange rate systems was initiated bySvensson
(1991) and Svensson (1993). He develops various techniques to extract devaluationexpectations from interest rate
differentials. De Grauwe (1994) also uses interest rate differentials to shed light on time-varying credibility.
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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