(Reprinted from HKCER Letters, vol. 52, September 1998)

A Contingency Plan for Dollarizing Hong Kong

Kurt Schuler

Editor's note: The Asian financial crisis takes on Hong Kong mainly in the form of speculative attacks on the Hong Kong dollar. In the past year or so, there have been heated debates and proposals on how the dollar should be defended with minimal adverse effects on the economy. Dollarization is one option that has been repeatedly mentioned but not thoroughly discussed. Here Mr. Schuler puts forth a detailed proposal that should serve as the basis for further analysis and exchange of ideas. His views do not necessarily represent those of the HKCER.

A diagnosis of Hong Kong's monetary problems

The Hong Kong dollar has withstood many tests, and has preserved its value against the U.S. dollar for the past 15 years while other Asian currencies have depreciated. Since the Asian currency crisis began, though, the Hong Kong dollar has suffered a number of speculative attacks. Some of the world's richest and most astute currency speculators are now betting that the Hong Kong dollar will be devalued.

Their bets are pushing up interest rates in Hong Kong dollars. Until the crisis, rates usually were close to the corresponding rates in U.S. dollars-sometimes even below. Since the crisis, interest rates in Hong Kong dollars have generally been higher than rates in U.S. dollars; for particular periods and types of lending they have been as much as 5 percentage points higher. High interest rates contribute to the recession Hong Kong is suffering, by raising the cost of expanding a business or buying an apartment with borrowed money. Borrowers in Hong Kong could obtain lower interest rates by borrowing in U.S. dollars rather than in Hong Kong dollars, but that would expose them to currency risks of the type that have bankrupted borrowers in other Asian countries recently.

Why do so many speculators think that the Hong Kong dollar will be devalued? The answer lies in Hong Kong's monetary system. The foundation of the system is a currency board arrangement, which maintains an official exchange rate of 7.80 Hong Kong dollars per U.S. dollar and backs the Hong Kong dollar monetary base 100 percent or more with U.S. dollar assets, such as U.S. government securities. The Hong Kong dollar monetary base comprises notes issued by the three note-issuing banks under the supervision of the Hong Kong Monetary Authority (HKMA), and coins and deposits issued directly by the HKMA. In principle, there is no reason why the HKMA should devalue; as long as it follows orthodox currency board principles, it will always have sufficient U.S. dollar reserves to meet all demands to convert the Hong Kong dollar monetary base into U.S. dollars. In practice, though, Hong Kong's currency board system has peculiar, unorthodox features that create confusion about its workings and doubt about its durability.

The HKMA announced on 5 September 1998 that it would correct some of those features, in particular the divergence between the market rate and the official rate of the Hong Kong dollar that contributed to keeping short-term interest rates in Hong Kong dollars higher than the corresponding rates in U.S. dollars. Most of the changes the HKMA announced are welcome, but they address only various technical aspects of the system, not the underlying legal and political aspects that cause doubt. The changes will tend to reduce short-term rates in Hong Kong dollars, but they will not necessarily reduce long-term rates. Long-term rates in Hong Kong dollars are higher than the corresponding rates in U.S. dollars mainly because of political risk and the perceived risk of devaluation, not because of technicalities affecting arbitrage. The flaws that remain include the following.

The currency board system lacks firm legal support. Neither statute law nor the Basic Law commits Hong Kong to any particular monetary system, anchor currency, or exchange rate. The government of Hong Kong has the power to devalue the Hong Kong dollar and abandon the currency board system instantly by administrative decision, without public debate or the approval of the Legislative Council.

The HKMA has acquired most of the functions of a central bank in addition to its currency board function. Many speculators now expect it to act like a typical central bank and devalue. The HKMA is far from a simple orthodox currency board. It manages government funds; issues securities; lends to banks; supervises financial institutions; influences interest rates; supports the stock market; and until recently, intervened in the foreign-exchange market-none of which a simple, orthodox currency board does, and some of which many central banks do not even do. The varied functions the HKMA undertakes in addition to supervising the issue of currency create confusion about whether Hong Kong's monetary system is still a currency board system, or instead a kind of central bank. Speculators are aware that currency boards do not devalue, but central banks typically do.

The Chinese government may have inadvertently encouraged speculation against the Hong Kong dollar by pledging its willingness to support Hong Kong's monetary system with Chinese foreign reserves. It is good that the Chinese government continues to support the principle of "one country, two systems" in monetary policy. However, statements that China is willing to use its own foreign reserves to support Hong Kong give the mistaken impression that a currency board needs enormous foreign reserves, equal to broad measures of the money supply such as M2 or M3. In truth, a currency board only needs reserves equal to 100 percent of the monetary base (M0). As of July 1998, the monetary base was approximately HK$90 billion. The huge additional foreign reserves that the HKMA has accumulated as a manager of funds for the Hong Kong government, while nice for the government, have no counterpart in any other past or present currency board system.

Failure to distinguish between fixed exchange rates and pegged exchange rates also contributes to the perception that a devaluation is likely. With a fixed exchange rate, the exchange rate is the top priority of monetary policy (in an orthodox currency board system, the only priority). With a pegged rate, other priorities, such as interest rates, have equal status with the exchange rate. That creates a conflict between priorities that usually ends in a devaluation. Orthodox currency boards maintain fixed exchange rates and therefore do not need to devalue; central banks that claim to maintain fixed rates in reality maintain pegged rates, which is why they have devalued again and again (for historical evidence, see Schuler 1996: 32-4 and Schuler 1998a: Table 1). Because economists fail to make this distinction, so do government officials and the public. The HKMA and the government need to emphasize the distinction and encourage others to do likewise.

The option of dollarization

Both the causes and the cures of Hong Kong's recession are largely external. Unlike the rest of China, Hong Kong is a highly open market economy with a fully convertible currency. Openness has contributed to Hong Kong's impressive long-run economic growth, but it also means that Hong Kong cannot rely on a large internal market or on exchange controls to protect it from the recession hurting all of East Asia outside of China. Economic growth in the region depends to a large extent on Japan, and to a lesser extent on China. If Japan can fix its financial system, cut taxes, and prevent unhealthy deflation, and if China can avoid actions that trigger a further round of currency depreciations, the rest of the region can start to recover soon; if not, the regional recession will continue through next year. Under the circumstances, the best any monetary system can do is help minimize losses in Hong Kong. Reforms that allow interest rates in Hong Kong dollars to fall closer to levels in U.S. dollars will help.

As a solution to Hong Kong's monetary problems, some people have proposed a floating exchange rate, which in effect would allow the Hong Kong dollar to depreciate against the U.S. dollar and convert the HKMA into a full-fledged central bank system. According to them, a floating rate would restore economic competitiveness and help Hong Kong out of the current recession. To work well, though, a floating rate requires credibility that under present conditions probably would be absent in Hong Kong. Floating rates have not helped other Asian countries out of their recessions; rather, they have made matters worse by destroying confidence in the local currency. The loss of confidence occurred in countries whose central banks were considered to have performed relatively well before the Asian currency crisis (Thailand, Indonesia, South Korea.) A floating exchange rate is a blunt instrument: it reduces the value of all local goods even in circumstances where only the prices of a few goods, such as property, really need to fall. Floating the Hong Kong dollar would in effect transfer tens of billions of dollars in wealth from people who save in Hong Kong dollars (mainly residents of Hong Kong) to those who save in foreign currency in Hong Kong and the rest of the world (mainly foreigners). The poorer people are, the lower the wages they will work for and the lower prices of local goods generally are, but destroying financial wealth is a strange way to achieve competitiveness.

Another solution that has been proposed is to devalue but still maintain the exchange rate link to the U.S. dollar. Once the HKMA devalued, though, people would not trust it again for a long time. Hong Kong would pay the price in the form of interest rates in Hong Kong dollars higher than now exist. Especially in the present nervous world economic situation, one devaluation would foster expectations of another.

Devaluation will not cure the recession Hong Kong is now experiencing, which results from international causes rather than local ones. Hong Kong's suffering has been substantial, but must be viewed in regional perspective. Many other countries are suffering worse than Hong Kong. The countries in the region that so far have suffered recession least are those whose currencies have depreciated least against the U.S. dollar.

The HKMA has recently tried another solution to Hong Kong's monetary problems: intervening in the stock market. At best, the intervention is an inefficient way of solving the problem of high interest rates in Hong Kong dollars. It does not address the underlying problem, which is that many speculators think the currency will be devalued. At worst, intervention ties up money that the government could use better elsewhere, such as on cutting taxes or providing unemployment compensation, and it may cost the taxpayers of Hong Kong a lot of money.

The problems of Hong Kong's currency board system are solvable. The government and the HKMA can take a number of steps, separately or together. The guiding principle should be that the best way for the government and the HKMA to fix the problems of Hong Kong's currency board system is to make the system more orthodox, that is, more rule-bound.

In principle, the currency board system and the current exchange rate with the U.S. dollar can last forever, because unlike a typical central bank, an orthodox currency board follows a monetary policy completely consistent with the goal of a fixed exchange rate. The biggest potential threat to the exchange rate in an orthodox currency board is not the currency board, but monetary policy in the anchor country. If the anchor country has a central bank, and the central bank creates high inflation or extreme deflation, the advantages of a fixed exchange rate to its currency diminish. The U.S. dollar, though not perfect as an anchor currency, has performed well over the long term. The United States is one of the few countries where central banking has never produced high inflation, and in the last 50 years the United States has had moderate inflation of 10 to 15 percent a year only in 1974 and from 1979 to 1981. In all of Asia outside the Persian Gulf, Singapore is the only country where the lifetime performance of central banking has been as good as in the United States. (Recall that Japan suffered high inflation for a few years after the Second World War.)

I hope to write a paper proposing steps to make the currency board system more orthodox. Meanwhile, a number of writers, including John Greenwood, Steve Hanke, Chen Nai-fu, and S. K. Tsang, have written newspaper articles and longer studies suggesting changes to the system (Greenwood and Gressel 1988, Culp and Hanke 1993, Chen and Chan 1998, Tsang 1998). (Two newspaper articles sketch my own proposals regarding Hong Kong, and a book contains other generally applicable ideas [Schuler 1997a, 1998c; Hanke, Jonung, and Schuler 1993: 109-13]. A government report of April 1998 contains the official response to those who have proposed changes [Hong Kong 1998]. The government has since adopted some of the changes that the report criticizes.)

The measures announced by the HKMA on 5 September 1998 (HKMA 1998) generally move Hong Kong's currency board in a more orthodox direction, but the government and the HKMA should go further. By retaining unorthodox features in the currency board system, they encourage further unnecessary speculative attacks against the Hong Kong dollar and unnecessarily high interest rates in Hong Kong dollars. A financial panic in Japan or a devaluation by China would provoke another speculative attack against the Hong Kong dollar, to test the resolve of the government and the HKMA. China will devalue-perhaps not this year or the next, but someday, because it has a central bank, and devaluing is what central banks do. When that day comes, Hong Kong needs to have, or at least have a plan for, a monetary system that creates less doubt among currency speculators than the current system.

The current system is like a leaky boat. So far, the leaks-the unorthodox features of the system-have not been big enough to sink the boat. If the crew fixes the leaks soon, the boat can weather the next big storm. If not, it may be necessary to abandon ship. Should that happen, a lifeboat is essential.

To prepare for the worst, Hong Kong needs a contingency plan to dollarize its economy, that is, to replace the Hong Kong dollar with the U.S. dollar almost completely at the current official exchange rate of HK$7.80 = US$1. Dollarization in the broad sense means using a foreign currency to fulfill some or all of the three textbook functions of money as a means of payment (medium of exchange), store of value, and unit of account. In most parts of the world where a foreign currency is used extensively, the preferred currency is the U.S. dollar, but it is possible to use a currency other than the U.S. dollar to "dollarize." For Hong Kong, the obvious alternative is the Japanese yen. However, "yen-ization" seems less desirable than dollarization. "Yen-ization" would break Hong Kong's link to the U.S. dollar and cause problems of transition, whereas dollarization would continue the link and, in the form proposed here, would not cause problems of transition because it would occur using the current official exchange rate of HK$7.80 = US$1. (At present, the HKMA allows banks to transact with it at a rate of HK$7.75 = US$1, but it has announced its intention to move eventually to a rate of HK$7.80 = US$1.) The Chinese yuan is pegged to the U.S. dollar, so "yen-ization" would also mean a floating exchange rates between Hong Kong and the rest of China. Accordingly, dollarization here will be used in the narrow sense that refers specifically to using the U.S. dollar; using the yen or another currency would require somewhat different steps from those for dollarization.

Dollarization requires redenominating Hong Kong dollar assets into the corresponding U.S. dollar assets: for example, Hong Kong dollar bank deposits will become U.S. dollar deposits of the same banks. However, dollarization does not require converting all Hong Kong dollar bank deposits into U.S. dollar notes (paper money), which would be costly, unnecessary, and unprecedented in any past case of dollarization.

Many countries have unofficial dollarization, in which people use the U.S. dollar even though prohibited by law. In Russia, for example, the value of transactions in dollars is estimated to be double the value of transactions in Russian rubles even though the dollar is not legal for internal trade. The best-known officially dollarized country today is Panama, which has been dollarized since 1904. Panama issues its own coins and has its own unit of account, the balboa, but since one balboa equals one U.S. dollar and Panama has never altered the exchange rate, it is accurate to view Panama as having full official dollarization. (For a description of the experience of Panama, see Moreno-Villalaz 1998.) Liberia is often mentioned as another case of dollarization, but it has had its own currency in circulation since 1986. The Liberian dollar originally was worth one U.S. dollar, but a few years later depreciated to 50 per U.S. dollar in the black market. Today both currencies circulate. The U.S. dollar remains the preferred currency of the public, as it has been since Liberia started using the U.S. dollar in 1944. In total, 28 independent countries and dependent territories officially use the U.S. dollar or another foreign currency as local currency today (for a list, see Schuler 1998b: Appendix A).

At least 120 countries have used the currency of another country at some time. Use of foreign currency as the official local currency has been frequent in exceptional circumstances, such as war or the first years of independence, but few countries have had it for a long time during normal circumstances. Long-lasting use of foreign currency as the official local currency has been rare except in small countries because people have assumed that each country must have a separate currency, preferably issued by a central bank. Economists have reinforced the prejudice against use of foreign currency by failing to investigate how it compares to central banking in theory and in practice. (The most prominent exception has been Milton Friedman [1973: 44-5].)

Dollarization is not a new idea for fixing the flaws of Hong Kong's monetary system: it was first considered at least ten years ago, by John Greenwood, who had persuaded the government to reestablish the currency board system in 1983 (Greenwood and Gressel 1988: 9-13). Until the last few months, though, dollarization was viewed as too radical to be worth much discussion. In the government's lengthy Report on Financial Market Review of April 1998, it receives slightly more than a page (Hong Kong 1998: 3.60-3.63; see also Annex 3.6, part C and Annex 3.7). Because there has been so little discussion of dollarization, many people are confused about what dollarization would require and how it would work. There is more than one way to implement dollarization, and so far, there has not been a specific, detailed proposal for dollarizing Hong Kong. Advocates and critics of dollarization alike need such a proposal as a catalyst for further reflection. Critics in particular need it because many have shown by their comments that they do not understand dollarization. I offer such a proposal here, building on my own previous ideas and those of other writers (Schuler 1997a, b; Tao and Lau 1998; Xu 1998). The more thoroughly people in Hong Kong think about dollarization, the smoother the transition will be should Hong Kong need to dollarize.

Since the HKMA has sufficient U.S. dollar assets to back the Hong Kong dollar monetary base 100 percent--in fact, far more than 100 percent--dollarization is feasible at any time, from a technical standpoint. Political obstacles are more important than technical obstacles. A key question is the reaction of the Chinese central government. Although article 110 of the Basic Law says that "The Government of the Hong Kong Special Autonomous Region shall, on its own, formulate monetary and financial policies," it remains to be seen whether the central government will allow dollarization, especially following a devaluation of the yuan. Much depends on the Chinese government's perception of the effects of dollarization. A strong argument can be made that the effects will be beneficial for the rest of China as well as Hong Kong. Dollarization will increase confidence that Hong Kong is a good place to invest. Dollarization will also reinforce Hong Kong's status as a world financial center by eliminating the division between the U.S. dollar market and the Hong Kong dollar market, bringing the U.S. dollar market onshore. Because of Hong Kong's role as a catalyst of economic growth in China, dollarization will benefit the rest of China. The Chinese central government has a pragmatic attitude toward Hong Kong--how many other governments would allow "one country, two systems"?--so if it is convinced that dollarization is good for China as a whole, it will approve of dollarization in Hong Kong.

How a dollarized monetary system works

Dollarization works almost just like an orthodox currency board that uses the U.S. dollar as the anchor currency. As will be explained later, the main difference between the two systems concerns seigniorage. Under both systems, the actions of the U.S. Federal Reserve System determine the U.S. dollar monetary base and thus influence broader measures of the money supply that include bank deposits. The United States and countries that are dollarized or have currency boards based on the U.S. dollar in effect form a common currency area and can be thought of as having a common money supply. Market forces rather than local central banks determine the distribution of the money supply between the United States and outlying areas such as Panama or Hong Kong.

The U.S. dollar has been among the best-performing currencies in the world for more than 200 years, despite occasional periods of trouble. As long as it continues to perform well, dollarization adjusts the supply of money to the demand for money more efficiently than a central bank does. To understand why, consider that the demand for money is at bottom a demand for a specific real amount of money. That does not mean people always perceive inflation correctly or that the real demand for money is stable; it just means that people care more about the purchasing power of their money than they care about the nominal amount (the number of units, irrespective of purchasing power). In Hong Kong, because of the linked exchange rate, the purchasing power of US$1 is the same as the purchasing power of HK$7.80. So, if Hong Kong dollar bank deposits are converted into U.S. dollar deposits at HK$7.80 = US$1, someone who formerly held HK$78,000 will now wish to hold about US$10,000, not US$78,000. The real demand for money fluctuates, and economists have been unsuccessful at devising models that accurately predict it. The only way to discover whether a particular real supply of money equals the real demand for money is to allow market forces to make the necessary adjustments.

The real supply of money is the purchasing power of each dollar times the nominal supply (the amount of dollars in existence). When the real supply of money does not match the real demand, the quickest, most efficient way for adjustment to occur is for the real supply to vary through changes in the exchange rate, if the exchange rate is floating, or changes in the nominal supply of money, if the exchange rate is fixed. A slower way for adjustment to occur is for the economy's output of goods and services to change. If consumers do not want output to change, adjustment through output is less efficient than adjustment through the exchange rate or the nominal supply of money.

A central bank directly controls only the monetary base (M0). Monetary aggregates broader than the monetary base (M1, M2, M3), which mainly comprise various types of credit issued by commercial banks and other financial institutions, are determined by the profit-seeking behavior of those institutions, which in most respects is the same under any type of monetary system in a market economy. Typically, a bigger nominal monetary base allows commercial banks to expand the nominal credit they grant, while a smaller nominal monetary base induces them to reduce the nominal credit they grant.

What the central bank does to the monetary base is the key to the difference between central banking on the one hand and a currency board or dollarization on the other. The central bank can create either a persistent excess or a persistent deficiency in the real supply of money when it engages in sterilized intervention, a type of operation in which it allows neither the exchange rate nor the nominal monetary base to change when its foreign reserves change. Because central banks generally target exchange rates in terms of a currency whose purchasing power is relatively stable, such as the U.S. dollar, targeting the exchange rate indirectly targets the purchasing power of the local currency.

Sterilized intervention involves the central bank in targeting the real monetary base, and through it, broader measures of the real money supply, rather than letting market forces adjust the real supply to the real demand. Mistakes in targeting the real supply of money create opportunities for arbitrage in foreign-currency markets and elsewhere: the bigger the mistakes, the bigger the opportunities. Central banks that do not allow the real supply of money to fall when the real demand falls encourage speculative pressure on the currency, because they allow the monetary base to grow to a size that their foreign reserves cannot support at the current exchange rate. Pressure builds until a devaluation and the resulting increases in the prices of many goods, especially foreign goods, reduce the real supply of money.

Sterilized intervention causes trouble. But of all the central banks in the world, only the Reserve Bank of New Zealand never engages in sterilized intervention; it has not intervened since 1985. The U.S. Federal Reserve System engages in sterilized intervention occasionally, but unlike many central banks it does not truly target the exchange rate. Instead, it concentrates its efforts on keeping inflation low by limiting the growth of the monetary base.

A dollarized monetary system does not engage in sterilized intervention because no central bank exists to loosen the link between foreign reserves and the monetary base. In a dollarized system the foreign reserves (specifically, the U.S. dollar reserves) are the monetary base, so a decrease in demand for the monetary base automatically decreases dollar reserves and sets in motion appropriate changes in capital flows, interest rates, and prices. The rules under which a dollarized monetary system operates leave it no freedom to supply a different amount of the monetary base than the public demands. A central bank, however, has the freedom in the short term to supply a larger or smaller monetary base than the public demands. Accordingly, a central bank tends to hinder the real supply of money from adjusting to the real demand. (For more detail on this argument, see Schuler 1998a.) This is an inherent flaw of central banking, which results from institutional characteristics and cannot be cured merely by replacing bad officials with good officials.

So, dollarization and an orthodox currency board are superior to central banking from the standpoint of economic theory, as well as from the standpoint of the historical record. The freedom of a central bank to manage the money supply and the exchange rate destabilizes rather than stabilizes the economy. Unless advocates of a floating exchange rate intend a policy that would forbid the HKMA from engaging in sterilized intervention, central banking would not balance the supply and demand for money as well as dollarization or an orthodox currency board, even in theory.

Economists usually think of capital flows as forcing significant adjustments in the money supply, interest rates, and prices, especially in countries with fixed or pegged exchange rates. In fact, though, the necessary adjustments are small for a country with a currency board or dollarization whose banking system is "internationalized" (fully open to foreign participation and hence well integrated into the world financial system). Instead, changes in the portfolios of financial institutions do most of the adjusting. An internationalized banking system smooths capital flows by integrating the local banking system into the world system. The dollarized country becomes part of a worldwide financial market less volatile than most of its component parts. For example, if a bank in Panama receives a deposit of US$1 billion and wishes to make new loans from the deposit, it looks at opportunities for lending throughout its worldwide branch network, rather than being restricted to lending the whole US$1 billion in Panama. It lends wherever in the world the potential for profit is highest, which probably will involve spreading new loans among several countries. On the other hand, if US$1 billion is withdrawn from a bank in Panama, the bank does not reduce its lending in Panama by US$1 billion; it reduces lending wherever in the world the potential for profit is lowest, which probably will involve spreading the reduction among several countries. Panama has experienced capital inflows and outflows exceeding 10 percent of gross domestic product (GDP, the annual value of goods and services produced in a country) without suffering cycles of boom and bust or big changes in prices as a result (Moreno-Villalaz 1998). Hong Kong's banking system is highly internationalized, but could be still more so, as is discussed below.

In a dollarized system, as in an orthodox currency board system, there is no need to "defend" the exchange rates with high interest rates. Because the exchange rate is credible, exchange risk is absent, and interest rates tend to be close to those in the United States, provided that political risk and other types of interest-rate risk are low. Furthermore, in a dollarized system there is no local monetary authority to influence interest rates by intervening in credit markets.

Costs and benefits of dollarizing

Let us now consider more precisely the costs and benefits of dollarization compared to a currency board. Note that for a currency board system, both the costs and the benefits of dollarizing are somewhat different than they are for a central banking system. (For a discussion of the costs and benefits of dollarization compared to central banking, with particular reference to Indonesia, see Schuler 1998b.)

Most obviously, dollarization will cost the government of Hong Kong seigniorage, which is the profit that the HKMA earns from issuing the Hong Kong monetary base. Under dollarization, the U.S. Federal Reserve System rather than the HKMA will receive the seigniorage. Loss of seigniorage is costly if, as is reasonable to assume in the particular case of Hong Kong, the government uses the seigniorage productively. The government's Report on Financial Market Review estimates seigniorage to be HK$5.1 billion a year at present, or about 0.6 percent of GDP (Hong Kong 1998: 3.63). We can convert the revenue from seigniorage year after year into its equivalent value as a proportion of this year's GDP by using a standard financial formula for expressing future payments in terms of their present, discounted value. The idea is the same used for calculating how much a series of future payments, such as mortgage payments, is worth in terms of cash right now. At an interest rate (rate of discount) of 3 percent a year, the present value of 0.6 percent of GDP a year perpetually is 20 percent of this year's GDP. (I use a rate of 3 percent a year because in many countries long-term real interest rates, that is, actual rates adjusted for inflation, have tended to gravitate around that level. A higher rate would reduce the present values calculated here, reducing the costs of dollarization.)

There will be one-time costs to converting computer programs and cash registers from Hong Kong dollars to U.S. dollars, though in many cases all that will be necessary is to divide amounts in old Hong Kong dollars by 7.80. Estimates of the costs Western European countries will incur from switching from national currencies to a single currency, the euro, center around 1 percent of GDP. As a rough indication of the one-time costs of conversion for dollarization, let us say that the cost will be 1 percent of GDP.

So much for the costs of dollarization. Now let us consider a neglected benefit. In a study of Panama, Juan Moreno-Villalaz (1998) suggests that when combined with an internationalized banking system, dollarization requires lower foreign reserves than other monetary systems because it has economies of scale. A well-known regularity of banking is that under certain conditions, banks' need for reserves increases more slowly than the growth in their deposits. That occurs because typically, as the deposits of a bank increase, their overall behavior becomes more statistically predictable. Dollarization in effect erases the distinction between local-currency and U.S. dollar deposits, enabling banks to unite in a common pool their formerly separate local-currency and U.S. dollar reserves. The behavior of the common pool is more predictable than the behavior of the two separate pools, so banks need fewer reserves than they do if a separate local currency exists. The absence of exchange risk also gives banks that are temporarily short of reserves the ability to borrow funds internationally at the same cost or lower than exists locally. Moreno-Villalaz estimates that if Panama had a currency board, the Panamanian financial system would need net foreign reserves equal to about 10 percent of GDP, compared to its actual net foreign reserves of 7 percent of GDP. As of May 1998, Hong Kong's financial system (excluding the HKMA) had HK$128 billon of net foreign reserves, or about 14 percent of GDP. If dollarization would reduce the financial system's need for net foreign reserves by 30 percent, as Moreno-Villalaz estimates it does for Panama, foreign reserves would only need to be about 10 percent of GDP. The savings are not 4 percent of GDP, but 4 percent times the difference between the return (perhaps adjusted for risk) on investing the money locally and investing it in foreign reserves. If the difference is 1 percentage point, the savings are 0.4 percent of GDP per year. At an interest rate of 3 percent a year, the present value of the savings is about 13 percent of this year's GDP.

Let us use the numbers from above to calculate a partial measure of the net cost of dollarization. The partial net cost of dollarization is the present value of seigniorage (20 percent of GDP), plus the one-time expense of switching prices from local-currency to dollars (1 percent of GDP), minus the present value of savings from lower foreign reserves (13 percent of GDP); the total is 8 percent of this year's GDP. At an interest rate of 3 percent a year, dollarization recovers the net cost if it increases economic growth by at least 0.24 percentage points a year perpetually.

The estimate we have just calculated is only partial because it focuses on the costs and benefits of dollarization that are easy to quantify. Other benefits are harder to quantify but no less important. One is that there will be no fear of devaluation. Though the HKMA need not devalue as long as it maintains an orthodox currency board, speculators think that under the current, unorthodox system it may devalue; that is why the forward exchange rate of the Hong Kong dollar to the U.S. dollar has recently been at a persistent discount to the spot rate. Another benefit of dollarization is that it will reduce interest rates from their current levels. Loans in Hong Kong dollars will become loans in U.S. dollars, and interest rates on U.S. dollars are below the corresponding rates in Hong Kong.

The conclusion I draw from the calculations is that the currency board system is slightly more advantageous than dollarization for Hong Kong, if operated in an orthodox manner so as to inspire confidence and keep interest rates in Hong Kong dollars close to the corresponding rates in U.S. dollars. If the currency board system is not operated in an orthodox manner, dollarization provides significantly lower interest rates and becomes more advantageous.

How to dollarize

Official dollarization will require converting Hong Kong dollar deposits at the HKMA and Hong Kong dollar notes into U.S. dollar assets -- notes, bank deposits in the United States, easily marketable assets such as U.S. Treasury bills, or some combination. (Foreign-currency deposits are already extensive in Hong Kong, comprising about HK$1.2 trillion of the total M3 money supply of HK$3 trillion as of July 1997.) Dollarizing Hong Kong will involve the steps below, which can be started immediately and completed within 30 days. The Appendix offers a model dollarization statute as a framework for the steps. Dollarization in the form proposed here is a simple reform. Dollarization in the form proposed here can be rapid because it involves no alteration of the official exchange rate and has as its starting point a monetary system with low inflation, adequate foreign reserves, and solvent banks. Other countries have made more complex monetary reforms in less time.

1. Determine the portion of the HKMA's liabilities that should be dollarized and set aside the corresponding amount of U.S. dollar assets. Under the proposal here, the HKMA will dollarize all Hong Kong dollar deposits at the HKMA plus all Hong Kong dollar notes, which are issued by the Hongkong and Shanghai Banking Corporation, the Standard Chartered Bank, and the Bank of China under currency board rules and backed by U.S. dollar reserves deposited at the HKMA. Deposits at the HKMA plus notes comprise almost all of the monetary base; the remainder is coins. For reasons explained below, Hong Kong dollar coins will not be replaced with U.S. dollar coins, but will continue to circulate.

Dollarization will not require huge foreign reserves that Hong Kong does not have. The foreign reserves of the HKMA need only equal the Hong Kong dollar monetary base (M0) excluding coins, which as of July 1998 was approximately HK$84 billion. (Coins were almost HK$6bn.) The HKMA's actual foreign reserves far exceed that amount. Dollarization requires only foreign reserves to cover M0, not broader measures of the money supply that include deposits at commercial banks, such as M1, M2, or M3. As in an orthodox currency board system, or in a central banking system in normal times, it is the responsibility of banks to hold reserves sufficient to meet the demands of their customers to convert deposits into notes. Under a currency board, dollarization, and central banking alike, the reserves banks hold in excess of legal requirements are ordinarily only a few percent of their total liabilities. Under the proposal here, Hong Kong dollar deposits will become U.S. dollar deposits of equivalent value at the current official exchange rate of HK$7.80 = US$1; they will not be converted into actual U.S. dollar notes. Apparently, no country that has ever dollarized has done so by converting all local-currency bank deposits into U.S. dollar notes, so it is bizarre to claim that dollarization in Hong Kong would require such an operation. Depositors will have no more reason to make mass conversions of U.S. dollar deposits into U.S. dollar notes than they now have to make mass conversions of Hong Kong dollar deposits into Hong Kong dollar notes. Depositors will also have no reason to switch deposits from some banks to others under dollarization. The assets and liabilities of banks will be the same as they are now. Only the unit of account will change, similar to the change from calculating in cents versus calculating in dollars. Expressed in terms of U.S. dollar values, nothing will change. The investment portfolios of banks and hence their creditworthiness will stay the same.

2. Establish a new currency unit, the new Hong Kong dollar, equal to one U.S. dollar and 7.80 old Hong Kong dollars. One new Hong Kong dollar will be equal to one U.S. dollar and to 7.80 old Hong Kong dollars of the type in circulation now. The purpose of this step is to harmonize units of account in Hong Kong and the United States, and to provide a legal basis for dollarization that is fully in accord with the Basic Law.

3. Make the U.S. dollar legal tender in Hong Kong. Perhaps also make other currencies legal tender. The U.S. dollar will be given all privileges as a legal tender, alongside the new Hong Kong dollar. All payments in Hong Kong dollars will also be permitted to be made U.S. dollars at the fixed exchange rate of HK$7.80 old = HK$1 new = US$1, and at no other rate.

To extend freedom of choice in currency, all foreign currencies, not just the U.S. dollar, can be given privileges as legal tender between consenting parties. That way people will be able to use other currencies if those suit them better. The U.S. dollar and (for sums of up to HK$5 new) the new Hong Kong dollar will be the "default" legal tender currencies; that is, if an agreement specifies only "dollars," the assumption will be that they are the intended currencies.

A historical precedent for this measure exists. In 1964 the Exchange Fund, the predecessor to the HKMA, brought packages of pound sterling notes to Hong Kong to reassure the public. (At the time, the Hong Kong dollar was linked to sterling at HK$16 = ?.) The packages were returned unopened because the news that they were in Hong Kong was sufficient to forestall a scramble for notes.

4. Announce that effective immediately, all old Hong Kong dollar wages, prices, assets, and liabilities are U.S. dollar wages, prices, assets, and liabilities at the rate of 7.80 old Hong Kong dollars per U.S. dollar. A bank deposit or bank loan of HK$780,000 old dollars will become a deposit or loan of US$100,000; a wage of HK$7,800 old per week will become a wage of US$1,000 per week; a computer screen that cost HK$780 old will be repriced to US$100. No commission fees will be permitted for converting values in old Hong Kong dollars into their equivalents in U.S. dollars. The new Hong Kong dollar will not be used as a unit of account except for coins. That will ensure that the government will gain practically nothing if it tries to meddle with the exchange rate of the new Hong Kong dollar.

Expressed in terms of U.S. dollars, nothing will change during dollarization. Contrary to what some critics of dollarization have claimed, there will be no scramble for borrowers to reduce the real value of their loans by converting the loans from Hong Kong dollars into U.S. dollars at a rate more depreciated than the official rate. Borrowers and lenders alike will be required to convert at the official exchange rate of HK$7.80 old = US$1.

Bank deposits and loans bearing fixed interest rates will continue to bear the same interest rates until they expire, except now the principal and interest will be payable in U.S. dollars. Interest rates in U.S. dollars will be lower than rates were in Hong Kong dollars just before dollarization. Borrowers will be able to benefit from lower interest rates if they can refinance their debts; if not, they still will be no worse off then they would have been under the currency board system, because in terms of U.S. dollars they will be paying equivalent amounts at the same rates of interest as they were paying in Hong Kong dollars. Dollarization will cause some redistribution of income: in general, new borrowers of Hong Kong dollars will pay less and lenders of Hong Kong dollars will earn less than they do now. But lenders will also enjoy some benefit because there will no longer be any possibility of a devaluation of the type that has bankrupted banks in Thailand, Indonesia, and South Korea. Overall, lower interest rates will benefit the Hong Kong economy by enabling businesses and consumers to borrow for projects they otherwise could not undertake.

5. Allow a transition period of no more than 30 days for replacing the old Hong Kong dollar with the U.S. dollar as a unit of account. During the transition period, wages can continue to be quoted optionally in old Hong Kong dollars, so that employers and banks have time to modify their bookkeeping and computer systems. Prices can also be quoted optionally in old Hong Kong dollars during the transition period, to spare merchants the trouble of repricing the goods on their shelves. After the transition period, the old Hong Kong dollar will cease to be a legal unit of account.

6. Immediately replace Hong Kong dollar deposits at the HKMA with U.S. dollar assets. The HKMA will convert all Hong Kong dollar deposits with it into U.S. dollar assets such as deposits at banks in New York. The HKMA will cease to be directly involved in the clearing system, so clearing balances will cease to be settled by transfers of funds at the HKMA. Hongkong Clearing can devise alternative arrangements.

7. Retire Hong Kong dollar notes (paper money) from circulation, the bulk of notes preferably to be retired during the transition period. Article 111 of the Basic Law states that "the Government of the Hong Kong Special Administrative Region may authorize designated banks to issue or continue to issue Hong Kong currency under statutory authority." The article implies that the government also has the power to remove the authorization of the three banks that now issue notes. (Unlike currency boards elsewhere, the HKMA itself does not issue notes; instead, the authorized banks must follow currency board principles in issuing notes and the HKMA holds the reserves backing notes in circulation. In effect, Hong Kong's variant of currency board note issue gives the authorized banks advertising space on notes.¹)

Under dollarization, U.S. dollar notes will replace old Hong Kong dollar notes in circulation at the exchange rate of HK$7.80 old = US$1. How quickly that can be accomplished depends on how quickly the HKMA can obtain U.S. dollar notes. It is desirable to replace the bulk of Hong Kong dollar notes during the transition period. Once retirement of Hong Kong dollar notes begins, banks will not be allowed to charge commission fees for replacing their customers' old Hong Kong dollar notes with U.S. dollar notes. After the period for retiring Hong Kong dollar notes from large-scale circulation is complete, banks and the HKMA will continue for several years to accept old Hong Kong dollar notes, so that holders of the notes in Guangdong and elsewhere have time to redeem them. However, old Hong Kong dollar notes will no longer be used for hand-to-hand payments in Hong Kong.

8. Keep Hong Kong dollar coins in circulation. Article 111 of the Basic Law states that "The Hong Kong dollar, as the legal tender in the Hong Kong Special Administrative Region, shall continue to circulate." Continuing to issue local coins while using U.S. dollar notes, like Panama, will satisfy the letter of the Basic Law. Using coins at the exchange rate of HK$7.80 old = US$1 will be awkward, though. The solution is to revalue Hong Kong coins (but not notes or deposits) to HK$5 old = HK$1 new = US$1, or to devalue coins (but not notes or deposits) to HK$10 old = HK$1 new = US$1. Hong Kong coins will then be convenient subdivisions of the U.S. dollar. If coins are revalued, it should be done immediately to avoid creating a shortage of coins while people wait for revaluation. If coins are devalued, the HKMA should make arrangements to compensate the losses of large holders of Hong Kong coins, such as banks and the MTR.

Eventually, new coins will be minted that are denominated in new Hong Kong dollars. Old coins will be retired from circulation. Coins in circulation should be backed by assets payable in U.S. dollars according to Hong Kong's traditional currency board ratio of 105 percent. Coins in circulation today are about HK$6 billion, which is about US$770 million.

9. Reorganize the HKMA as necessary. The HKMA will cease to be an institution making monetary policy. The HKMA's staff can remain the same. The HKMA will continue to have a substantial role in the financial system managing government funds, regulating financial institutions, and gathering financial statistics. However, its activities will cease to create uncertainty about the exchange rate because it will have no power to alter the exchange rate.

Legal aspects of dollarizing

The government's Report on Financial Market Review and other observers have claimed that dollarization may violate the Basic Law (Hong Kong 1998: 3.63(a)). An examination of the relevant articles of the Basic Law suggests otherwise. Here is what the Basic Law says.

Article 111 The Hong Kong dollar, as the legal tender in the Hong Kong Special Administrative Region, shall continue to circulate.

The authority to issue Hong Kong currency shall be vested in Government of the Hong Kong Special Administrative Region. The issue of Hong Kong currency must be backed by a 100 percent reserve fund. The system regarding the issue of Hong Kong currency and the reserve fund system shall be prescribed by law.

The Government of the Hong Kong Special Administrative Region may authorize designated banks to issue or continue to issue Hong Kong currency under statutory authority, after satisfying itself that any issue of currency will be soundly based and that the arrangements for such issue are consistent with the object of maintaining the stability of the currency.

Article 112 No foreign exchange control policies shall be applied in the Hong Kong Special Administrative Region. The Hong Kong dollar shall be freely convertible....

Article 113 The Exchange Fund of the Hong Kong Special Administrative Region shall be managed and controlled by the government of the Region, primarily for regulating the exchange value of the Hong Kong dollar.

Observe that the Basic Law does not define what a Hong Kong dollar is, what assets are to be used to back the currency, or who may issue Hong Kong currency. The government implicitly has the power to decide all those questions as it pleases. Because the Basic Law is elastic, dollarization does not violate it. Dollarization in the particular form proposed here, under which locally issued coins will continue to exist, satisfies even a quite strict interpretation of the provision that the Hong Kong dollar "shall continue to circulate." (The government should issue coins of HK$0.01 new to HK$1 or 2 new.) The Exchange Fund can continue to exist as the issuer of coins, with no other monetary functions. The Basic Law specifies the Hong Kong dollar as legal tender, but it does not prohibit other currencies from also being legal tender. Legal tender privileges need not be a monopoly; in a few countries, including Argentina, the dollar has legal tender privileges that are extensive or even equal to local currency.

Statute law about currency is as elastic as the Basic Law. The Exchange Fund Ordinance says:

(1) There shall be established a fund to be called "the Exchange Fund"; which shall be under the control of the Financial Secretary and shall be used primarily for such purposes as the Financial Secretary thinks fit affecting, either directly or indirectly the exchange value of the currency of Hong Kong and for other purposes incidental thereto....

(1A) In addition to using the Fund for its primary purpose, the Financial Secretary may, with a view to maintaining Hong Kong as an international financial centre, use the Fund as he thinks fit to maintain the stability and the integrity of the monetary and financial systems of Hong Kong....

(2) The Fund, or any part of it, may be held in Hong Kong currency or in foreign exchange or in gold or silver or may be invested by the Financial Secretary in such securities or other assets as he, after having consulted the Exchange Fund Advisory Committee, considers appropriate; and the Financial Secretary may for the account of the Fund -

(a) buy or sell such currency, foreign exchange, gold, silver, securities or assets accordingly; and

(b) after having consulted the Exchange Fund Advisory Committee, enter into any financial arrangement that he considers appropriate for the prudent management of the Fund.

(3) Without restricting the generality of the powers of the Financial Secretary under subsections (1) and (1A) but subject to subsection (4), the Financial Secretary may borrow for the account of the Fund either in Hong Kong or elsewhere, on the security of the general revenue (Laws of Hong Kong, chapter 66, section 3).

Observe that the ordinance does not commit Hong Kong to any particular monetary system. Hong Kong abandoned the currency board system in 1974 and returned to it in 1983 without altering statute law. This suggests that dollarization will not necessarily require any change in statute law; it can be achieved by an administrative decision by the government. In that case, though, a later government could just as easily undo dollarization. To make dollarization well entrenched, it should be established by law. Again, the Appendix contains a model statute.

Dollarization may require minor changes in financial regulations, accounting rules, and so on. The government, in consultation with the financial community, should appoint a committee of experts to examine matters and make recommendations to the executive branch. The Report on Financial Market Review claims that dollarization would involve "huge legal problems as some of the contracts will automatically become void" (Hong Kong 1998: 3.63(a)). That would be true if dollarization were implemented at an exchange rate other than the current official rate of HK$7.80 = US$1, but the proposal here would use the current official rate, so in terms of U.S. dollars, amounts specified in contracts will not change. Dollarization will not create any gaps in financial markets or in reference rates such as base lending rates; on the contrary, markets in U.S. dollars are much bigger and more extensive than markets in Hong Kong dollars, so it will be easy to find a U.S. dollar analogue for any contractual obligation in Hong Kong dollars. If dollarization would create difficult legal questions, the government should appoint an exploratory committee now to examine the questions and suggest answers, rather than waiting until dollarization actually occurs.

Dollarization does not require the approval of the U.S. government or the involvement of the U.S. Federal Reserve System. Hong Kong will need about US$12 billion to replace all Hong Kong dollar notes in circulation with U.S. dollar notes. The resulting seigniorage will be a benefit for the U.S. government, so it is hard to understand why the United States would disapprove of dollarization in Hong Kong. Even it did, consider that researchers at the Federal Reserve estimate that of the total supply of U.S. dollar paper money, which is about US$450 billion, 50 to 70 percent is held outside the United States. Almost none has migrated abroad with the official approval either of the U.S. government or of the governments whose people hold the dollars. Russians are estimated to hold more U.S. dollar paper money than anyone except Americans: US$20 billion or more, which at the current exchange rate exceeds the entire supply of ruble notes, coins, and bank deposits. Russians have acquired their U.S. dollars through normal channels of trade, and in spite of efforts by their own government to discourage them. Hong Kong can acquire U.S. dollars in a similar manner. The approval of the U.S. government would be convenient to have, but it is not essential.

It has also been suggested that because Hong Kong is on the other side of the world from the United States, clearinghouse operations in U.S. dollars will pose special difficulties and need the approval of the Federal Reserve. But transactions in U.S. dollars need not occur in the United States; that is the reason for existence of the Eurodollar market. Banks in the dollarized system of Panama today settle their clearings through an account in a bank in New York City, but at other times they have cleared through accounts outside the United States. Clearing operations by banks in Hong Kong need not occur in New York; they can occur locally, using U.S. dollar assets deposited in trust at the clearinghouse. The local interbank market will be at least as big as the market for Hong Kong dollars is today, and probably bigger, since dollarization will unify the Hong Kong dollar and U.S. dollar lending markets. Should it be thought necessary to use clearinghouse facilities in the United States during business hours in Hong Kong, the Fedwire system of the Federal Reserve is open from 12:30 a.m. to 6:30 p.m. Monday to Friday, New York time, and CHIPS (the Clearing House Interbank Payments System of the New York Clearing House) is open from 12:30 a.m. to 4:30 p.m. Monday to Friday, New York time.

Effects of dollarizing

Dollarization will leave wages and prices unchanged in terms of U.S. dollars. The only difference will be that wages and prices will be quoted in U.S. dollars instead of the equivalent amount of old Hong Kong dollars.

Interest rates will be lower because the dollarization will eliminate devaluation risk arising from fear that the HKMA is not strongly committed to maintaining the current exchange rate. Devaluation risk accounts for 1 to 4 percentage points of interest, depending on the period of the loan (the longer the period, the higher the devaluation risk). Eliminating devaluation risk will encourage economic growth, though not necessarily enough to pull Hong Kong's economy out of recession. Very short-term interest rates in Hong Kong, which have been volatile since the Asian currency crisis began, will be less so. The Asian currency crisis has had little effect on the volatility of interest rates in Panama. The possibility of borrowing U.S. dollars overnight, for a week, or for a month in the extensive U.S. market allows short-term rates in Panama to be about as steady as they are in the United States. If Hong Kong dollarizes, the results will be similar, though rates may remain a little more volatile than they are in the United States because the most active time of day for bank-to-bank lending in the Hong Kong market occurs during the last active time in the United States.

As under the present monetary system, under dollarization, inflation in consumer prices may on average continue to be higher than in the United States. There is no need to be concerned that dollarization itself will make Hong Kong uncompetitive with respect to the United States, though. Consumer price indexes contain a large component of nontradable goods (goods that cannot easily be transported from country to country), such as rent and electricity. Wages and the prices of many nontradable goods with high labor content tend to rise quickly in any fast-growing country, no matter what monetary system it has (Greenwood 1991). The increase is self-limiting: when it proceeds so far as to reduce competitiveness, people stop buying goods from Hong Kong. Wages and prices of nontradable goods increase more slowly, or even fall, as in the case of property prices in Hong Kong now. As under the current system, fluctuations in the exchange rate of the U.S. dollar against other currencies will have short-term effects on Hong Kong's competitiveness, but in the long term competitiveness depends on an efficient economy.

Attempts to improve competitiveness by devaluing create more problems than they solve. Countries that have tried "managed devaluation" or a "crawling peg," including Indonesia and many Latin American countries, have found that it leads eventually to currency crises and uncontrolled maxi-devaluations. As long as the major currencies in East Asia and the world float against each other, their fluctuations will affect competitiveness unpredictably, and Hong Kong, like other economies, must learn to live with the fluctuations.

That means that, in particular, property values, and to a much smaller extent wages, will have to continue falling in terms of U.S. dollars for some time. Booms and busts in the property market are frequent, and the experience of Hong Kong is not unique, as a look at property values in New York City, London, and Tokyo over the last 20 years will show. The government should refrain from comprehensive attempts to support the property market, otherwise it risks repeating the mistakes the Japanese government has made in the 1990s.

Stability of banks under dollarization

Like a currency board system, a dollarized system lacks a central bank as a lender of last resort, so it needs other arrangements to improve the liquidity of commercial banks. Hong Kong already has the strongest banking system in East Asia, but it could be still stronger.

One way to strengthen the banking system is to allow more foreign competition. Foreign banks licensed in Hong Kong after 1978 are prohibited from having more than one retail office plus one back office in Hong Kong. That hinders them in competing for retail business with local banks. Foreign banks that meet Hong Kong's regulatory standards of financial health should be allowed to establish branches without restriction, compete on equal terms with local banks, and buy ownership in local banks up to 100 percent. The case for free trade in banking and other types of finance is as strong as the case for free trade in oranges or automobiles. Full competition forces local banks to meet international standards of strength and service, improving the quality of banking for consumers. Purely local banks are less able to diversify risks than international banks, so when there occurs a locally originating shock to the banking system, such as a big drop in property prices, all local banks may become illiquid. The largest banks in Hong Kong are international banks, but the smaller ones are purely local banks, many of which will have to merge with stronger local or foreign banks under free trade in banking.

Fears that foreign banks will "dominate" the financial system are misplaced: in a competitive setting, banks have little or no power to dictate to customers. To prevent customers from switching to rival banks, banks must serve customers well. Foreign owned banks that offer poor service will lose business to foreign and locally owned banks that offer better service.

Another way to improve the liquidity of banks is to allow them to exercise an option clause. Banks would have the option, for example, of preventing customers from withdrawing deposits for a specified period in exchange for paying depositors a penalty rate of interest during the period. That would give banks time to bolster their reserves if a credit crunch made it prohibitively expensive to do so immediately. The penalty rate would discourage banks from exercising the option except when the threat of illiquidity was palpable. The option clause would be voluntary: banks could choose to adopt it or not, and customers could choose only to have deposits at banks that did not adopt it. Banks that exercised the option clause should be required to have an independent auditor assess their business to make sure that they are illiquid (have positive net worth but insufficient reserves) rather than insolvent (have negative net worth). If they are insolvent they should be liquidated. Though no dollarized system seems ever to have had an option clause, some other monetary systems without central banks have (Dowd 1993: 31-3, 41-57).

Objections to dollarization

People have made a number of objections to dollarization. We have already examined claims that dollarization would require huge additional foreign reserves and that it would contradict the Basic Law. Let us briefly examine the other objections. Let us begin with concerns of political symbolism. It has been argued that the Hong Kong dollar is an essential symbol of Hong Kong, and that dollarization would infringe on Hong Kong's sovereignty. The argument is curious given that Hong Kong is not an independent country, but a special administrative region of China. In addition, under the form of dollarization proposed here the Hong Kong dollar will continue to exist, though only as a unit for coins. Dollarized countries that are independent do not find that dollarization constrains their independence, or that a locally issued currency is essential to sovereignty or to national pride; neither would Hong Kong.

Another objection is that a currency other than the U.S. dollar may be better for "dollarization." The dollar has appreciated sharply against most currencies in the last few years, and may appreciate even more. However, a few years ago, the same was true of the yen, the only likely alternative to the U.S. dollar. Floating exchange rates among the major currencies mean that large appreciations and depreciations against some of them will arise no matter whether Hong Kong is dollarized or has a floating exchange rate itself.

A related objection is that Hong Kong will be hurt if the U.S. dollar someday becomes an unstable currency with high inflation. The solution to this potential problem is to allow people freedom to use any currency. Though initially the U.S. dollar will be the most widely used currency, people should be free to use whatever currency they wish. If people wish to make contracts specifying payment of wages, business expenses, or loans in yen or German marks, let them do so. That way, people will be able to use the most stable currencies in the world if they wish. Allowing competition among currencies is the most efficient way to provide what consumers most want in currency (White 1989).

Dollarization is not "too simple" for a large and sophisticated financial center like Hong Kong. On the contrary, the more financially sophisticated Hong Kong becomes, the greater the value of a simple and transparent monetary system. Central banking is central planning in money, and central planning works as poorly in money as it does in agriculture or in industry. That is why the historical performance of central banking has been much worse than the performance of market-led monetary systems such as the currency board system. Inflations, devaluations, exchange controls, and currency confiscations have all been far more frequent under central banking (Schuler 1996). Because it has gained so many of the features of a central bank, the HKMA invites for the Hong Kong dollar the fate that has befallen the baht, the ringgit, the won, and other currencies issued by Asian central banks. Making the currency board system more orthodox, or dollarizing as a last resort, will make Hong Kong's monetary system more compatible with its market economy.

Many people may think that dollarization, if adopted, should only be temporary. Historical experience and economic theory, in contrast, both suggest that if the choice is between dollarization and central banking, dollarization should be permanent. The overall record of central banking has been bad: most countries would have done better by simply establishing orthodox currency boards or dollarizing, using one of the major international currencies as the anchor currency. Economic theory also indicates that because a typical central bank engages in sterilized intervention and a dollarized system does not, dollarization is more efficient than a typical central bank at adjusting the real supply of money to the real demand for money.

The idea of dollarization may encounter political obstacles locally from groups with a vested interest in the current monetary system, particularly the HKMA and some banks. That is why dollarization is likely to be implemented only in an emergency, when the pressure of events overwhelms vested interests, making far-reaching institutional reforms possible. The proposal here is a contingency plan for the indefinite though perhaps near future, so to claim that it is politically impossible today is no objection to it.

Finally, it may be asked whether the threat to dollarize would be effective. If the government makes the threat, will anything short of actual dollarization reduce speculation against the Hong Kong dollar? The experience of Argentina in 1995 suggests that a threat can be effective. During the height of the "tequila effect" crisis, the Argentine minister of the economy threatened to convert Argentina's currency board-like system into a dollarized system. Speculation against the Argentine peso diminished even though Argentina had devalued many times before, under central banking.

Critics will no doubt devise other objections to dollarization, but there is no reason for dismissing dollarization just because people make objections. It is possible to make objections to any monetary system. The true test of a monetary system is experience. There is ample historical and current experience with official and unofficial dollarization. No far-fetched conjectures are necessary: if you want to know how dollarization works, look at Panama, or Puerto Rico. Dollarization works well there and elsewhere. It does not encounter the problems that critics claim would arise in Hong Kong. Purely hypothetical objections are not sufficient to outweigh the practical success of dollarization.

Dollarization should not be considered a blow to the pride of Hong Kong or China. Rather, it is a logical extension of the principles underlying the currency board system: a fixed exchange rate and a transparent monetary policy determined by rules rather than by the arbitrary decisions of politicians. Moving from a currency board to dollarization is not so much giving up on an independent currency as reaffirming a rule-bound monetary policy. Dollarization would strengthen the tradition of respect for private property rights that has made Hong Kong one of the world's richest cities. The foreign reserves that back a currency are acquired by the effort of the people, yet central banks treat the reserves as their own property, to use as they please. Dollarizing Hong Kong rather than floating (depreciating) the Hong Kong dollar and letting the HKMA become a full-fledged central bank would show that in Hong Kong things are different, and that the government will refrain from confiscating the hard-earned wealth of the people.

Kurt Schuler is a U.S. monetary consultant. His writings include Should Developing Countries Have Central Banks? (1996) and Russian Currency and Finance: A Currency Board Approach to Reform (with Steve H. Hanke and Lars Jonung, 1993). He can be contacted by e-mail at <kurrency@erols.com> or through his Web site at <http://www.erols.com/kurrency>.

The author would like to thank Chen Nai-fu, Luk Yim-Fai, George Selgin, Gary Shiu, Tao Dong, and Steven Xu for comments.

1An alternative is to devolve all responsibility for issuing notes on the authorized banks, and perhaps on any other bank that wants to issue notes. The banks would issue U.S. dollar notes instead of Hong Kong dollar notes. Such a system of "free banking" existed in Hong Kong from 1845 to 1935 and it worked well (Schuler 1989). George Selgin (1988), a former lecturer in economics at the University of Hong Kong, has suggested that Hong Kong return to free banking. Though I am sympathetic to free banking, I do not discuss it further here because it is yet not well understood outside a very small circle of economists. Explaining a policy of free banking to financial markets and the public in an emergency would be much harder than explaining a policy of dollarization.

Appendix: A model dollarization statute

The model statute is meant to suggest the main features that are desirable for a law on dollarization. Legal technicalities may require an actual statute to be somewhat different.

In accord with Articles 110 to 113 of the Basic Law, the government of the Hong Kong Special Administrative Region enacts a "Statute on the New Hong Kong Dollar and on Dollarization."

1. The locally issued currency of Hong Kong shall be the new Hong Kong dollar, composed of 100 new Hong Kong cents. One new Hong Kong dollar shall equal one United States (U.S.) dollar, or 7.80 old Hong Kong dollars. The old Hong Kong dollar is defined as the official currency of Hong Kong up until the date this law enters into force.
2. Authorization to issue Hong Kong dollar currency is withdrawn from the banks that currently issue notes (the Hongkong and Shanghai Banking Corporation, the Standard Chartered Bank, and the Bank of China).
3. The U.S. dollar shall be legal tender in Hong Kong for any amount. The new Hong Kong dollar shall be legal tender for amounts up to 5 new Hong Kong dollars. Consenting parties may also use as legal tender in particular instances any other currencies they specify, for any amount they choose.
4. The Hong Kong Monetary Authority (HKMA) shall cause old Hong Kong dollar notes to be withdrawn from circulation and shall replace them with U.S. dollar notes at the exchange rate of 7.80 old Hong Kong dollars per U.S. dollar. The HKMA shall preferably accomplish the bulk of this task within 30 days after this law enters into force. The HKMA shall replace its old Hong Kong dollar deposits with U.S. dollar deposits at a U.S. bank. The HKMA shall cause old Hong Kong dollar notes to continue to be accepted for redemption for at least five years after this law enters into force.
5. The government of Hong Kong shall not issue notes. It may continue to issue coins provided that the coins are backed 105 percent by a reserve fund of assets, predominantly U.S. securities, payable in U.S. dollars. The coins shall be fully convertible into U.S. dollars at the exchange rate of one new Hong Kong dollar per U.S. dollar. The highest denomination of new Hong Kong dollar coins shall be 2 dollars.
6. Wages, prices, assets, and liabilities shall be converted from old Hong Kong dollars to U.S. dollars at the exchange rate of 7.80 old Hong Kong dollars per U.S. dollar. (For example, a wage of 7800 old Hong Kong dollars per week shall become a wage of 1000 U.S. dollars per week.) By 30 days after this law enters into force, wages and prices shall cease to be quoted in old Hong Kong dollars.
7. Interest rates and other financial ratios shall remain the same in U.S. dollars as they were in old Hong Kong dollars. The maturities of loans and other financial obligations shall remain unchanged. (For example, a fixed interest rate of 10 percent a year for a three-month loan in old Hong Kong dollars will remain 10 percent a year for the remainder of the three months in U.S. dollars.)
8. Old Hong Kong dollar coins, and only coins, may be revalued or devalued with a range whose lower limit is 5 old Hong Kong dollars per new Hong Kong dollar and whose upper limit is 10 old Hong Kong dollars per new Hong Kong dollar. If coins are devalued, the Hong Kong Monetary Authority shall make appropriate arrangements to compensate large holders of coins for the losses they suffer from devaluation. Compensation shall be limited to the extent of devaluation multiplied by the value of coins that holders of coins have.
9. The Chief Executive, in consultation with members of the financial community, shall appoint a committee of experts on technical issues connected with this law to recommend changes in regulations that may be necessary.
10. Previously enacted legislation conflicting with this law is repealed.
11. This law becomes effective immediately.

References

There are many articles and some books about unofficial dollarization, but apparently none that discuss at length how to establish an officially dollarized system.

Asian Monetary Monitor (Hong Kong), various issues.

Basic Law. 1996. The Basic Law of the Hong Kong Special Administrative Region of the People's Republic of China. (Adopted at the Third Session of the Seventh National People's Congress on 4 April 1990.) [Beijing]: Information Office of the State Council of the People's Republic of China.

Calvo, Guillermo A. 1996. "From Currency Substitution to Dollarization and Beyond: Analytical and Policy Issues." In Guillermo A. Calvo, Money, Exchange Rates, and Output. Cambridge, Massachusetts: MIT Press. Discusses some questions of definition.

Chen, Nai-fu, and Alex Chan. 1998. "To Defend a Strong Currency in Times of Crisis." Unpublished manuscript, Hong Kong University of Science and Technology, 19 January. Mentions dollarization as a last resort for Hong Kong.

Culp, Christopher, and Steve H. Hanke. 1993. "The Hong Kong Linked Rate Mechanism: Monetary Lessons for Economic Development." Unpublished paper, Department of Economics, Johns Hopkins University (Baltimore), June. Proposes ways of making exchange rate arbitrage tighter in Hong Kong's monetary system.

De Grauwe, Paul. 1994. The Economics of Monetary Integration, 2nd ed. Oxford: Oxford University Press. Focuses on academic issues related to monetary union in Western Europe.

Dowd, Kevin. 1993. Laissez-Faire Banking. London: Routledge. Chapters 2 and 3 discuss option clauses.

Fischer, Stanley. 1982. "Seigniorage and the Case for a National Money." Journal of Political Economy, v. 90, no. 2, April: 295-313. Analyzes the costs of dollarization.

Fischer, Stanley. 1993. "Seigniorage and Official Dollarization." In Nissan Liviatan, ed., Proceedings of a Conference on Currency Substitution and Currency Boards: 6-10. World Bank Discussion Paper 207. Washington: World Bank. A concise statement of the conventional (and not entirely correct) wisdom among economists about dollarization.

Friedman, Milton. 1973. Money and Economic Development: The Horowitz Lectures of 1972. New York: Praeger. Advocates dollarization or currency boards for developing countries.

Greenwood, John. 1991. "The Problem of CPI Inflation--Monetary or Structural?" Asian Monetary Monitor, 15, 3, May-June: 1-14. Analyzes economic competitiveness under a fixed exchange rate.

Greenwood, John, and Daniel Gressel. 1988. "How to Tighten Up the Linked Rate Mechanism." Asian Monetary Monitor, 12, 1: January-February: 2-13. Mentions dollarization as a possibility for reforming Hong Kong's monetary system.

Hanke, Steve H., Lars Jonung, and Kurt Schuler. 1993. Russian Currency and Finance: A Currency Board Approach to Reform. London: Routledge. The most comprehensive recent book on currency boards.

Hanke, Steve H., and Kurt Schuler. 1996. Alternative Monetary Regimes for Jamaica. Kingston: Private Sector Organisation of Jamaica. Contains a brief description of how to convert a central bank to an officially dollarized system.

HKMA. See Hong Kong Monetary Authority.

Hong Kong. Laws. Available at <http://www.justice.gov.hk>.

Hong Kong. Financial Services Bureau. 1998. Report on Financial Market Review. April. Available at <http://www.info.gov.hk/fsb/finance>. A defense of the status quo in monetary policy.

Hong Kong Monetary Authority (HKMA). 1998. "Strengthening of Currency Board Arrangements in Hong Kong." Circular, 5 September, available on HKMA Web site <http://www.info.gov.hk/hkma>.

Hong Kong Standard, Internet edition, <http://www.hkstandard.com>, various issues.

Ingram, James C. 1962. Regional Payments Mechanisms: The Case of Puerto Rico. Chapel Hill, North Carolina: University of North Carolina Press. The first thorough case study of financial integration within a currency area.

Liviatan, Nissan, editor. 1992. Proceedings of a Conference on Currency Substitution and Currency Boards. World Bank Discussion Paper 207. Washington: World Bank. Includes discussion of the costs and benefits of dollarization compared to a national currency.

Maynard, Geoffrey. 1970. "The Economic Irrelevance of Monetary Independence: The Case of Liberia." Journal of Development Studies, v. 6, no. 2, January: 111-32. An early statement of the effects of dollarization.

Moreno-Villalaz, Juan Luis. 1998. "Lessons from the Monetary Experience of Panama: A Dollar Economy with Financial Integration." Typescript, available online at <http://www.erols.com/kurrency/panama.html>. A case study particularly valuable for its discussion of Panama's internationalized banking system. A longer version was published in Spanish as La experiencia monetaria de Panam_: lecciones de una econom_a dolarizada, con una banca internacional. Panama: Banco Nacional de Panam_, 1997.

Revista de An_lisis Econ_mico. 1992. Special issue on convertibility and currency substitution, v. 7, no. 1, June. Some articles discuss unofficial dollarization.

Schuler, Kurt. 1989. "A Brief History of Hong Kong Monetary Standards." Asian Monetary Monitor, 13, 5, September-October: 11-29.

Schuler, Kurt. 1992. "Currency Boards." Unpublished Ph.D. dissertation, George Mason University. Available online at <http://www.erols.com/kurrency/webdiss1.html>. A summary of the history of currency boards to about 1990.

Schuler, Kurt. 1996. Should Developing Countries Have Central Banks? Currency Quality and Monetary Systems in 155 Countries. London: Institute of Economic Affairs. Data on the performance of central banking versus other monetary systems.

Schuler, Kurt. 1997a. "Tighten the Dollar Link." Asian Wall Street Journal, 6 November: 10. Mentions dollarization as a last resort for ensuring a fixed exchange rate for Hong Kong.

Schuler, Kurt. 1997b. "Wind Without Direction: Why Dollarization is Better than Devaluation" (in Chinese). Next Magazine, 12 December: 2-3. Describes how to convert a currency board system to an officially dollarized system.

Schuler, Kurt. 1998a. "The Problem with Pegged Exchange Rates." Typescript, available on request; forthcoming in Kyklos 1999, no. 1. Explains how fixed exchange rates, such as dollarization provides, differ from the pegged exchange rates that many central banks maintain.

Schuler, Kurt. 1998b. "Dollarizing Indonesia." Typescript, available online at <http://www.erols.com/kurrency/indodllr.html>. A detailed proposal for dollarizing a central banking system. A condensed translation was published as "Dolarisasi, sebuah alternatif" and "Peran bank sentral dalam dolarisai," Bisnis Indonesia, 31 July: 5.

Schuler, Kurt. 1998c. "Bolstering Hong Kong's Dollar." Asian Wall Street Journal, 24 August 1998: 8.

Selgin, George A. 1988. "A Free Banking Approach to Reforming Hong Kong's Monetary System." Asian Monetary Monitor, 12, 1, January-February: 14-24. An unusual but logical approach to monetary reform. See also the author's Web site, <http://www.arches.uga.edu/~selgin>.

South China Morning Post, Internet edition, <http://www.scmp.com>, various issues.

The Stateman's Year Book. Annual. New York: St. Martin's Press.

Tan, Pin Neo, ed. 1997. Currency Board System: A Stop-Gap Measure or a Necessity? Singapore: Board of Commissioners of Currency Singapore. Proceedings of Currency Board Symposium '97. Has a bit of discussion about the relationship between currency boards and dollarization.

Tao, Dong, and Joseph Lau. 1998. "Dollarisation: An Emergency Exit for Hong Kong?" Asia Economic Perspective (Credit Suisse First Boston). August. Analyzes probable effects of dollarization and other policies.

Tsang, Shu-ki. 1998. "The Hong Kong Government's Review Report: An Interpretation and a Response." Essay 1 of "Two Essays on Hong Kong's Currency Board System." Unpublished paper, series CP 98009, Business Research Centre, School of Business, Hong Kong Baptist University, May. Discusses applying in Hong Kong the "Argentina-Estonia-Lithuania" model of arbitrage between notes and deposits.

White, Lawrence H. 1989. "Fix or Float? The International Monetary Dilemma." In Lawrence H. White, Competition and Currency: Essays on Free Banking: 137-47. New York: New York University Press. Exposes flaws in the theory of optimum currency areas.

Xu, Steven. 1998. "'Dollarize' Hong Kong." Asiaweek, 28 August: 53. Argues that dollarization is a logical extension of the principles of a currency board.

The Hong Kong Centre for Economic Research
School of Economics and Finance
The University of Hong Kong
Phone: (852) 2547-8313 Fax: (852) 2548-6319
email: hkcer@econ.hku.hk

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