banking system could be controlled in two ways by the Exchange Fund. First, Exchange Fund reserves could be used for direct manipulation of the foreign exchange market. Second, the Exchange Fund could take loans from or make them directly in the interbank funds market. These measures were adopted by the Hong Kong government as steps aimed at controlling escalating credit and money creation. Still, these measures proved largely ineffective and Chiu (2) notes that the government “mainly resorted to moral suasion to influence retail deposit rates set by the Hong Kong Association of Banks (HKAB) which were adjusted upwards eight times in 1980 and 1981.”
Linking the exchange rate to the U.S. dollar made sense because the U.S. is one of Hong Kong’s largest trading partners, and the U.S. dollar is the foremost international currency in markets that make up a significant amount of Hong Kong trade. In the late 1980s, the U.S. dollar depreciated sharply. Many speculated that Hong Kong would revalue its currency, but in order to maintain the stability and credibility of the peg, the Exchange Fund intervened in the foreign exchange and money markets trying to absorb the overflow of U.S. dollars. Neither of these measures proved very effective, and the inadequacies of the economic structure were shown in 1987 and 1988 when “massive speculation inflow exerted significant strengthening pressure on the Hong Kong dollar” (Chiu 6). The government was able to thwart this speculation, but it clearly demonstrated the need for basic finance and economic reforms.
Ironically, this crisis put into motion the making of technical changes that would eventually serve to undermine the currency board. These technical changes basically amounted to an increase in discretionary power for the Exchange Fund. Beginning in 1988, a series of reforms were undertaken that included three categories: (1) tightening the discipline in the management ...