So it has come to this point. Regardless of what you think about alleged EU indecision and infighting, the barbarians are definitely at the gate. The stakes are high; indeed, some even believe that the fate of European monetary union hangs in the balance. Like in so many times past, it is certainly easy to blame faceless speculators in the hullabaloo. There are also those rating agencies who appear hellbent on downgrading Greece, Portugal, and Spain at a most inopportune time as the EU and IMF crews try to assemble a definitive rescue package for Hellas. Long after this episode is over, I suspect there will again be much debate about freedom of capital flows and excessive rating agency procyclicality. No matter; we are here now and being slow on the draw will do Europe no favours.To be sure, there are big differences between the Asian financial crisis and the current one of PIIGS countries battling to reach financial health. For one thing, the PIIGS are not as exactly prone to balance-of-payments crises since their trading partners are mostly other European nations as well. So, having sufficient foreign exchange is not the main issue. Rather, it is controlling market sentiment that the fiscal difficulties these countries find themselves in will not run away into becoming a situation even the combined resources of--their willingness aside--Germany and the IMF cannot rein in. That is, what is the likelihood of any of the PIIGS defaulting, and another...and another?
One of the things that the Asian financial crisis and the European debt crisis share, however, is the imperative to contain runaway panic. The credit rating agencies are certainly not doing the EU any favours as yields on two-year Greek paper hover around an astonishing 30%. While Greece is certainly in no great shape, the first order of business is to corral the herd. There is little reason for Greek borrowing costs to be like this even after all the Enron-inspired accounting of its past administrations. Repeat: even if the euro is certainly underperforming, this is not a currency crisis but a funding crisis.
Now, something the whitebread commentariat seems to have forgotten despite its endless blathering is the example of Hong Kong in 1998 facing down those speculating on the devaluation of the Hong Kong dollar in the wake of the Asian financial crisis. As you know, the Hong Kong Monetary Authority (HKMA) operates a currency board that pegs the value of the HK$ to the US$. The proximate cause of the establishment of this board in 1983 was wrangling between the UK and China over the fate of the world-famous entrepot. Then, as now, uncertainty about a looming catastrophe--handing this bastion of free enterprise to the Communists--triggered the creation of something which has proven remarkably durable.
In 1998, Hong Kong too fell under severe pressure as speculators mounted heavy bets against the HK$ peg while contagion spread from Southeast Asia to parts beyond. Hong Kong had just been handed back to the Chinese, adding complications at the helm. However, the city's authorities knew that had it not defended the currency board, it would have fallen by the wayside like so many others before its turn came. In the same manner, the European authorities know their time has come for a stern test. Here is the introduction on how Hong Kong went "all in" to prevent a rout:
When the Asian financial crisis broke out in 1997, many countries’ currencies tumbled and their economies suffered. However, the Hong Kong Monetary Authority (HKMA) mounted a successful defense of the Hong Kong dollar under the currency board arrangement. In one of the most unusual episodes in recent exchange-rate history, the HKMA intervened simultaneously in the foreign exchange, stock, stock futures and interbank markets. In August 1998, at the height of the currency turmoil, it purchased $15 billion worth of local blue-chip stocks.The mechanisms of speculation were as follows according to the operating principles of the currency board:
Since Hong Kong’s 1997–98 crisis, the financial markets have stabilized. The stock market has recovered. Although its economy underwent five quarters of contraction from 1998 to early 1999, Hong Kong survived the crisis with relatively light damage compared with many of its neighbors. By April 2001, the HKMA had not only recouped the initial cost of the intervention but had done so with significant gains from equity appreciation. The unprecedented intervention seems to have worked. Nevertheless, the intervention broke the Hong Kong government’s laissez-faire tradition and drew significant criticism. Now, with the benefit of hindsight, we may be able to better gauge the intervention’s effects and consequences.
Under the currency board, interest rates are automatically adjusted in response to changes in the monetary base. When there is depreciation pressure on the Hong Kong dollar, the HKMA is obliged to buy Hong Kong dollars at the official rate. This causes the monetary base to contract, pushing interest rates higher and attracting foreign capital inflows so as to maintain exchange-rate stability. If the exchange rate strengthens, banks may purchase Hong Kong dollars from the HKMA. This expands the monetary base, pulling interest rates down and, thus, discouraging further capital inflows.And the actions taken were as follows. The two main options were controlling capital flows or heavy intervention given market movements unwarranted by fundamentals. Clearly, a financial centre could not have gotten away with the former option. So, Hong Kong did the latter:
During the Asian financial crisis, speculators exploited this interest rate predictability. They took short positions in the Hong Kong stock and stock futures markets. At the same time, they sold borrowed Hong Kong dollars against the U.S. dollar. Under the currency board, the HKMA stood ready to buy back Hong Kong dollars. And herein lies the dilemma under the currency board. On the one hand, continued buyback shrank the monetary base and drove the short-term interest rate up sharply, arresting the outflow of U.S. dollars in defending the currency board. On the other hand, overnight interest rate upsurges—300 percent at one point in October 1997—triggered precipitous drops in stock and stock futures prices, producing hefty profits for short-sellers. After every attack, market confidence plummeted...
Few options were available to reverse the trend of depleting foreign currency reserves and bleeding equity markets. Among them, two stood out—outright capital control and direct intervention. While during the crisis Malaysia adopted the former, Hong Kong chose the latter. When the speculative attack intensified again in August 1998, the HKMA intervened simultaneously in the money, stock and stock futures markets in addition to buying back Hong Kong dollars. During the last two weeks of August, it imposed penalty charges on targeted borrowers that served as settlement banks for the speculators and bought $15 billion worth of Hang Seng Index stocks (8 percent of the index’s capitalization). In addition, it took long positions that pushed the stock futures 20 percent higher. After the intervention, the exchange rate quickly stabilized, and currency futures and short-term interest rates returned to sustainable levelsUs Asians have long admired the financial savvy of the wizards of Hong Kong. Of course, the point men in Hong Kong's efforts to staunch speculation in virtually all markets was then-Financial Secretary Donald Tsang and the HKMA's then-Chief Executive Joseph Yam. While the name may not be familiar to Westerners, the visage of Sir Donald Tsang should be familiar wearing his signature, dapper bowtie. Eventually, Tsang of course became the Chief Executive of Hong Kong after succeeding the unpopular Tung Chee-Hwa. Meanwhile the similarly well-regarded Joseph Yam served for a couple of more years as head of the HKMA before retiring late last year.
Of the three Western central bank chiefs, I generally hold Jean-Claude Trichet in higher regard than the loathsome Ben Bernanke and the more favourable Mervyn King. As the latter taught at the LSE for quite some time, I probably better keep my trap shut on the latter! Nevertheless, there is indeed a stern test at hand. My best advice to Trichet is to consult those who have been here before and have coped with these pressures well. Given my druthers, I'd hire Joseph Yam as a consultant to the EU straight away. Sir Donald would certainly be willing to give a few words of advice, too.
To recap, this comparison may not be perfect, but there are congruities on the points that need to be addressed:
- the mechanisms by which speculation undermines the health of the entire monetary system need to be understood;
- once these mechanisms are better understood, the financial Powell Doctrine must be put into motion--just as Hong Kong's authorities had done before;
- Hong Kong managed all this without putting the brakes on capital flows--something Greece obviously cannot do as part of the Eurozone;
- ECB appraisals need to understand the interrelationship among debt, equity, foreign exchange, and futures markets for coordinative purposes. So far, ECB action has considered mostly capital or debt markets.
- the Eurozone is much larger in every dimension than Hong Kong;
- the cadre of European leadership is larger and more diverse than that of Hong Kong;
- the EU (again) faces primarily fiscal pressure, not monetary pressure even if it is the latter that must be prevented from giving way;
- wayward EU nations experiencing funding problems are nowhere near as healthy as Hong Kong circa-1998, but they aren't as problematic as markets indicate, either.
