The Currency Board in Hong Kong: Operational Weaknesses and A Proposed Refinement Scheme

Abstract

It is generally thought that a strong currency board system was the key to successfully defend the Hong Kong dollar during the Asian financial crisis in 1997/1998. However, the actual operation of Hong Kong’s currency board system was perhaps very different from the general public’s perception. This chapter is to explore the major operational weaknesses of Hong Kong’s currency board system during the Asian financial crisis. Not only did those weaknesses make the currency board ineffectively utilize the huge foreign reserve to stabilize the HK$ exchange rate and interest rate, but also became a loophole in the financial system. This loophole enticed speculative attacks on the HK$ spot market, the HK$ forward market, and the stock market in Hong Kong. After exploring the operational weaknesses, we investigate a proposed refinement scheme to improve the operational weaknesses and discuss its improvements and implications.

I would like to thank Nai-fu Chen, Corrinne Ho and especially Merton Miller for their helpful comments on earlier versions of this paper. I am also grateful to the financial support from Hong Kong RGC earmarked research grant HKU7137/00H. The author can be reached at the School of Economics & Finance, Faculty of Business and Economics, University of Hong Kong, Pokfulam Road, Hong Kong (Tel: (852)–28578510, Email: alexchan@econ.hku.hk).