Hong Kong's International Financial Centre: Retrospect and Prospect

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during emergencies, but these usually passed quickly. 33 They may not like all of the consequences thereby implied, but great and less-great powers have typically found themselves unwilling to bear for long the costs of alternative choices. For most, embracing capital mobility has also meant accepting exchange rate and interest rate flexibility. One alternative choice under conditions of capital mobility is rigidly to peg an exchange rate and give up control over domestic monetary policy. This was Hong Kong’s choice in 1935, when it abandoned the silver standard and pegged the HK dollar to the pound sterling at a rate of 16 to 1. It was also its choice in 1967 when it repegged to the pound, and again in 1972 when it pegged loosely to the US dollar. In 1983, it moved decisively to the present system, which links the HK dollar tightly to the US dollar through a currency board arrangement. This exchange rate system carried Hong Kong through a turbulent period in its history. As noted above and discussed further below, it was tested severely in 1998, and it survived. Although there are opportunity costs involved and economists can argue about them, the historical facts suggest a broad political consensus within Hong Kong, one not unlike the consensus apparent in smaller countries joining the Economic and Monetary Union in Europe. If the choice is between giving up the freedom to move capital in and out of Hong Kong and giving up the ability to set domestic interest rates autonomously, then the latter choice is preferred. In the case of Hong Kong, the specific policy instrument needed to maintain that choice and to some extent to buffer the negative effects of a passive monetary policy is a very large pool of foreign currency reserves, the Exchange Fund. At a deeper level, the link and the Exchange Fund worked together to help preserve another kind of autonomy. Both before and after July 1, 1997, when Hong Kong became a Special Administrative Region of the People’s Republic of China, the arrangement gave Hong Kong’s government room for maneuver vis-à-vis the Mainland. It did so, not least by providing to foreign and domestic investors confidence in Hong Kong’s markets, even as those markets continued the long process of integration with Mainland markets. Shanghai’s restoration as China’s main national financial centre, and its longer term chances of regaining its place as the region’s international financial centre seems like a reasonable bet in the long run. Who knows when that day will arrive? Whenever it gets close, it will likely pose a distinct challenge for Hong Kong. If and when that day draws near, Hong Kong will already have switched its peg to the RMB or simply adopted the RMB as its home currency. How else could it flourish in such changed circumstances? Perhaps then it will take its place as a regional but still important financial centre within greater China. Until complete convertibility arrives, however, participants in Hong Kong’s financial markets will retain opportunities for arbitrage between two still-distinct systems. For its part, the Mainland will at the same time retain a most convenient channel for sending capital out, not least to ameliorate associated political pressures, and for bringing it back in as circumstances warrant. 33 John Goodman and Louis Pauly, “The Obsolescence of Capital Controls? Economic Management in an Age of Global Markets,” World Politics, vol. 46, no. 1, October 1993, pp. 50-82. 42
In this regard, it is entirely possible that reformist decisionmakers in Beijing may be stymied in their efforts to accelerate the process of RMB convertibility in the near to medium term. Internal and external developments might conspire to push the point of no return in China’s financial and capital markets into the distant future. Either way, a relatively autonomous Hong Kong stands to gain during the interim period until the RMB is fully convertible. After that, the game changes fundamentally. But the retention of a degree of autonomy differently conceived may even then give a prosperous Hong Kong and its financial centre a privileged place within greater China. To that possibility, we return after looking in more depth at the current strengths of Hong Kong financial service sector. 43
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Hong Kong's International Financial Centre: Retrospect and Prospect

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