Overcoming Chinese Monetary Division and External Anchoring in East Asia*

Overcoming Chinese Monetary Division

George M. von Abstract Furstenberg There are few recent historical precedents for maintaining the Professor, Department of Economics high degree of separation that still prevails between the internal Wylie Hall, Indiana University monetary arrangements of Hong Kong and mainland China. This Bloomington, IN 47405 USA paper explains why this separation is likely to erode and considers [email protected] the economics of the different forms that monetary unification of China could take. It argues that achieving such unification without Jianjun Wei Department of Economics resorting to capital controls or expropriation is a precondition for Wylie Hall, Indiana University developing a second major international currency in East Asia that Bloomington, IN 47405 would rival the yen. Until the renminbi has been established as an USA [email protected] international currency within a unified and sound financial system that has achieved Hong Kong’s current standards, there can be no progress toward a regional monetary union in East Asia. An internal goal of Chinese monetary union is banking reform and financial integration, and an external goal is to help emancipate both China and East Asia as a whole safely from the U.S. dollar standard.

1. Introduction

As long as China remains one country with (at least) two currencies, the renminbi (RMB) and the Hong Kong dollar

* This paper was presented at the Asian Economic Panel meeting held on 11–12 May 2003 in Tokyo. Naoyuki Yoshino (Keio Uni- versity, Tokyo), Fan Gang (National Economic Research Insti- tute, Beijing), Richard Wong (The University of Hong Kong), and the editor of this journal, Wing Thye Woo (University of California, Davis), provided excellent discussion and perspec- tives helpful for revisions. An earlier version was presented by von Furstenberg at the 22 June 2002 G8 Pre-Summit conference, Sustaining Global Growth: Prosperity, Security and Develop- ment Challenges for the Kananaskis G8, hosted by the Univer- sity of Calgary, the Guido Carli Association, the G8 Research Group, and the Research Group on Global Financial Gover- nance, in Calgary, Canada. Wei would like to thank the Hong Kong Institute for Monetary Research for allowing him to be in residence as a visiting predoctoral fellow in the fall of 2002.

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(HKD), the HKD should not ºoat independently against all other currencies, as, say, the yen has been doing. Even Milton Friedman, who tends to favor ºexible exchange rates for a very wide range of applications, advised Hong Kong against such a policy (Friedman 1994; Friedman and Mundell 2001). Indeed, the catalogue of reasons against ºoating the HKD independently is long enough to make such a proposal a dead issue (Yam 1998; Latter 2002).

Hong Kong’s economy is highly open and intertwined with those of its neighbors, but it is also becoming “small” (even ªnancially) relative to that of the mainland. Yam (1996, 4) once dismissed the notion that Hong Kong’s monetary system would one day be dwarfed by that of mainland China by pointing out, quite correctly for 1996, that Hong Kong’s average annual money supply (M2) “is about 40% as big as China’s.” By the end of March 2003, however, that percentage was down to less than 20 percent,1 and it is likely to fall to about 10 percent by the end of the decade. The reason is that although Hong Kong may do well over the period, the mainland’s economy and monetary system will continue to grow much faster. Hence the only relevant question is whether the HKD should continue to act like the U.S. dollar (USD) or whether it should eventually act more like the RMB,2 and in the process be replaced in an orderly way.

A recent IMF publication (2002, 3) describes the growing ties between Hong Kong and mainland China since Hong Kong’s return to China’s sovereignty:

Integration between the two economies has deepened, notwithstanding the Asian crisis: Mainland-related entrepôt trade has continued to increase; a large share of China’s foreign currency ªnancing is raised in the Hong Kong SAR ªnancial market; a growing range of economic activities are integrating across the border; and Hong Kong SAR business has become increasingly centered around China-related activities.

Such a situation seems to cry out for a common currency, because separate currencies act as a strong barrier to trade.3 This paper discusses how best to achieve the

1 At the end of March 2003, mainland China’s M2 reached 19.5 trillion yuan, or around US$2.35 trillion, with foreign-currency deposits of ªnancial institutions amounting to less than US$0.15 trillion. Hong Kong’s M2 was 3.5 trillion HKD, or around US$0.45 trillion, including US$0.20 trillion in U.S. dollar claims. 2 Tang (2002) focuses on whether it would be preferable to peg the HKD to the USD or to the RMB. Tang ªnds that the structure of Hong Kong’s entrepôt trade is such that the opportu- nity cost of choosing one trading partner’s currency over another is small, according to the calibrated results of his model. 3 See Rose (2004) for an appraisal of estimates of the effect of monetary union on trade.

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monetary uniªcation of China. The purpose of uniªcation is not only to strengthen internal trade and hence economic growth (Frankel and Romer 1999; Chou and Wong 2001; Frankel and Rose 2002), but also to banish currency crises between Hong Kong and China and simultaneously avoid currency crises between the whole of China and the outside world. Achieving Chinese monetary union (CMU)4 without continuing to peg to the USD would also meet one of the essential prerequisites for a wider monetary union in continental East Asia.

In a short paper it is not possible to justify all the premises and judgments on which the paper is based. Yet they must at least be stated at the outset to help explain the broader contextual view underlying the limited areas considered in detail:

1. We accept Rogoff’s (2001, 243) conclusion that “into the foreseeable future, it would not be desirable to aim for a single world currency, and that from an economic point of view, it would be preferable to retain at least, say, three to four if not n [independently ºoating] currencies.” Similarly, as Mundell (1961, 659) once held, “The optimum currency area is not the world.” A new continental East Asian currency, born of CMU, that ºoats against the USD and the euro permanently, and against the yen at least during the transition from a China-based unilateral monetary union to a multilateral monetary union, is essential for a region that is integrating its production and trade networks internally. 2. Because of the direct and indirect effects of Japan’s protracted banking crisis and government debt burden (see Fukao 2002), the yen is becoming less suitable as a possible common standard for monetary integration in continental East Asia. With some exceptions, such as Singapore (see Borensztein, Zettelmeyer, and Philippon 2001), the countries in that region have looked to the USD as the common external anchor rather than the yen. The dollar anchor is likely to become unsustainable once capital account convertibility in the main countries of the region (particularly mainland China) has progressed. Instead, an internal anchor, such as inºation targeting, must arise from China. Thus a fourth major international currency, in addition to the USD, euro, and yen, will have to crystallize in continental East Asia before the region’s monetary emancipation can occur. 3. Similar to the United Kingdom, which has kept aloof from European monetary union (EMU), Japan initially will stand aside from any China-based monetary union. Only after China’s uniªed currency has developed into a major international denomination rivaling the yen, could it become one of the two pillars of a

4 The acronym CMU is irresistible, even though it has already been claimed by the Hong Kong Monetary Authority’s Central Moneymarkets Unit, a central custodian and clearing system for debt instruments.

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multilateral monetary union with most East Asian (and some Southeast Asian) countries. Assuming political compatibility among these nations, the union eventually could include Japan, provided the economic and ªnancial integration of China and Japan continues to increase and these countries’ banking and ªnancial systems are reformed to the point of reaching internationally accepted standards of soundness, provisioning, and transparency.

This paper focuses mainly on the ªrst step in the scenario above, the achievement of CMU. To provide some historical guideposts, section 2 discusses the salient features of the monetary uniªcation processes in the American colonies. Section 3 explains why currency schisms are dangerous within a single economically integrating and liberalizing country. Section 4 analyzes the extent to which different plans for monetary union apply these lessons and are likely to achieve a major international currency for all of China that would ºoat against the USD. Section 5 concludes, empha- sizing that (1) the way in which Chinese monetary uniªcation is achieved is important to the successful evolution of an East Asian monetary union in the future, and (2) because the externally anchored exchange-rate system between the HKD and the RMB is fraught with risk, it is important that Hong Kong carefully plan and execute its exit from the currency board before the RMB is allowed to ºoat against the USD.

2. Lessons from monetary disunity in American colonial history

Monetary history holds some interesting lessons about how monetary disunity arises in a country or region and how it tends to be resolved. In the 13 separate Brit- ish colonies in America, the value of their money was linked to two external silver currencies, British sterling and the Spanish peso (popularly known in the colonies as the piece of eight5). The piece of eight appears to have served as the decisive monetary standard, in that “intercolonial exchange was effected at par based on the comparative values of the piece of eight of the two colonies involved rather than on the comparative commercial rates of exchange on London at the time of the transaction” (McCusker 1978, 159). In the 1700s in colonial America, when neither arbitrage nor price information could be instantaneous, what mattered was the monetary standard used in practice for calculating the cross-rates of colonial currency transactions. Just as the piece of eight (i.e., the silver dollar) was always the standard in England’s North American colonies, so has the USD been the standard in Southeast Asia (with

5 The piece of eight had 422.9 grains (less than one troy ounce of 480 grains) of 0.935 ªne silver and was valued at 4s 6d (4 shillings and sixpence), or at a little under a quarter-pound Brit- ish sterling (£1 ϭ 20s), based on its silver content.

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minor interruptions) for over three decades (McKinnon 2001). This is why it has a special role to play in the discussion of alternative routes to the monetary uniªca- tion of China.

Another striking lesson comes from the forces that pushed toward colonial moneys’ being accepted as substitutes for one another at a ªxed rate, so that payment in the currency of one colony could be readily accepted in a neighboring colony. The network externalities that currencies afforded determined whether they were used only inside their native colony or also outside it, as happened in the case of New Jersey. According to a 1740 account (in McCusker 1978, 169–70), “New York bills, not being current in Pennsylvania, and Pennsylvania bills not current in New-York, but Jersey bills current in both, all payments between New-York and Pennsylvania are made in Jersey bills.” Because the HKD and the USD are viewed as close substitutes in mainland China, however, it would not be correct to claim that the situation in Hong Kong and China is exactly analogous to the monetary disunity present in the Ameri- can colonies. That is, one cannot claim that the RMB is not current in Hong Kong, and the HKD is not very current in mainland China, but the USD is current in both areas, so most payments between Hong Kong and mainland China are made in USDs. Nevertheless, there is more than a grain of truth in this analogy.

The practical needs of intercolonial trade exerted pressures to accept colonial moneys as substitutes for one another at precisely ªxed rates of interchange. In the case of China, proposals to ºoat the RMB against the USD (and hence against the HKD) or to establish an appreciable band around its central rate, without ªrst achieving internal monetary union, ignore the compelling expedient of a ªxed rate of equiva- lence in internal exchange. In the American colonies, ªxed cross-rates were taken for granted and required no particular vigilance or market checking of the conversion rate with the pound sterling in London. Hence different colonial moneys competed on the basis of their usefulness, that is, on their designation in practice as legal tender for public and private debts, rather than on the basis of their stable value relative to one another.6

Moneys anchored in perfect substitutes, such as silver content, can coexist conª- dently inside and outside their original jurisdiction at a perfectly ªxed exchange

6 The evidence for the existence of customary rates of intercolonial exchange again comes mostly from the period after 1750: “The accepted ratio between New York currency and the Lawful Money of New England was £133.33 to £100. £100 Maryland or Pennsylvania currency cost £106.67 New York currency, at least from 1762 on. Earlier it seems to have varied somewhat, but in 1768 the Chamber of Commerce ofªcially adopted the £106.67 rate” (McCusker 1978, 159).

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rate because they have the law of arbitrage on their side. There are several instances in history of formal arrangements for mutual acceptance of moneys based on coins with equal precious-metal content, in which coins issued by one country were legal tender in other countries, whose coins, in turn, were also legal tender in the ªrst country. In contrast, an exchange rate ªxed by statute between gold and silver quan- tities, such as 1:15.5 under bimetallism, or a ªxed exchange rate between commodity money and unbacked paper money, invariably triggers Gresham’s Law. As the relative price of the two moneys begins to deviate from the ofªcially decreed price relation, the cheaper of the two legal means of settlement is chosen, and the higher- valued form of money is driven from circulation. Obviously, therefore, if underlying market values are not maintaining a ªxed relation, the only way to keep different moneys in joint circulation is to allow the exchange rate between them to vary also.

3. Why are two currencies in one country unsafe?

Before discussing the optimal form of CMU in greater detail, it needs to be shown why the lack of such a union invites unnecessary risks, particularly once capital controls have been phased out on the mainland. Why is Hong Kong vulnerable to changes in the real exchange rate between HKD and RMB, including an RMB appreciation against both HKD and USD? We will again start with an analogous situation on another continent to gain perspective on that in Hong Kong.

3.1 Exchange rate exposure for maquiladoras and re-exporters This section will demonstrate that even maquiladoras or middleman economies such as Hong Kong can have a major problem with exchange rate hedging. Indeed, the difªculty may be ampliªed rather than mitigated by their middleman status. Maquiladoras serve as assembly and ªnishing stations for inputs generally sourced from the same large neighboring country to which the ªnished goods are sold. Com- plete direct hedging of their exchange exposure may be made difªcult by the following two conditions, which apply in different degrees to the maquiladoras and Hong Kong ªrms:

1. The value-added in the maquiladoras involves (labor) costs that are functionally incurred in a currency other than that of their dominant trade partner (e.g., not indexed to the exchange value with that currency). 2. The gross output of the maquiladoras has to be priced in the different local currencies of national or regional markets that are separable in the short and me- dium run. Under pricing-to-market (PTM), price discrimination in response to unexpected exchange rate changes thus persists between the different markets for some time.

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To derive the direct hedge conditions, it helps to start with the general price deter- mination equation and an application to the prototypical maquiladora, a ªrm in the northern border region of Mexico (mx):

ϭ α 1Ϫα Pmx k (e pus /MPI) (w/MPL) , (1)

where lowercase letters distinguish input prices (p) or wages (w) from output prices (P); the subscripts us and mx refer to the United States and Mexico, respectively; e is the peso per dollar exchange rate; MPI is the marginal product (MP) of intermediate goods inputs (I), which may include the rental value of imported plant and equip- ment; and labor input (L) is taken to be the only cost component of domestic (i.e., Mexican) value-added. The zero-proªt condition is k ϭ 1, but it is assumed to hold only in the long run. Thus k may be interpreted as 1 plus a variable markup rate, where that markup tends to return to a normal level in the long run. When price discrimination and PTM subsequently are assumed, it will be useful to distinguish

Pmx,us, the peso equivalent of the dollar price of Mexican sales to the U.S. market,

from Pmx,mx, the market price, in pesos, of Mexican sales at home. The ªrst subscript relates to the producer’s home currency, and the second refers to the consumer’s price and the currency in which it is quoted and paid before being translated back into home currency, if needed.

Now assume that a rise in the price of U.S. inputs is part of a general inºationary trend in the United States, so that input and output prices rise by the same percentage. Then in “classical” maquiladora production and trade, a given percentage rise

in the U.S. price of inputs (pus) that is equal to the rate of increase in the U.S. price of the output that is sold back into the U.S. market will increase proªtability, ceteris paribus, that is, as long as the peso wage rate in Mexico and the exchange rate are unaffected. Hence, with pricing to the U.S. market,

ϭ d(ln Pmx,us) d(ln pus)

and

ϭ Ϫ α d(ln k) (1 ) d(ln pus). (2)

Once NAFTA had gone into effect in early 1994, maquiladora output with U.S. content could be sold in the rest of Mexico without tariff penalties. The real depreciation of the Mexican peso in the previous example then implies that on sales from the maquiladoras to Mexico, assuming pricing to the Mexican market on such ªnal sales ϭ so that d(ln Pmx,mx) 0,

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ϭϪα d(ln k) d(ln pus). (3)

If the cost share of Mexican value-added (1 Ϫ α) is 0.5, then above-average proªts on sales to the United States and below-average proªts on sales to Mexico could just balance out if sales were about equally split between the two countries. This re- quires, of course, that the markets for the product in question can be separated temporarily between the United States and Mexico so that price differences on an exchange-converted basis can endure for some time.

Now consider a real depreciation of the Mexican peso that is brought about by a rise

in e rather than equal-percentage increases in Pus and pus. Again assuming PTM, Pus

and pus are now unchanged. But Pmx,us, the maquiladora factory (peso) price equiva-

lent of the ªxed U.S. market price of goods, is equal to ePus and thus increases with e. The outcome for proªts is perfectly analogous with equations (2) and (3). For sales

to the Mexican market we again assume that Pmx,mx and peso money wages are unaffected in the short run before exchange pass-through begins. Hence, on sales to the United States,

d(ln k) ϭ (1 Ϫ α) d(ln e), (2a)

and on sales to Mexico,

d(ln k) ϭϪα d(ln e). (3a)

It is obvious, therefore, that with a Mexican value-added percentage of about 50 percent, maquiladora producers may be able to insulate or hedge their bottom line against real exchange rate changes that may not be fully reversed until a few years later. They can do so by selling half of their output back to the United States and half to Mexico, as long as price discrimination remains feasible between these two markets. Remarkably, it makes no difference to the combined proªt outcome whether the real exchange rate appreciates or depreciates, provided the Mexican value-added share is 50 percent.

However, the actual percentage of Mexican value-added on maquiladora production appears to be considerably less than 50 percent. The only data we have found are somewhat dated, in part because after NAFTA it was no longer important for tariff administration to isolate maquiladora production statistically. In 1991, value- added by in-bond industries was US$4,134 million (Banco de México 1992, table 54), whereas in-bond imports were US$11,783 million (Banco de México 1993, table 48). Using these data as a guide, the Mexican in-bond value-added was 26 percent (4,134/15,917), so that α ϭ 0.74. Hence, to keep proªts unchanged the value share

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(as distinct from the volume share) of total sales from the maquiladoras to the United

States (Smx,us) and the value share of total sales from the maquiladoras to Mexico

(Smx,mx), with these two shares assumed to sum to unity, would have to be such that

ϭ Ϫ α Ϫ α ϭ Ϫ α ϭ d(ln k)/d(ln e) Smx,us(1 ) Smx,mx Smx,us 0. (4)

Hence maquiladoras would have to have 74 percent of their sales going to the United States to insulate proªts from exchange rate change. This may explain why a high percentage of maquiladora sales have continued to be directed to the United States, even after NAFTA took effect in 1994. In 1998, for instance, total imports of the in-bond industry were US$42,557 million, whereas total exports (assumed to be overwhelmingly to the United States) amounted to US$53,083 million (Banco de México 1999, table 45). Thus, of an estimated total output of US$57,509 million (obtained by dividing 42,557 million by 0.74), 92 percent was sold back into the United ϭ α ϭ States. Hence with Smx,us 0.92 and 0.74, a real depreciation of the peso raises k and helps proªts, whereas appreciation of the peso hurts proªts. Because there is a net export from the maquiladoras to the United States equal to almost one-ªfth (92 Ϫ 74 ϭ 18 percent) of the gross value of total maquiladora output, the sales dis- tribution hedge is somewhat incomplete.

To recapitulate, complete direct hedging would require balanced trade, as shown by ϭ α the condition Smx,us from equation (4). By contrast, any difference between S and α indicates a hedging gap that is either positive, as in the present case, with depreciation of the domestic currency raising proªt, or negative, with the opposite result.

3.2 Exchange risk in Hong Kong’s trade with the mainland Since 1994, the RMB and the HKD have in effect been tightly pegged to a common external anchor, the USD, and hence to one another. There is no reason for that arrangement to endure, however, once the RMB achieves full capital account convertibility and exchange controls are removed. Large international currencies, whose ranks the RMB then will have joined, do not maintain ªxed exchange rates with one another. If the HKD still existed at that future time and remained pegged to the USD, the RMB/HKD rate would be in turmoil.

Particularly since 1997–98, there have been recurring suspicions, priced out in exchange markets, that either the RMB or HKD rates (or both) would be changed and that dollar pegging would give way, at least temporarily, to ºoating. Hong Kong banks tend to widen bid-ask spreads with the RMB when there is an increase in the perceived risk of an RMB or HKD exchange rate realignment. For instance, RMB/ HKD bid-ask spreads nearly doubled overnight in early August 1998 when there appeared to be an acute risk of RMB depreciation against the USD, and they still

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have not returned to their prior low levels (Wei 2004). When China’s State Adminis- tration of Foreign Exchange changes the RMB/HKD reference rate, then the rate quoted by some of the leading banks active in this exchange business in Hong Kong (e.g., Bank of China Hong Kong and Bank of East Asia) tends to extrapolate the change in the reference rate rather than anticipate a return to the central triangular parity. Hence the market questions the ªxity of the RMB/HKD rate via the joint ªx of the two currencies to an external anchor, the USD.

Given that exchange rate risk may well be perceived to be mounting in the economic and ªnancial relations between Hong Kong and China, insufªcient direct hedging may be presumed to be a growing concern. Hong Kong’s value-added on re-exports to and from the mainland of 6 percent and 27 percent, respectively, appears to be around 19 percent on weighted average. Hong Kong’s re-exports to the mainland are only about 60 percent as large as re-exports from the mainland. Re- exports refer to items, not of Hong Kong origin, that are reshipped from Hong Kong or are being returned from Hong Kong to their country or region of origin with only minor changes in extrinsic characteristics, such as the state of assembly, surface ªnish and appearance, and packaging. If goods are substantially transformed in Hong Kong, they are regarded as exports rather than re-exports. Goods that are shipped through Hong Kong on a through bill of lading, so that they pass through Hong Kong without clearing customs, are not treated as re-exports either. The gross value of re-exports from Hong Kong is six times as large as the value of its exports.

Finished goods “returned” to China often begin with raw materials or parts that are re-exported through Hong Kong to plants in China for “outward processing” in comparatively low-skilled labor-intensive operations such as assembly; 44 percent of re-exports from Hong Kong to the mainland were processing-related (IMF 2000). The resulting semi-ªnished goods are then shipped “through Hong Kong for in- spection, ªnishing, or packaging before [being exported] to their ªnal destination” (Hanson and Feenstra 2001, 4). Processing-related re-exports from the mainland through Hong Kong to the mainland and to ªnal destinations elsewhere accounted for 88 percent of all Hong Kong’s re-exports from the mainland. Their re-import value was 3.4 times as large as the value of processing-related re-exports to the mainland (IMF 2000), suggesting a mainland value-added in the semiªnished goods delivered to Hong Kong of 2.4/3.4 (70 percent), a fraction subsequently referred to in this paper as (1 Ϫ β).

The share of Hong Kong content in the value of re-exports is on average 19 percent, whereas Hong Kong’s domestic-origin exports (70 percent of which do not go to the mainland) are estimated to have a domestic content of 50 percent. Taking the

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weighted average of 19 and 50 percent, where the weight of the former percentage is six times that of the latter, yields an overall average of 23 percent (or 1 Ϫ α ϭ 0.23). However, for estimating exchange risk exposure, the mainland value-added in Hong Kong’s re-exports is not simply the complement of 0.23 (or α ϭ 0.77), but less, because about 30 percent (or ␤ϭ0.30) of the value of mainland goods that are ªnished in Hong Kong and then re-exported is attributable to inputs sourced from what may be considered for pricing purposes the East Asian dollar zone. (All these percentages, taken or derived from a single source [IMF 2000, 46–53], refer to 1998 trade in goods.)

s ϭ The HKD supply price (Phk ) is given by equation (5). With k 1, it is equal to the marginal cost of production for ªnal sales. These take place in Hong Kong (hk), the mainland (ml), and the “East Asian Dollar” (us) area, which is treated as the “rest of the world”:

s ϭ β Ϫ1 1Ϫβ α 1Ϫα Phk k{[(ehk,us pus) (ehk,us e ml,us pml) ]/MPI} (w/MPL) . (5)

The exchange rate between the HKD and the RMB is obtained as the cross-exchange rate with the USD so that all individual exchange rates (e) shown above are with USD. MPI is the marginal product of intermediate inputs, w is the money wage, MPL is the marginal product of labor in Hong Kong, and 1 Ϫ α is the Hong Kong value-added percentage. As before, a lowercase p refers to input prices and an uppercase P refers to output prices set in the different customer markets. The share of physical sales volume is s. Setting the average blended revenue per unit of sales (converted to HKD) equal to k times the marginal cost then yields

ϩ Ϫ1 ϩ Phk shk Pml (ehk,us e ml,us) sml Pus ehk,us sus

ϭ β Ϫ1 1Ϫβ α 1Ϫα k{[(ehk,us pus) (ehk,us e ml,us pml) ]/MPI} (w/MPL) . (5a)

As previously deduced, the complement of the Hong Kong value-added share (α) is 0.77, and β, the share of inputs sourced from the East Asian dollar area, excluding the mainland, is 0.30. Hence the weight for inputs effectively priced in RMB (even if invoiced in USD) is (1 Ϫ β) ϭ 70 percent.

Working assumptions In quantifying the net effect of three combinations of exchange rate changes on the short-run proªtability parameter (k), using equation (5a), we make the following assumptions:

1. Prices of intermediate goods are set in their producer’s currency, and the same price is quoted to foreign and domestic buyers at all times.

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2. Prices of ªnal goods are set in customer markets and kept ªxed in the currency of the consuming country (or special administrative region), regardless of exchange rate movements in the short run. Hence we assume zero degree of PTM for intermediates and 100 percent PTM for ªnal goods. Such an assumption is not uncommon in the literature (see von Furstenberg 2003). 2a. Alternatively, if the HKD depreciates by itself against the USD, the assumption may be made that the increasing HKD cost of imported inputs will be fully passed through to the prices of ªnal goods in the Hong Kong market. PTM continues in all other markets for ªnal goods, leaving local currency prices else- s where unchanged. Measured by the rate of change in the supply price, d(ln Phk ), α the cost effect of such a depreciation is precisely d(ln ehk, us), with a Cobb- Douglas cost function (equation [5]). This result provides for efªcient substitution of Hong Kong labor input (L) for imported intermediates (I) whose relative price has risen, but the reduction in MPL and the increase in MPI together have no net effect on cost, so that only the direct effect matters. 3. Money wages are ªxed in local currency (HKD) and do not respond to exchange rate movements in the short run.

After taking the logarithms of equation (5a) and differentiating the result with respect to the relevant rate of change in e, sales revenue shares (S) replace physical 7 ϭ ϭ ϭ shares (s). Their values are Sml 0.34, Shk 0.15, and Sus 0.51, which sum to 1. The revenue shares from the different markets are held constant for simplicity. We now consider three ways of depreciating the HKD:

A. By appreciating the RMB against the USD, while keeping the currency board parity and all other exchange rates with the USD unchanged8 B. By depreciating the currency board parity or by untying the HKD from the USD and letting the HKD depreciate, while all other East Asian dollar currencies, including the RMB, remain pegged to the USD C. By depreciating both the HKD and the RMB at the same rate against the USD so as to keep the internal exchange rate (between the HKD and the RMB) ªxed, while leaving the exchange rates of all other East Asian dollar currencies with the USD unchanged ϵ ϩ ϩ 7 For instance, Sml [Pml (ehk,us /eml,us) sml] / [Phk shk Pml (ehk,us/eml,us) sml Pus ehk,us sus]. The share of sales volume (s), in contrast to the share of revenue generated by sales to different countries (S), is generally not reported, although the two would be the same if the law of one price held and the product mix sold was the same in each country. 8 The effect is the same as depreciating the HKD against the USD at the same rate as all other East Asian dollar currencies, with the exception of the RMB, whose exchange rate with the USD remains unchanged.

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Case A. In the case of an isolated depreciation of the RMB against the USD and all other currencies,

ϭ Ϫ β α Ϫ ϭ Ϫ ϭ d(ln k)/d(ln eml, us) (1 ) Sml 0.70 (0.77) 0.34 0.20. (6)

For an isolated appreciation of the RMB, the sign is reversed (Ϫ0.20).

Hence Hong Kong proªts will be lowered by an effective depreciation of the HKD Ͻ that is brought about by an isolated appreciation (d [ln eml,us] 0) of the RMB against the USD and against all the other currencies whose dollar peg remains unchanged.

As ehk,us is constant, the currency board arrangement holds. The proªtability of Hong Kong sales to the dollar zone, including the East Asian dollar area (see Mc- Kinnon 2001), is adversely affected by the equal appreciation of the RMB against the HKD and the USD because this equal appreciation raises Hong Kong’s cost of inputs used in its exports to the dollar zone more than the HKD value of the proceeds from Hong Kong’s ªnal sales to the mainland. We highlight this result to draw at- tention to the threats to Hong Kong’s economic and ªnancial stability that could arise from the destruction of internal monetary union, a union that is based on a reliable ªxity of the HKD/RMB exchange rate.

This gap of Ϫ20 percent is somewhat larger in absolute terms, and larger still in relation to the Hong Kong value-added percentage of 23 percent, than the maquiladora gap of 18 percent in relation to a maquiladora value-added percentage of 26 percent. The difference in sign means that whereas a depreciation of the Mexican peso against the dollar would increase the proªtability of maquiladora production, the analogous joint depreciation of the HKD and the USD against the RMB or appreciation of the RMB against the HKD and the USD would reduce the proªtability of production in Hong Kong. The difference in outcomes is consistent with viewing parts of the mainland bordering Hong Kong, and not Hong Kong itself, as being comparable to the maquiladoras.

The reason that an appreciation of the RMB against the HKD and the USD would reduce the proªtability of Hong Kong’s trade is that the adverse effect of the increase in the HKD cost of inputs from the mainland exceeds the favorable effect of the additional HKD proceeds from ªnal sales to the mainland. These proceeds are, in effect, priced to market in RMB even if invoiced in USD. Indeed, the exchange rate exposure of Hong Kong is ampliªed by its middleman status. The resulting vulnera- bility leverage factor is close to 1, as the absolute value of the hedging gap (0.20) is near the domestic value-added share of 0.23 in Hong Kong’s total exports and

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re-exports. Hence Hong Kong’s not-directly-hedged exchange exposure is very large on trade in goods.

Since complete direct hedging cannot be achieved through bilateral trade balancing in the present case, hedging could be supplemented by Hong Kong ªrms’ making RMB loans to their mainland subsidiaries or other parties to augment their RMB receivables. However, such external loans paid out or payable in RMB have not generally been permitted by the mainland authorities. Other ªnancial instruments, such as RMB nondeliverable forward and futures exchange instruments are available, but they are not adequately deep and cost-effective for hedging RMB. Even if they were, their usefulness and availability for hedging is limited when the magnitude of future exchange rate exposures is highly uncertain, as it tends to be in dynamic manu- facturing operations9 under ºuid market conditions. Lack of hedging, in turn, may have contributed to the mainland authorities’ fear of ºoating.

Case B. In the case of the HKD depreciating not only against the USD but also against all other currencies, including the RMB,

ϭ ϩ α ϭ ϩ ϭ d(ln k)/d(ln ehk,us) Sus Sml – 0.51 0.34 – 0.77 0.08. (7)

Using pricing assumption (2a),

ϭ α ϩ ϩ α d(ln k)/d(ln ehk,us) Shk Sus Sml – ϭ 0.77(0.15) ϩ 0.51 ϩ 0.34 – 0.77 ϭ 0.20. (7a)

A depreciation of the HKD against the USD and all other currencies (including the RMB) that maintain ªxed exchange rates with the USD slightly increases proªts if the prices of the ªnal goods produced and sold in Hong Kong remain ªxed in HKD, as in equation (7).

If these prices are raised to pass through the increased HKD costs of imports from the mainland and elsewhere, the proªt-raising effect of an isolated depreciation of HKD is more pronounced. Of course nominal wages in Hong Kong will not remain unaffected for long by such obvious increases in the cost of living. But as long as w has not been renegotiated, the result in equation (7a) means that a 10 percent depre-

9 Although Hong Kong’s exports of nonfactor services are larger than its domestic-origin exports of goods alone, we do not have comparable data for estimating the exchange exposure on services.

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ciation raises expected proªts by an amount equal to 2 percent of the total cost of goods sold and by 2/0.23 ϭ 8.7 percent of their Hong Kong value-added.

Our results in cases A and B, that an isolated appreciation of the RMB against the USD (which means a joint depreciation of the HKD and all other East Asian currencies against the RMB, because these currencies remain pegged to the USD) would be bad for Hong Kong, whereas an isolated depreciation of the HKD against the USD would be good, may appear paradoxical at ªrst glance. Isolated appreciation of the RMB would hurt Hong Kong because the value of the ªnal goods that Hong Kong exports to mainland China is less than the value of the inputs it receives from that source. Isolated depreciation of the HKD against the USD (i.e., depreciation of the HKD against currencies of the rest of the East Asian dollar area, including the RMB) would help Hong Kong because the value of the ªnal goods that Hong Kong exports to the East Asian dollar area outside China is greater than the value of the raw and intermediate inputs it sources from that area. Hence Hong Kong’s input costs rise more than its sales revenue in case A, depressing proªts, and less in case B, raising proªts.

Case C. In the case of a joint depreciation of the HKD and the RMB against the USD and all the other currencies that are expected to remain pegged to the USD, that is, ϭ d(ln ehk,us) d(ln eml,us),

ϭ βαϭ ϭ d(ln k)/d(ln e) Sus – 0.51 – 0.30(0.77) 0.28. (8)

A joint depreciation of the RMB and the HKD against the USD that maintains internal monetary union is most effective in increasing the proªtability of Hong Kong’s trade and is more proªtable than an isolated depreciation of the HKD against the USD. However, it is unlikely that the HKD and the RMB could depreciate jointly against the USD while all other East Asian dollar currencies kept their pegs to the USD unchanged.

The RMB should not be allowed to start ºoating freely against the USD until after CMU has been formalized and the HKD has been decommissioned, as recommended in this article. However, once China is ready to break the link to the USD, other East Asian currencies may decide to ºoat either jointly with the RMB or independently against the USD. For these currencies, the beneªts of remaining pegged to a common external anchor, the USD, would be greatly reduced, and the risk of currency crisis would be increased, by keeping the dollar peg in place once the uniªed RMB ºoated freely against the USD. This may serve as a reminder that any

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large country’s choice and management of its exchange rate regime has important external effects on other countries and may change their options.

3.3 Fixed exchange rate between the HKD and the RMB: Do not wait until it breaks We conclude that a real joint depreciation of the HKD and the USD against the RMB, much talked about in Asia and apparently priced into RMB nondeliverable forward contracts (Bank of China 2003), would hurt proªts earned in Hong Kong considerably, because in this case input cost exposure exceeds sales revenue exposure. The exchange rate exposure of Hong Kong’s trade with mainland China that is not directly hedged is almost as high as the Hong Kong value-added component of such trade. This is a dangerous form of ampliªcation or “leverage” of exchange risk, hith- erto little noted, that comes from Hong Kong’s middleman status.

Heightened exposure to exchange risk may be characteristic of entrepôt economies in which domestic value-added accounts for only a small share of the total cost of goods sold. Under PTM, an x percent depreciation raises proªts by x percent of foreign sales as a ªrst approximation. Then, if the entire cost of products sold repre- sents domestic value-added, the effect is equiproportional. In fact, under this autarkic production structure with PTM, the effect cannot be more than 1:1, even if a country’s entire output is sold abroad while imports enter only as ªnished goods for ªnal sales. The effect would be greater than 1 when relating x percent of total cost to a domestic value-added percent less than 1. In theory, exchange risk exposure of a “middleman” economy thus can be “leveraged” by its entrepôt status to a multiple of the value-added to internationally traded goods in its economy. For instance, if Hong Kong, which on average contributed 23 percent of the value in such goods, sold nothing back to the mainland from the end of the production chain (so that ϭ Sml 0 in equation [6]), and the RMB appreciated as in case A, Hong Kong’s exchange risk exposure with RMB would be Ϫα (1 Ϫ β) ϭϪ54 percent, more than twice its value-added percentage in absolute terms. Because that risk exposure would be contingent on future operations of uncertain volume and design, it can be hedged only directly, by dynamically matching and rematching the currency distri- bution of costs and revenues on an ongoing basis, and not by a succession of ªnancial forward contracts large enough to cover the present value of all future exposures that are difªcult to pin down in advance.

The results above also show that tampering with the ªxed exchange rate between the HKD and the RMB prior to Chinese monetary uniªcation would be disruptive. On the one hand, the IMF supports Hong Kong’s linked exchange rate system, which is based on the maintenance of a ªxed parity between HKD and USD. At the

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same time, the IMF recommends a policy of ºexible exchange rates for RMB (viz., a wide renminbi trading band against USD) that would tend to undermine that parity. The Hong Kong Monetary Authority’s (HKMA’s) own researchers are far more dis- criminating in that regard (Ha, Fan, and Leung 2002). Our result, that an appreciation of the RMB against the HKD and the USD (with the HKD/USD exchange rate remaining ªxed) would reduce the proªtability of production in Hong Kong, is distinct from, but most likely consistent with, the expectation that Hong Kong’s trade balance then would decline. We note, however, that Wei et al. (2000) obtain the opposite result. They use a computable generalized equilibrium model to estimate the effects of a devaluation of the yuan and ªnd a “negligible,” but net negative, effect on Hong Kong’s trade balance, whereas we expect a net positive effect on the proªtability of Hong Kong’s trade. They note that, in spite of this negligible effect on the trade balance, a yuan devaluation could lead to panic selling of HKD assets through adverse effects on market psychology.

Perhaps a point of general agreement is that anything that destroys the effectively ªxed exchange relation between the HKD and the RMB likely will be destabilizing and problematic. Conversely, the case for having a single currency in Hong Kong and the mainland is becoming very strong from the side of trade in goods and services. It is less certain in general that global ªnancial integration of the sort that CMU could bring to China also appreciably spurs economic growth (Edison et al. 2002). However, anything that promotes institutional development and market orientation of the mainland’s bad-debt-laden ªnancial system is very likely to increase the contribution of the mainland’s ªnancial sector to economic growth. This expectation appears particularly well founded because a successful model to emu- late, that of Hong Kong’s world-class ªnancial system, is close at hand to instruct the process of ªnancial development and reform.

4. CMU by ªrst retiring HKD with property rights protected and then unpegging RMB

4.1 Transitional versus permanent dollarization or dollar pegging for Hong Kong Argentina’s reckless trampling on property rights in the deep ªnancial and economic crisis of 2002 has cast a long shadow over the prospects of that country and of any national currency it may seek to sustain. Forced “peso-iªcation” of USD- denominated deposits and assets in Argentine banks devalued them greatly and un- equally. Thus, if any lasting loss of reputation resulting from a lack of contract ªdelity is to be avoided, the monetary uniªcation of China will not be achieved pru- dently by simply hitching the HKD to the RMB by requiring conversion and then letting the surviving currency rise or sink against the USD when it is left to “ºoat.”

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Appreciation of the uniªed currency against the USD would mean that debtors (and those with short positions) who had contracted in HKD would lose, as the USD cost of their converted debts now payable in the uniªed currency increases, and depreciation would hurt HKD creditors (and those with long positions) relative to their original contracts. Instead of initiating partial expropriation of one side or the other in this way, the HKD’s currency board arrangement must be given a property- rights-preserving exit.

The ªrst step needed for Chinese monetary uniªcation without conªscation is the dollarization of the HKD. This step has already been recommended by Mundell (2000). However, in contrast to Mundell (2000) we are not recommending dollarization as a permanent monetary system for Hong Kong. Mundell envisions the USD as an excellent permanent anchor for the Asian currencies and looks forward to the formalization of a dollar-based currency area in East Asia, including China and Hong Kong, in the long run. As a sop to national monetary identity and to retain some local seigniorage revenue, Mundell advocates allowing formal dollarization to be combined with intramarginal amounts of dollar-equivalent stand-in currencies that would be issued by the dependent members of the currency union, analogous to the Scottish pound and the pound sterling. In contrast, we ad- vocate dollarization “intramarginally,” as an exit strategy to honor pre-existing currency board obligations. Once past this one-time stock dollarization, there would likely be support in the market for renminbization “at the margin” of new activity, that is, the use of RMB in newly negotiated wage and price contracts and in current transactions by households and businesses.

McKinnon (2001) advocates using the USD as the common monetary standard and not as the common currency for the region. He emphasizes the beneªts of introduc- ing ofªcial dollar parities that are treated as long-term obligations to which the government is committed to return after any currency crisis. McKinnon (2001, 237) claims that “with regressive exchange rate expectations and the future price level more secure in the face of any mishap forcing the (temporary) suspension of the ªxed exchange rate commitment, the authorities could seriously encourage length- ening the term structure of domestic and foreign ªnance in the bond market.”

Local ªnancial structures are opening up and will eventually strengthen in mainland China, and the relative importance of the U.S. market to the mainland and Hong Kong is shrinking. In 1999 the U.S. market took about 25 percent of mainland China and Hong Kong’s exports and supplied 10 percent of their imports (IMF 2000). In the near-universal economic slowdown of 2001–02, China was an engine of regional economic growth, accounting for a growing share of East Asia’s trade.

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Hence we do not share the view that maintaining a USD peg, particularly with the yen-dollar rate on the loose, would bring the blessings of stability to a continental East Asian monetary area far into the future. The region as a whole (with the exception of Hong Kong) is at present far too statist and lacks transparency in government and ªnancial transactions. Yet it would be anachronistic to expect this fast- growing and increasingly conªdent economic area, which contains over one-third of the world’s population, to be permanently dependent on the USD and permanently lacking ªnancial and economic policy emancipation. East Asia’s combined real GDP soon may exceed that of the United States if capital formation, productivity growth, and improvements in technology continue at their present pace. Politically, it will be difªcult to defend the view that maintaining a ªxed nominal exchange rate with the USD in open capital markets continues to merit repeated sacriªces from the region once it is well on its way to building an internationally respected noninºationary monetary and ªnancial order of its own. Growing signs of U.S. long-term ªscal irre- sponsibility since 2001 are creating additional unwelcome interest and exchange rate exposures for countries that peg to the U.S. dollar. Thus the only thing certain about the notional equilibrium level of the real exchange rate between the RMB and the USD in coming years is its lack of constancy.

Regarding McKinnon’s proposed regionwide hard peg to the USD as a way to achieve stable cross-rates internally, it is unclear how a successful speculative attack on one currency might affect the security of the peg for other currencies. As Wyplosz (2002) notes, if pegging has no institutional backup, it will have to rely solely on the separate decisions by individual countries. Little else could defeat speculative attacks, because USD-based regional swap arrangements (e.g., the Chiang Mai Initiative of May 2000 between the ASEAN countries plus China, South Korea, and Japan) have inherent limitations. The most notable of these limitations are that no U.S.-dollar-based lender of last resort is participating in these swap arrangements and that such arrangements require a method of ªnding defendable parities that are both politically acceptable in the member countries and economically persuasive to market participants.

McKinnon (2001) also does not demonstrate that scrambling back to the old dollar parity, if it were ever lost, would be a politically credible proposition in all countries that had to deviate from that parity. In fact, he envisions an East Asian arrangement that would be stronger than that imposed in many countries under Bretton Woods. What this means is that all countries in the region, and hence the region as a whole, may devalue or revalue by a uniform percentage against the USD, but only temporarily and in an emergency. How a uniform exchange rate realignment, on and off, might be negotiated en bloc within the group of East Asian countries or by that

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group with the United States (and then be made to “stick” in exchange markets regardless of any obvious differences in countries’ fundamental circumstances) is not spelled out.

4.2 Basket pegging and other nonstarters Schemes to peg a uniªed international Chinese currency of the future to a basket of currencies consisting of the USD, euro, yen, and pound sterling (or to a subset of this group) will be spurned in open ªnancial markets (see Tsang 2001). Although direct interbank clearing in major foreign currencies (including the euro) has been in- troduced in Hong Kong, basket pegging would be ill-advised because it would in- troduce cumbersome hedging requirements for the prevailing USD claims. These claims are obligations that, in Hong Kong at least, often are not fully hedged against the local currency. Even though Hong Kong’s derivatives market is the ªfth-largest in the Asia-Paciªc region and is quite deep, basket pegging would only complicate the task of hedging. Reaction to the announcement of former Finance Minister Domingo Cavallo’s 2001 contingency plan to change the Argentine peso’s currency board parity from 1 USD to 0.50 USD and 0.50 euro is instructive in this regard: it in- stantly weakened conªdence in Argentina’s scheme of currency board pegging and contributed to its demise.

4.3 The advisability of post-CMU ºoating against other major currencies Once ªrm exchange rate commitments are made, the political temptation is to try to keep them as long as possible for reputational reasons. McKinnon considers that in the long run the formation of a dollar-based currency area in Asia, including China, Hong Kong, and most Asian countries, could be used as a platform for an independent Asian currency.10 If the message is that a dollar-based currency area with ªxed exchange rates and rationally regressive (i.e., ªxed) exchange rate expectations will have to be maintained successfully for quite some time before it can serve as a platform for an independently ºoating currency, then McKinnon’s condition should be cut short: China should move toward independent ºoating, like that implemented for the euro, right after achieving internal monetary uniªcation.

Argentina’s experiences during its most recent crisis of 2001–02 have shown that the collapse of the currency board arrangement of a country can expose currency mis- matches so severe that they cripple its entire ªnancial and economic system (see Calvo, Izquierdo, and Talvi 2004). The formal U.S. dollarization of HKD claims

10 However, in the end McKinnon repeats his earlier judgment that “[b]ecause no region-wide ‘Asian euro’ exists or is in prospect, the dollar is the only plausible anchor for creating an East Asian zone of monetary stability in price levels and exchange rates” (McKinnon 2002, 50).

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would eliminate much of this risk, but the subsequent market-driven transforma- tion of Hong Kong ªnancial sector balance sheets toward straight RMB assets and liabilities would tend to resurrect it. Hence it is important to let the RMB ºoat visibly against the USD and for the authorities to show no “fear of ºoating” as soon as the HKD is decommissioned.

4.4 Chinese ªnancial development and currency consolidation in stages: Some pleasant arithmetic In our view, CMU and managed ºoating that is free of long-term commitments to a ªxed external exchange rate would have to be achieved before regional monetary union could be implemented. It is useful to give at least a bare-bones outline of the transitional steps we have in mind. Data for December 2002, which were published in various tables of the March 2003 issue of the Monthly Statistical Bulletin of the HKMA, show the following year-end balances in millions of HKD:

• Currency board investment in designated USD assets (including accrued interest and minus net payables). Currency board account ϭ HK$275,813 million (HKMA 2003, table 8.3). • Foreign-currency assets of the exchange fund (excluding foreign-currency deposits with banks in Hong Kong). Analytical accounts of the exchange fund ϭ HK$832,881 million (HKMA 2003, table 8.2). • Sum of the currency board account and the accounts of the exchange fund ϭ total foreign reserves ϭ HK$1,108,694 million. • Monetary base ϭ HK$246,106 million (HKMA 2003, table 8.3). • Ratio of foreign reserves to currency (HKD notes and coins) ϭ 8.91. • Ratio of foreign reserves to monetary base ϭ 4.50. • Ratio of foreign reserves to M3 (HKD) ϭ 0.34.

At the ªnal conversion of HKDs into USDs or equivalent, depositors with HKD claims should be given a choice of having their account balances converted and redenominated without charge in USD, in USD-indexed RMB (in practice, yuan), or in straight RMB, each with its competitively determined interest rate. Hong Kong banks would have to hedge not only the ªrst of these three types of deposits, already in wide use, with credibly USD-denominated bank assets, but the second type of deposit as well. This might require calls followed by renegotiation and reissuance in USD of those HKD-denominated bank assets whose issuers have sufªcient external USD receivables to pose little counterparty risk. The remaining portion of HKD- denominated bank assets would have to be converted either into straight RMB, to the extent Hong Kong depositors accept unindexed higher-yielding RMB deposits over the other types of deposit, or into covered USD-indexed RMB assets. Such as-

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sets could be made credible for those without reliable USD receivables, for instance, if the Exchange Fund were willing to provide forward cover against its ample USD reserves, which amount to more than one quarter of HKD M3. Measures used successfully in other countries, such as the auctioning of put options of local currency for USD by the Banco de México to domestic banks, might also be constructive. It would be equitable in the system of ªscal federalism, indeed autonomy, implied by the “one country, two systems” guarantees of Hong Kong’s Basic Law to have the People’s Bank of China furnish the HKMA with some amount of RMB currency free of charge. The amount of RMB currency to be granted should be sufªcient to match that part of the HKD currency that is turned in (for subsequent cancellation) for RMB either immediately and directly or after a detour through USD.

In practice this would mean that the HKMA’s management of the payment and settlement system and of clearing balances with eligible banks would be conducted in USD for some time, during which the development of facilities for doing business in RMB would be phased in at all the banks active in Hong Kong. At the end of 2000, two dozen branches of mainland banks were operating in Hong Kong (IMF 2002), and this might facilitate the rapid introduction of banking business denominated in RMB. Already in the ªrst half of 2002 there were hints from both the governor of the People’s Bank of China and from the HKMA that licensed banks in Hong Kong could begin to accept RMB deposits. These deposits would initially have to be hedged by RMB-denominated loans to clients on the mainland.

There are good reasons to think that, when given a choice between USD and RMB after the demise of the HKD, Hong Kong residents will retain much of their attach- ment to USD claims, so that much of the initial asset substitution will be from HKD to USD. However, much of what is broadly meant by currency substitution, including transactions balances at banks, will be from HKD to RMB. We base this judgment on the fact that only 13 percent of Hong Kong’s all-currencies M1 consisted of USD, whereas the percentage of USD in time and savings deposits, taken as the difference between M2 and M1, was almost 50 percent (47 percent) at the end of March 2003. Hence Hong Kong residents, just like residents of Argentina, prefer to invest their savings in USD claims but keep their transactions cash in local currency.11

11 We recently discovered that de la Torre, Yeyati, and Schmukler (2003) have independently concluded that a process similar to the one proposed here, that is, one of asset substitution into dollars but with transaction balances then increasingly attracted to a new local currency through “peso-iªcation at the margin,” might have provided a way out for Argentina before it plunged into the severe 2001–02 crisis that crushed its currency board and much else. In their proposal, regaining some degree of monetary and exchange rate ºexibility in a highly asset-dollarized system would be combined with an orderly amortization of currency board

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Once the HKD has disappeared through dollarization or dollar-indexed renminbization, loans denominated in the sole surviving Chinese currency are likely to be de- manded by Hong Kong applicants as well. The growth in renminbi-denominated assets and liabilities of Hong Kong banks would then occur at a market-determined pace to take advantage of any growing network externalities with mainland China, in which the yuan, and not the USD, is the dominant transactions currency. Hong Kong’s nonªnancial businesses, which account for most production and consump- tion activities, thus would eventually choose to settle current transactions predomi- nantly in the uniªed Chinese currency. This would be done for the convenience of customers and as a way to reduce currency risk, given the close economic integration of Hong Kong with the Chinese mainland, as noted above (see also Wan and Weisman 1999). International ªnancial business transactions in Hong Kong could continue to be conducted mainly in USD, as they are elsewhere in the world.

As estimated by Tsang (2001), even without legal tender status almost 40 percent of the total HKD issue appears to be held and used in mainland China, but mainly in the Pearl River Basin near Hong Kong. A more recent estimate by Peng and Shi (2003) is about half as large. Replacing HKD claims with USD or USD-indexed RMB claims would not give such claims any special status in mainland China, where USD claims in banks amount to only about 6 percent of M2. The uniªed Chinese currency would become legal tender in both mainland China and Hong Kong, but the achievement of full (or “total”) convertibility would allow open currency competition with the USD and perhaps other major currencies in demand as well. This would put competitive pressure on the uniªed Chinese currency, whether renamed or not, to develop its reputation and usefulness so as to expand its hold and to capi- talize on the network externalities available to it in China’s vast internal market. Successful inºation targeting would be an essential complement to letting the sole surviving Chinese currency ºoat against other major international currencies, whose ranks it would have joined.

Our suggested approach is likely to leave Hong Kong’s world-class international ªnancial business, which is now conducted mostly in USD, less disturbed than a forced exchange of HKDs for unindexed renminbi, which could be accom- plished, for instance, by making the renminbi legal tender for discharge of HKD-

obligations and respect for currency preferences. However, if the utility and viability of Hong Kong’s linked exchange rate system in recent years really came mainly from maintaining a ªxed exchange rate with the RMB, certain ofªcial statements notwithstanding (Yam 1998, point 17; Yam 1996), this imperative of an absolutely ªxed nominal exchange rate between Hong Kong and the mainland would be served most credibly by relinquishing the HKD.

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denominated obligations at a ªxed rate. In the latter event, the RMB would become the exclusive legal tender in all of China but with the dubious international reputation of being an inferior and centrally designated successor to HKD claims. The pro- spective real value of such claims, and the usefulness of the RMB denomination in international trade and ªnance, would be thrown into doubt. The net effect would be to betray the trust engendered by Hong Kong’s linked exchange rate system, to the detriment of the international reputation of the RMB and of the governance of its ªnancial system.

5. Conclusion

Chinese monetary uniªcation and the way it is achieved will determine whether there will be an international Chinese currency in the not-too-distant future. This currency could come to serve as one of the pillars of an East Asian monetary union, including Japan, or it could continue to exist on its own, with perhaps some unilateral accessions from the region. Although there may be political imponderables, Tai- wan, Singapore, and Malaysia could perhaps become interested in such a unilateral monetary union with China on economic grounds, and other subgroups can be en- visaged also (Ling 2001; Bayoumi and Mauro 2001). Most importantly, however, if Chinese monetary uniªcation is achieved without selective expropriation and without preventing currency competition (particularly from the USD), it may lay the foundation for an international currency that can ºoat safely against all the other major currencies. Indeed, the temptation to take less than fully hedged positions in USD liabilities or to be negligent in assessing counterparty risk of those who owe USD to their creditors becomes especially strong if the de facto USD peg of the RMB is expected to continue.

A second major international currency, and not an East Asian dollar standard, thus needs to crystallize in East Asia before there can be only one such currency through monetary union in the region. The main obstacle to such a development is the unresolved bankruptcies in the mainland Chinese banking system, in which nonper- forming loans until recent years accounted for nearly 40 percent of the book value of loan assets.12 Placing Hong Kong’s sound ªnancial institutions and the mainland’s unsound ªnancial institutions in direct cross-border competition could produce a ªnancial variant of Gresham’s Law, as the bad system undercuts the good system. In this regard, waiting until all the conditions are right for CMU may not be real- istic. Speculative attacks and currency crises will not wait. The externally anchored

12 Zhu (1999) lays out some of the unresolved problems of China’s banking and ªnancial system.

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(i.e., USD-linked) ªxed exchange rate system between the HKD and the RMB inside China could disintegrate at almost any time as a result of a collapse of Hong Kong’s currency board arrangement (CBA) or as a consequence of an appreciable change in the USD value of the RMB that cannot be mimicked by an equal-percentage change in the USD value of the HKD. Hence Hong Kong, rather than contemplat- ing its past blessings under the linked exchange rate system, needs to become pro- active while following the logic of Chinese development and regional integration. Otherwise, its next monetary and exchange arrangement will be forced upon it by crisis.

There may not be enough time to complete the loan workout for the mostly government-owned ªnancial system of mainland China before pressure to revalue RMB proves overwhelming. In that case, a monetary union between Hong Kong and China may have to precede the emergence of the RMB as an international currency, rather than give birth to such a currency. Even then, the most important principle to follow is to convert HKD claims and obligations to USD- or to RMB-denominated claims that are indexed to the RMB/USD exchange rate, before the CBA is destroyed or the RMB/USD ªx is abandoned. This conversion cannot be achieved if China waits until pressures on the current rates (7.8 HKD/USD and/or 8.28 RMB/USD) have become impossible to resist. Hence moving toward CMU, even if imperfectly, cannot safely be deferred lest the terms of the union needlessly destroy some of the wealth of Hong Kong residents (and other users of HKD) under the pressure of events that may well turn into crisis. Argentina’s experience from 1991 to 2002 has shown that an “unnatural” and distant U.S.-dollar-based CBA, if left alone to its own devices, is a Faustian bargain that delivers good times for a good number of years in return for a catastrophic ending down the road. Reasonably safe exits are available only during good times and thus get passed up politically, giving the devil a chance to get his due in the end.

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