Policy Discussion PaperNo. 0031

Adelaide University• Adelaide • SA 5005 • Australia

THE VANISHING INTERMEDIATE REGIME ANDTHE TALE OF TWO CITIES:

HONG KONG VERSUS SINGAPORE

Ramkishen S. Rajan and Reza Siregar

July 2000

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CIES POLICY DISCUSSION PAPER 0031

THE VANISHING INTERMEDIATE REGIME

AND THE TALE OF TWO CITIES:

HONG KONG VERSUS SINGAPORE

Ramkishen S. Rajan* and Reza Siregar**

*Centre for International Economic Studies,School of Economics,Adelaide University,

South Australia 5005, Australiaand

Institute of Southeast Asian Studies, Singapore.E-mail: ramkishen.rajan@adelaide.edu.au

** Department of Economics,National University of Singapore,

Block AS2, 1 Arts Link,Singapore 117570

E-mail: ecsrys@nus.edu.sg

July 2000

________________________________________________________________________This paper draws partly on joint work by the first author with Graham Bird and the secondauthor with Choo Lay Har and Christopher Walker. The authors are grateful for their insights.The usual disclaimer applies.

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THE VANISHING INTERMEDIATE REGIME AND THE TALE OF TWOCITIES: HONG KONG VERSUS SINGAPORE

Abstract

Following the East Asian crisis, some prominent economistshave advocated that small and open economies in Asia adopt anirrevocably fixed regime. Such a hard peg, it is argued, signals greatercommitment to rule out arbitrary exchange rate adjustments as wellas the authorities� willingness to subordinate domestic policyobjectives such as output and employment growth to the maintenanceof the pegged exchange rate. But is this a reasonable position toadopt? In order to answer this question, we consider and contrast theexperiences of Hong Kong and Singapore. While both of theseeconomies share a number of similarities, the former operates a USdollar-linked currency board regime and the latter maintains anadjustable peg in the form of a monitoring band arrangement with thecentral parity based on a trade-weighted currency basket

Key Words: currency baskets, exchange rate regimes,fixed regimes, floating regime, Hong Kong,Singapore

JEL Classification:F31, F33, F41

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1. INTRODUCTION

The recent crises in developing economies in Asia and elsewhere have raised a number of

theoretical issues and puzzles, many of which have important implications for economic policy. One

of the most important is the question of what the appropriate exchange rate regime for small and

open economies is. The seeming frequency with which �soft pegs� have been broken has led to the

growing belief that developing economies must adopt corner solutions to exchange rates

arrangements (CFR, 1999 and IFIAC, 2000). In other words, it is argued that the only viable

exchange rate option for such economies is flexibility, on the one hand, or credible pegging, on the

other. A �credible peg� or �super fix� in turn refers to one of three possibilities: a currency board

arrangement, effectively abandoning the domestic currency for a new currency (monetary union),

or using domestically the currency of another country (dollarisation or eurorisation). This

recommendation has come to be referred to as the �vanishing intermediate regime�1.

1 Other adjectives used include the �missing / excluded middle�, �death of the middle-of-the-road regimes�or the hallowing effect�.

The official exchange rate classification by IMF suggests a sharp trend away from the

intermediate arrangements (non-credible pegs) and towards floating regimes in particular (Table 1).

However, Calvo and Reinhart (2000b) and Levy-Yeyati and Strurzenegger (1999) separately show

that, in most cases, countries that proclaim themselves as having flexible exchange rates (based on

3

de jure IMF classification) in fact operate �soft pegs� or ��adjustable pegs� in practice. Calvo and

Reinhart (2000b) go on to conclude that there is an acute and widespread �fear of floating� among

developing and even some developed countries. Calvo and Reinhart (2000a) and Reinhart (2000)

find that floating in developing countries in general has been limited to short time spans immediately

following currency crises or hyperinflationary episodes. This ought not to be surprising in view of

the well-documented problems with a floating regime.

Specifically, there is a near consensus that countries with flexible regimes have experienced

�excessive� volatility over the last few decades with consequent negative impacts on trade,

investment and growth (Bird and Rajan, forthcoming). Even in the absence of a negative effect on

the level of investment, insofar as flexible regimes have commonly been associated with currency

misalignments, a flexible regime could have an adverse influence over the composition of investment

as decisions may be based on disequilibrium prices (Williamson, 1999).

In view of this there has been growing enthusiasm for the irrevocably fixed corner solution.

While Eichengreen (1999a) has concluded that a single, regional currency zone may be the most

attractive option for small and open economies, but such an option is politically � if not

economically � non-viable in East Asia anytime in the near future (Bayoumi and Eichengreen,

1999a,b). Of course, countries could unilaterally abandon the domestic currency altogether by using

domestically the currency of another country. Indeed, Hausmann (1999) has argued that developing

countries in Latin America should form a monetary union with the US, or more specifically, they

should abandon their respective national currencies in favour of the US dollar (dollarisation). While

such a policy may well have merit in Latin America, the relatively low levels of dollarisation in

Southeast Asian (compared with Latin America), on the one hand, and the economically significant

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role played by Japan and the yen in Southeast and the larger East Asia, on the other, implies that

dollarisation (let alone eurorisation or yenisation) is not a serious option for this region. Additionally,

political compulsions may preclude the adoption of such a policy no matter what the cost-benefit

calculus (national moneys often being seen as a symbol of national sovereignty).

For proponents of corner solutions, this therefore seems to leave a currency board as the sole

option. For instance, in strongly advocating a currency board solution for developing economies,

Dornbusch (1999) states that

(n)ational central banks have been key players in creating thefinancial vulnerability that was the back drop of the crises of the pastfew year….There are few advantages to national money and none toa mismanaged one…But there is a genuine problem of what do withAsia…(J)ust pegging..(to)..the dollar may be a…solution - assuggested by Hong Kong, than mismanaged pegs or ad hoc policies.

Such a hard peg, which is transparent and verifiable (Frankel et al., 2000), is supposed to

signal greater commitment to rule out arbitrary exchange rate adjustments (i.e. the escape clause

cannot be invoked) along with the authorities� willingness to subordinate domestic policy objectives

such as output and employment growth to the maintenance of the pegged exchange rate. But is this

a reasonable position to adopt? Would Asian economies be well advised to follow this policy

recommendation?

In order to answer these questions, we consider the experiences of Hong Kong and Singapore

during the period of 1983/1984 to 1999. The choice of these two economies is dictated by the fact

that both of them are small and open ones, are regional financial centers with broadly similar

economic structures and with strong regional links (trade and investment), and are seen as having

the soundest �fundamentals� in the region. These similarities imply that economies are exposed to

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relatively similar external shocks, including the contagious fallout from the recent East Asian

financial crisis of 1997-98. Despite these commonalties, Singapore has pursued a soft peg based on

a trade-weighted currency basket while the Hong Kong dollar is rigidly pegged to the US dollar via

a currency board arrangement. This is despite both economies possessing fairly high degrees of

internal flexibility. With these two economies, we therefore have a rare opportunity to undertake as

close to a controlled laboratory experiment as one could hope for in real world international

macroeconomics.

The remainder of this paper is organised as follows. The next section briefly reviews the

exchange rate policies and macroeconomic performances of Hong Kong and Singapore, as well as

highlights trends in effective exchange rates and export competitiveness in the two economies.

Section 3 briefly discusses the concept of the Natural Equilibrium Real Exchange Rate (NATREX)

developed by Stein (1994, 1996), focusing specifically on the operationalisation of the concept.

Section 4 then goes on to estimate the real equilibrium exchange rate for both currencies, an issue

that is of particular importance to developing countries (Dornbusch, 1988 and Edwards, 2000). In

particular, we attempt to ascertain whether there is any evidence of misalignment in the two

currencies. We also attempt to answer the more general question as to whether Hong Kong�s

currency board regime has �outperformed� the non-rules based intermediate regime pursued by

Singapore over the last two decades as advocates of such a corner solution would have us believe.

The final section concludes the paper with an extended discussion of the costs and benefits of the

exchange rate arrangements of the two economies and the policy options and implications thereof.

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2. EXCHANGE RATE ARRANGEMENTS IN HONG KONG AND SINGAPORE

2.1 The Hong Kong Currency Board

Hong Kong adopted the currency board system in October 17, 1983. Since then, the Hong

Kong dollar has been fixed at the nominal rate of 1 US dollar = 7.80 Hong Kong dollars. A one

percent bandwidth regulates the fluctuation of the nominal rate of HK dollar against the US dollar.

During the initial period of present currency board system, the Hong Kong monetary authority

(HKMA) was, by and large, passively following the automatic adjustment mechanism of the

currency board. However, since 1988, Hong Kong has been characterised as having moved from a

�rule-bound regime� to a �new regime in which active discretionary interventions were pursued�

(Kwan et al., 1999). This is so as the HKMA introduced several new key monetary instruments

which allowed the policy makers the opportunity to engage in more discretionary intervention in the

money and foreign exchange markets (Kwan et al., 1999).

2.2 Singapore’s Managed Float

The Monetary Authority of Singapore (MAS) manages the Singapore dollar against a basket of

currencies of Singapore�s main trading partners and competitors2. The central parity/level is determined

in the basis of countries that are the main sources of imported inflation and competition in export

markets. Estimates of derived weights suggest that the US dollar had a weight of about 0.6, the

remainder being divided between the yen and other currencies (Table 2). The Singapore dollar is

allowed to float within an undisclosed target band around the computed central parity. Neither the

2 See Lu and Yu (1999) for a discussion of the historical background, evolution and institutional arrangementssupporting Singapore�s managed exchange rate regime.

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central parity nor the bandwidth is completely fixed, being periodically reviewed so as to ensure that

they are �consistent with economics fundamentals and market conditions�. In effect, the MAS seems

to have adopted a �monitoring band� as opposed to a more conventional �crawling band�, in which

there is an obligation to defend the edges of the band. The obligation in the case of a monitoring band

is �instead to avoid intervening within the band� (notwithstanding intermittent intervention to �smooth

out� exchange rate fluctuations as opposed to trying to defend the currency) (Williamson, 1998).

To illustrate the degree of flexibility - of the Singapore exchange rate policy, the MAS

allowed the Singapore dollar to depreciate by about 20 percent during the height of the East Asian

crisis; while more recently, it is suspected to have intervened heavily in the market to prop up the

Singapore dollar during the bearishness against regional currencies following sharp falls in the

NASDAQ (The Straits Times, May 12, 2000). Admittedly, this sort of monitoring band may be

interpreted by some as being no different from a dirty floating regime. However, unlike a floating

regime, with a monitoring band, the threat of possible intervention by the monetary authority may

suffice to reduce speculative attacks. The point of a monitoring band (or a crawling band with soft

edges) is that if the authority decides that market pressures are overwhelming, it can choose to allow

the rate to take the strain even if this involves the rate going outside the band (Williamson, 1998).

Throughout the 1980s and 1990s as a whole, the Singapore�s adjustable peg regime has been

complemented by a policy of steady appreciation of the Singapore dollar against a basket of major

trading partner currencies so as to contain domestic cost pressures (Lu and Yu, 1999). The key

objective has been to insulate the domestic economy from the imported inflation. The appreciating

trend was most clearly visible after 1986-87 (Figure 2).

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2.2 Comparative Macroeconomic Performance, 1984 to 1998

Table 3 summarises some key macroeconomic indicators in Hong Kong and Singapore for

the period between 1984 and 1998. As can be seen, while both economies have had comparably low

unemployment rates, Singapore has, since the 1990s, consistently outperformed Hong Kong, both

in terms of having experienced faster economic growth rates and lower rates of inflation. The

differences in economic performances were particularly stark in the midst of the regional financial

crisis. Open unemployment did rise in both economies in 1998. However, while Hong Kong�s GDP

fell by 5 percent (as opposed to an average of over 5 percent growth in the 1990s), Singapore was

one of the few economies in East Asia to have achieved a positive growth of 0.5 percent that year

(though this was sharply down from an average growth of almost 9 percent throughout the 1990s).

2.3 Trends in Effective Exchange Rates and Export Competitiveness

Figures 1 and 2 show close co-movements in the real effective exchange rate (REER) and

nominal effective exchange rate (NEER) series for both economies. As can be seen, Hong Kong has

on average experienced a stronger appreciation of the REER than the NEER. In contrast, in

Singapore, the REER�s appreciation was outpaced by that of the NEER3. Based on these trends one

might have expected Hong Kong�s export performance to lag behind that of Singapore�s. In fact,

overall export performance remained strong in both economies, growing at an average annual rate

of 10.5 percent for Hong Kong and 11.4 percent for Singapore since early 1980's (Figure 3 and 4).

However, when we decompose the overall exports into its two components of domestic exports and

3 An increasing trend in the REER and NEER implies an appreciation of the domestic currency. A strongerappreciation of the REER than the NEER implies that the domestic price level is rising faster than the prices

9

re-exports, a contrasting trend emerges. Most of Hong Kong�s exports were attributed to re-exports,

particularly since 1990. The growth rate of domestic exports stagnated between the period of 1990

and 1995 and has declined since 1996. The rapid appreciation of Hong Kong�s REER did in fact lead

to a steady erosion in the competitiveness of its domestic exports, especially between 1988 and 1997.

In the case of Singapore, both domestic exports and re-exports contributed to the overall impressive

performance of overall exports.

3. THE NATREX MODEL

While the preceding discussion of trends in effective exchange rates is indicative, it is

insufficient. To evaluate conclusively performance of the two exchange rate regimes, it is important

to determine the respective consistency of the observed REERs of the two currencies against the

underlying macroeconomic fundamentals of the respective economies. As noted by Edwards (2000)

(e)xchange rate overvaluation is very costly, and has been at the heartof most recent currency crises. Defining effective methodologies todetermine the presence of overvaluation is essential (p.2).

In other words, we need to ascertain some sort of �equilibrium benchmark� such that any deviations

from that equilibrium rate at any point of time would be considered as evidence of currency�s

misalignment. To do so, we appeal to the concept of a Natural Equilibrium Real Exchange Rate

(NATREX) model developed by Jerome Stein (1994, 1996).

The NATREX is the rate that is determined by the prevailing real economic fundamentals

in the economy. The NATREX model does not require us to assume any prior level of equilibrium

exchange rate as a benchmark to estimate the misalignment of the currency. As Stein and Paladino

of the major trading partner countries.

10

(1998) have emphasised, the NATREX model

is directly amenable to empirical testing, without making anysubjective judgments of what is: anticipated or unanticipated,permanent or transitory changes. It is based upon the attempt ofmicro agents, who make independent saving, investment, importand export decisions, to optimise when they know that there issignificant uncertainty..The NATREX model is positive notnormative..(it)..is precisely the real exchange rate associated withboth internal and external balance (pp.1688-89 & 1712).

Since Stein (1994, 1996), Stein and Paladino (1998) and others since have extensively

discussed the theoretical background of the NATREX model, we focus instead on a general

working model of the concept (see Appendix A). This study closely examines quarterly

movements of the two currencies during the period of 1983 to 1999. More specifically, the

period of analysis for Singapore is Q1:1983 to Q3:1999. In order to limit any endogenous

problems in our evaluation due to the initial stage of the currency board system in Hong Kong,

we exclude the turbulent transition period of 1983 when the currency board system was

established (having replaced a floating regime). Thus, for Hong Kong, the period under study

is Q1:1984 to Q3:1999. Importantly, this time period encompasses the East Asian financial

crisis of 1997. We further divide the observations into two sub-periods - pre-1990 and post-

1990. This allows us to evaluate whether the post-1990 period, which corresponded to the

more discretionary intervention period in Hong Kong, was indeed associated with more severe

misalignment.

3.1 Single Equation Estimation

The NATREX model does not require that the observed REER and the real equilibrium

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rate be stationary. In fact, the NATREX will vary through time depending on the changes in

the underlying fundamentals. In other words, it is a moving equilibrium exchange rate - a

complete contrast from the underlying hypothesis of the PPP model, for instance (Edwards,

2000 and Edwards and Savastano, 1999).

The NATREX approach starts with the assumption that there is a vector of fundamentals

(z) which determines an economy�s NATREX or equilibrium real exchange rate (ERER):

The small letters represent natural logs. For Hong Kong, these fundamentals are {gHK, r*,

prdHK, totHK}, where g is real government spending, r* is world real interest rate, prd is

productivity, tot is terms of trade. For Singapore, zt includes {gS, r*, kS, totS}. The descriptions

of the variables are the same as for Singapore, except for k (capital stock)4. Data limitations

preclude an estimation of capital stock levels for Singapore and productivity levels for Hong

Kong for the entire observation period. To address this problem, we follow Montiel (1997) in

introducing time trends (t) to capture the effects of missing fundamentals.

Since the erer is not observable, we estimate the following two sets of equations5:

4 This set of variables has frequently been identified in the literature as the exogenous fundamentaldeterminants of real exchange rate movements in small and open economies (Stein, 1994, 1996,Edwards, 2000 and Edwards and Savastano, 1999).

5 Such single equation econometric models are commonly used in the literature on thedetermination of equilibrium real exchange rates (Edwards and Savastano, 1999 and Edwards,2000).

(1) HongKong. , Singapore= i );zf( = erer it

it

(3) _ + t + pol + tot + prdsupS + r + g + = reer 2t6S

t5S

t4t3*

t2S

t10S

t βββββββ

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where: reer is a natural log of observable real effective exchange rate. A dummy variable pol

is also introduced for Singapore to capture the policy shift from a steady nominal depreciation

managed floating to a gradual nominal appreciation policy in early 1986 as discussed in the

previous section. Eqs. 2 and 3 seek the best fit of the REER on the economies� relevant

exogenous economic fundamentals. We construct the equilibrium effective exchange rate for

each economy�s currency using the coefficient estimates obtained from regressing the above

two equations (α and β).

3.2 Coefficient Estimates: What Theory Tells us

It is important to briefly highlight the prior signs of the coefficients to be expected

based on the theoretical literature.

Government Expenditure (g): Following Obstfeld and Rogoff (1996), we assume that

government expenditure is disproportionately devoted to nontradables. As g rises, the relative

demand for nontradables also goes up, triggering an increase in price of nontradables or a real

appreciation, i.e. α1 > 0, β1 > 0.

World Real Interest Rate (r*): International interest rate arbitrage implies that when

the return for foreign currency dominated assets (r*) exceeds local currency dominated assets

(r), investors shift their portfolios away from local assets to foreign assets, i.e. α2 < 0 and β2

< 0.

Productivity (prd): An increase in productivity is expected to appreciate the domestic

currency via the Balassa-Samuelson condition, i.e. β3 > 0.

(2) _ + t + tot + k + r + g + = reer 1t6HK

t4HK

t3*

t2HK

t10HK

t βααααα

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Capital Stock (k): We assume that capital is channelled primarily to the tradables

sector, an assumption which is appropriate for open economies like Hong Kong and Singapore.

Thus, an increase in capital stock should increase labour productivity in the tradables sector,

translating into a fall in the price of tradables vis-à-vis nontradables, i.e. α3 > 0.

Terms of Trade (tot): An improvement in the terms of trade will cause a capital inflow

into the tradable sector. As discussed above, this implies that β4 (α4) > 0.

4. EMPIRICS

The data sources used in this study is presented in Table 4. We conduct three stages

of sequential tests. The first is the Unit Root test. If the variables are all found to be integrated

of order 1 (I(1)), the Johansen Cointegration test will be applied to check for existence of

cointegration relationship(s) among all variables in Equation 2 and 3. Having estimated the

erer, we conduct another unit root test to evaluate the stability of REERs of the two

economies.

4.1. The Unit Root Test

To determine the order of integration of each variable, we use the standard ADF

regression:

where: Y = {reerS,

reerHK , totS, totHK, gS, gHK, r*, prdS, polS and kHK}, with all variables in logs, and t denotes a

time trend. The ADF test reveals all the variables to be integrated of order 1 (Table 5). The

(4) _ + Y + t + Y + = Y tt1ik=1i2t110t ∆�∆ αβββ

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Akaike Criteria test determines the appropriate number of lag periods. However, given the

potential presence of structural breaks in many time series variables, the low power of ADF

test may not be sensitive enough to differentiate a stationary series from one that is non-

stationary.

To evaluate the unit root property more structurally, we apply the next set of tests

introduced by Banerjee, Lumsdaine and Stock (1992) - henceforth BLS - who provide a more

in-depth investigation of the possibility that aggregate economic time series can be

characterized as being stationary around �a single or multiple structural breaks�. BLS do so

by extending the Dickey-Fuller t test by constructing the time series of rollingly computed

estimators and their t statistics. Following BLS, we compute the smallest (minimal) and the

largest (maximal) Dickey-Fuller t test statistics from the rolling test, both of which are

compared to their respective critical values (Table 6). Both the minimal and maximal Dickey-

Fuller t test statistics of the BLS rolling test are found to be significantly larger than each

respective critical value. These test results confirm the findings of the ADF tests that the null

hypothesis of nonstationarity at the 5 percent critical value cannot be rejected for all the key

variables6.

4.2 Johansen Maximum Likelihood-Cointegration Test

Given all variables are I(1), we next conduct the Johansen cointegration test procedures

6 The BLS rolling unit root test results at the first difference for all variables are found to be significantlysmaller than their respective 5 percent critical values. Hence all variables are found to be I(1),confirming the ADF test-results. The trend (t) and dummy variable for Singapore (pol) were not

15

on both single equation models (Eqs. 2 and 3). The trace statistics (likelihood-ratio) indicate

that there is one cointegrating relationship (significant at 5 percent level) in each of the single

equation models (Table 7 and 8). More importantly, all fundamental variables for both Hong

Kong and Singapore have significant and theoretically consistent coefficient estimates.

included in this test.

We next construct the erer series by using the estimate coefficients. Figures 5 and 6

plot the fundamentally derived equilibrium exchange rates for the two currencies (hkerer and

sgerer) against observed real effective equilibrium exchange rates (hkrer and sgrer). Those

figures clearly show growing degrees of misalignments in the Hong Kong dollar, particularly

during the period of 1987 to 1997. Figure 7 fortifies this conclusion. The Hong Kong dollar

experienced a persistent undervaluation between 1992 and 1996/1997, becoming overvalued

post-crisis (Figure 6). In contrast, the Singapore dollar only became undervalued during the

recent crisis, having experienced years of fundamentally consistent REERs before that (Figure

5).

4.3 Testing for Stability in the Real Exchange Rate Series

We apply the following standard criterion as a condition for judging the stability of

Hong Kong�s real exchange rate regime:

(5) I(0) is _such that ,_ = erer - rer tttt

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That is, for the real exchange rate to be stable, its misalignment (captured by εt ) from the

equilibrium rate must be stationary. The ADF-unit root test is applied to εt (eq. 5)7. We divide

the observations into two sub-periods - 1980s (Q1:1984 to Q4:1991) and 1990s (Q1:1991 to

Q3:1999). As with all regional economies, Hong Kong and Singapore experienced far more

intense infusion of capital (especially portfolio capital) in the latter period (Kwan et al., 1999).

This two-period analysis also allows us to evaluate the implications of the more discretionary

policy interventions in the financial and exchange rate market taken by HKMA in the 1990s.

Contrasting trends once again emerge (Table 9). We find the Hong Kong dollar to have

been a stable currency in 1980s, but not in the 1990s. The null hypothesis of nonstationarity

can be rejected in the 1980s but not for the 1990s. In contrast, the results for Singapore

indicate a stable Singapore dollar in the last decade.

5. CONCLUSION AND POLICY IMPLICATIONS

The foregoing empirical analysis indicates that the monitoring band mechanism

accompanied by a policy of gradual nominal exchange rate appreciation has been relatively

successful in insulating the Singapore economy from foreign price shocks and in maintaining

a real effective exchange rate that has been consistent with the economy�s underlying

macroeconomic fundamentals. The currency was modestly undervalued but generally stable

for most of the 1990s. In the spirit of the monitoring band (Williamson, 1998), the Singapore

dollar was allowed to float during the midst of the crisis and particularly after the devaluation

7 Since we break the observations into several periods, the sub-sample set is too small for the BLS unit-root test.

17

of the Taiwanese currency, which was an important export competitor. Against the backdrop

of the spate of devaluations of the regional currencies, the Singapore dollar promptly

depreciated by 20 percent. This expenditure-switching policy was matched by draconian and

credible expenditure-reducing ones, hence ensuring relatively stable domestic prices8.

Consequently, the nominal depreciation was translated into an undervalued real effective rate

as suggested by the NATREX model.

What about Hong Kong�s experience? Starting from the late 1980s to 1991, its REER

stayed closely aligned to its equilibrium rate. Between 1990 and 1995, Hong Kong�s average

inflation rose to an average of more than 9 percent. In an attempt to control these inflationary

pressures, the HKMA raised the key domestic interest rate independently of the US Federal

Reserve in May 1991. Given the currency board arrangement, the positive interest rate spread

offered in Hong Kong over mature markets in the US led to massive capital inflows until

1996/97. A large portion of the new capital was absorbed by the property sector. This over-

investment in the real estate fuelled a property bubble (as in the case of Thailand, the first

economy to be affected by the regional crisis)9. The independent policy measure taken by the

HKMA in 1991 was part of the �more discretionary policy interventions� actively pursued

since the late 1980s (Kwan et al., 1999). The less transparent and more independent policies

were in turn at least partly responsible for the growing misalignments in the 1990s. This

reflected the fundamental cost of conducting independent monetary policies simultaneously

8 Ngiam (2000) details the economic policies undertaken by the Singapore government in response tothe regional crisis.

9 Surge in funds from mainland China in the run up of the handover of the colony to Chinese ruleintensified the financial bubble in Hong Kong.

18

with a currency board regime. This policy inconsistency contributed to a worsening in the

overall macroeconomic performance of the economy (Table 3). The problems were

exacerbated during the regional crisis as the currency�s rigid peg to the US dollar led to an

overvaluation of the Hong Kong dollar from the second quarter of 1997. This consequently

motivated a speculative attack on the currency soon after the devaluation of the Taiwanese and

Singapore currencies.

It is against this background that we conclude that the more flexible intermediate

exchange rate regime in Singapore �has outperformed� the currency board system in Hong

Kong in general, and particularly in the last decade when a series of external shocks hit the

regional economies. This seems to support the analyses by Rajan (2000) and Williamson

(1998, 1999) who argue that, in a world of generalised floating among major currencies, the

most feasible and desirable alternative for small and open economies in Asia in the relatively

near and medium terms may be a genuine currency basket arrangement, so as to insulate the

economy from cross-rate variations10.

On the one hand, by pursuing such an arrangement, the countries may be able to

cushion their vulnerability to fluctuations in the currencies of its major economic partners, thus

limiting variations in the effective exchange rate. Such a system may be a way of trading off

the disciplinary and credibility benefits of a pegged regime with the flexibility of a floating

one. However, there is of course a Catch-22 involved with a currency board arrangement: an

economy faced with sharp external shock may require some degree of discretion to mitigate

10 Of course, if the major currency (US dollar, Japanese yen and euro) are managed within certain targetzones as sometimes suggested (by Fred Bergsten and others), there would be little difference between

19

the effects of these shocks. Failing this, there could be a build up of imbalances, consequently

making a currency ripe for a speculative attack. However, it is this very discretion that

undermines the credibility and concomitant benefits of a super fix. As noted, Hong Kong had

pursued such a discretionary policy in the 1990s, resulting in a sustained attack on the Hong

Kong dollar in the midst of the crisis, as agents understandably doubted the commitments of

the HKMA to the currency board arrangement (the resulting painful macroeconomic

consequences were highlighted in section 2). Indications are that Hong Kong has de-

emphasised discretion and returned to a rule-based regime since the crisis (i.e. post 1998)

(Kwan et al., 1999). While this reversion to �auto pilot� may help to shore up the credibility

of the arrangement, there is always the concern about the consequences of such inherent

external rigidity when the next external shock hits and the entire adjustment must take place

internally.

Does all of this imply therefore that Hong Kong would be well advised to forsake its

currency board regime in favour of a Singapore-type intermediate regime with more

flexibility? The preceding analysis seems to suggest a firm �yes�. However, this conclusion

would be premature, as we have not paid attention to a number of other issues.

First, the orchestration of an exit from a fixed exchange rate regime to a flexible one

is a difficult manoeuvre which could be destabilising (Eichengreen, 1999b and Eichengreen

et al., 1999). This issue is of particular relevance to Hong Kong as the authorities have

a single currency and multicurrency or basket currency arrangement.

20

invested a great deal of resources to rebuild confidence in the exchange regime following the

regional financial crisis. One cannot be sure if the end game is necessarily worth it11.

11 In fact, the Singapore experience of exit from a hard peg has been held up as a role model of sorts forhow other economies could successfully exit their pegs (Eichengreen, 1999).

Second, in the event that policy makers lack credibility and are not as immune to

political pressures, there is virtue in conducting macroeconomic policy under a rules-based

system (i.e. �disciplining device�). A currency board arrangement, which establishes a firm

link between base money supply and the stock in international reserves may discipline policy

makers and ensures policy transparency and thus credibility. In this regard, the worst regime

would seem to be a rule-based one which allows scope for policy makers to exercise

discretion. This of course undermines - if not completely negates - the advantages of a rule-

based regime.

Third, the primary aim of Hong Kong adopting the firm US dollar link in October 1983

was as an emergency measure to prevent the Hong Kong dollar collapsing in the midst of a

political row between China and Britain over the future of the economy in 1982-83. The Hong

Kong authorities may see political value in maintaining the exchange rate on �auto pilot�,

hence ensuring some degree of economic sovereignty from Mainland China. In other words,

there may be strong political reasons to maintain a super fix regime that may well outweigh

economic rationale that suggests otherwise. The deeds of the HKMA authorities seem to

concur with this thesis. The Hong Kong authorities have, during the height of the regional

21

financial crisis, been among the strongest proponents of moving towards intensified Asian

monetary coordination and cooperation, leading possibly to a full-fledged monetary union -

an alternative hard peg arrangement. This in turn could be interpreted as an attempted �escape

strategy� from the currency board arrangement due to the high costs of its operation.

22

APPENDIX A

THE NATREX MODEL IN BRIEF

The basic structural equations of the NATREX model are the followings.

S(k, F; Z, u) - I (k, y, R, r:Z, u) = CA (R, y, F, r:Z, u); u = 0, (A.1)

r + ρ(t) = r*; ρ(t) = E{∆R * [Z(t)]}, (A.2)

dF/dt = -A(R, y, F, r:Z, u) = L(R, k, F, r:Z), L = I - S, (A.3)

dK/dt = I (A.4)

where: R = real exchange rate; r = domestic real interest rate; r* = foreign real interest rate;

S = saving; I = investment; k = capital stock; F = foreign debt; CA = Current Account; y =

productivity; u = deviation of rate of capacity utilisation;_ρ(t) = risk premium; Z = the vector

of fundamental variables. This vector Z includes mainly real exogenous fundamental variables

explaining the movements of real exchange rate and current account variable.

Eq. (A.1) is the macroeconomic balance equation. It states that excess investment over

saving (I - S) equals to current account deficit. The equilibrium real exchange rate will adjust

to ensure that the current account deficit equals to investment (I) less saving (S). (I-S) > 0. Eq.

(A.2) is the uncovered interest rate parity model with Asymptotically Rational Expectation a

la Stein (1994). It is basically the portfolio balance equation. Eqs (A.3) and (A.4) capture the

changes in the foreign debt level and the investment level respectively over the period.

Thus, the NATREX model adds dynamic stock - flow interactions to the standard

macroeconomic approach balance model. Their inclusion of the dynamic equations allows the

NATREX to vary over time, reflecting the changes on the fundamental variables. In the

23

medium run, an economy may face a current account imbalance. In the long run, however, the

foreign debt and capital stabilise. What is important for the empirical application of the model

is to find the appropriate set of fundamental variables included in vector (Zt). For most

applications of the NATREX, the vector (Zt) includes the terms of trade, productivity variable,

world interest rate and saving/expenditure.

24

25

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28

Table 1: IMF Exchange Rate Classification (%)

Percent of Countries in the sample which were classified by the IMF as havinga:

Year Peg Limited Flexibility Managed Flexible

1970 97.2 0 0 2.8

1975 63.9 11.1 13.9 11.1

1980 38.9 5.6 47.2 8.3

1985 33.3 5.6 36.1 25.0

1990 19.4 13.9 30.6 36.1

1995 13.9 8.3 38.9 38.9

1999 11.1 11.1 33.3 44.5Note: a sample based on 154 exchange rate arrangementsSource: Calvo and Reinhart (2000a)

Table 2: Derived Currency Weight of Crisis-hit Southeast Asian Economies, 1979-1995

Frankel and Wei (1994)a Kwan (1995)b

Currency US dollar yen US dollar yen

Indonesian rupiah 0.95 0.16 0.99 0.00

Malaysian ringgit 0.78 0.07 0.84 0.04

Philippine Peso 1.07 -0.01 1.15 -0.24

Thai baht 0.91 0.05 0.82 0.11

Singapore dollar 0.75 0.13 0.64 0.11

Region-wide 0.93 0.07 0.95 0.00Note: a) based on weekly movements for the period January 1992 to May 1992

b) based on weekly movements for the period January 1991 to May 1995

29

Table 3: Selected Key Macroeconomic IndicatorsUnemployment (%)a GDP Growth (%) Inflation (%)b

HK SG HK SG HK SG

1984 - 1990 2.24 3.61 6.90 7.0 8.20 2.20

1991 - 1997 2.26 2.58 5.27 8.81 6.80 2.80

1997 2.48 2.45 5.15 8.80 5.80 1.40

1998 4.80 3.20 -5.00 0.50 2.40 0.50

Note: a Open Unemployment; b Annual Changes of GDP Deflator; HK: Hong Kong & SG: Singapore

Table 4: Data DescriptionsSingapore

Variable Description

ReerSG Real effective exchange rate of Singapore dollar against 23 trading partners. The source is(http://www.jpmorgan.com).

totSG Terms of Trade is calculated as direct price of export / direct price of import. The source isthe IFS, IMF (various years).

gSG Real government expenditure is derived by adjusting nominal government expenditure bythe country�s GDP deflator. The source is IFS, IMF (various years).

ProdSG Total factor productivity index is represented by GDP (gross domestic product) per capitadata-series. All information are obtained from Monthly Digest of Statistics, SingaporeDepartment of Statistics (various years).

polSG Policy dummy to capture the shift to a managed appreciation. The variable equals to onefrom quarter 1, 1983 to quarter 2, 1986. Otherwise, it is equal to zero.

Hong Kong

reerHK Real effective exchange rate of Hong Kong dollar against 23 trading partners. The source is(http://www.jpmorgan.com).

totHK Terms of Trade is calculated as unit value of export / unit value of import. The source is theIFS, IMF (various years).

gHK Real government expenditure is derived by adjusting nominal government expenditure bythe country�s GDP deflator. The source is IFS, IMF (various years).

kHK Capital Stock variable is calculated as Kt = It + (1- δ) Kt-1 . Variable I is the gross fixedcapital formation, obtained from HKMA Monthly Statistical Bulletin (various years). Tominimise the impact of the choice for initial capital stock (K0) on the usable series for K,

30

data I is selected from the period as far back as quarter 1, 1973. K0 (1973) is chosen so thatthe growth of capital for 1973-1984 would be highly correlated with the growth of outputduring that period.

Variables that are used in both the Singapore and Hong Kong models

r* World real interest rate. To derive the series, we subtracted the three month annualised USconsumer price index inflation from the three-month U.S. dollar LIBOR rate. The source isIFS, IMF (various years).

t Time trend (see Montiel 1997).

31

Table 5: ADF Unit - Root TestVariable Singapore Hong Kong

reer at level (1)*: -1.548AIC**: -7.8149

at first diff (1)*: -3.721AIC**: -7.8254

at level (1)*: -2.821AIC**: -7.173

at first diff (1)*: -4.057AIC**: -7.040

tot at level (2)*: -2.733AIC**: -7.176

at first diff (1)*: -6.609AIC**: -7.121

at level (5)*: -2.876AIC**: -6.278

at first diff (5)*: -8.312AIC**: -6.390

g at level (3)*: - 1.938AIC**: -3.097

at first diff (1)*: -6.606AIC**: -3.040

at level (1)*: -1.461AIC**: -4.289

at first diff (1)*: -7.978AIC**: -4.294

r* at level (1)*: - 1.7015AIC**: -4.3792

at first diff (1)*: -4.5629AIC**: -4.3741

at level (1)*: - 1.7015AIC**: -4.3792

at first diff (1)*: -4.5629AIC**: -4.3741

k at level (1)*: -2.305AIC**: -10.645

at first diff (1)*: -2.701AIC**: -10.573

prod at level (1)*: - 3.0896AIC**: -7.8859

at first diff (1)*: -9.9580AIC**: -8.2200

pol at level (1)*: -1.6638AIC**: -4.1589

at first diff (1)*: -5.8753AIC**: -4.1168

* ( ): number of lags; ** Akaike Information CriterionAll of these variables are found to be I(1) at 5% confidence level of significance

32

Table 6: Rolling Unit-Root Test

Variable Singapore Hong Kong

Maximum Minimum Maximum Minimum

tot -1.020 -3.900 -0.133 -1.770

g 0.217 -4.080 0.11 -1.56

prod 0.837 -0.410

k 0.19 -0.225

r* -0.850 -4.820 -0.850 -4.820

reer 2.030 -1.145 -0.080 -1.390

*Max tdf at 5% level for sample < 100: -1.49; **Min tdf at 5% level for sample < 100: -5.01

Table 7: Johansen Test Results for Singapore

----------------------------------------------------------------------------------------------------------------------------------Sample: 1983:1 1999:3 Included observations: 67Lags interval: 1 to 1

Likelihood 5 Percent 1 Percent HypothesisedEigenvalue Ratio Critical Value Critical Value No. of CE(s)

0.424710 122.1567 114.90 124.75 None * 0.406560 85.11373 87.31 96.58 At most 1 0.292111 50.15180 62.99 70.05 At most 2 0.239655 27.00540 42.44 48.45 At most 3 0.069638 8.648540 25.32 30.45 At most 4 0.055313 3.812376 12.25 16.26 At most 5*L.R. test indicates 1 cointegrating equation at 5% significance level

reer = -7.576 + 0.154 g - 0.066 r* + 1.441 prd + 0.519 tot - 0.261 pol - 0.012 t (0.053) (0.024) (0.246) (0.270) (0.035) (0.003)( ) are the standard errors.----------------------------------------------------------------------------------------------------------------------------------

33

Table 8: Johansen Test Results for Hong Kong----------------------------------------------------------------------------------------------------------------------------------Sample: 1984:1 1999:3Included observations: 61Lags interval: 1 to 1

Likelihood 5 Percent 1 Percent HypothesisedEigenvalue Ratio Critical Value Critical Value No. of CE(s) 0.447364 97.89492 87.31 96.58 None * 0.380961 61.71856 62.99 70.05 At most 1 0.312610 32.46373 42.44 48.45 At most 2 0.096796 9.597689 25.32 30.45 At most 3 0.054019 3.387473 12.25 16.26 At most 4* L.R. test indicates 1 cointegrating equation at 5% significance level.

reer = -25.31 + 0.378g - 0.144 r* + 1.421 k + 1.632 tot - 0.030 t (0.124) (0.064) (0.619) (0.535) (0.011)( ) are the standard errors.----------------------------------------------------------------------------------------------------------------

Table 9: ADF Unit-Root Test for (reer - erer)Country 1983/1984:01 - 1991:4* 1991:01 - 1999:03

Singapore: # of lags = 2; # of obs = 36(5% critical value: -3.5561)at the level:ADF t-stat = -2.9410AIC*** = -2.6780

at the first difference:ADF t-stat = -5.2016**AIC*** = -2.4655

# of lags = 2; # of obs = 35(5% critical value: -3.5426)at the level:ADF t-stat = -6.1612**AIC*** = -3.4382

Hong Kong: # of lags = 1; # of obs = 32(5% critical value: -3.5671)at the level:ADF t-stat = -4.1959AIC*** = -0.6820

# of lags = 1; # of obs = 35(5% critical value: -3.5791)at the level:ADF t-stat = -0.1367AIC*** = -2.6084

at the first difference:ADF t-stat = -3.6720AIC*** = -2.6100

* The period starts at quarter 1, 1984 for Hong Kong and at quarter 1, 1983 for Singapore.

34

** Significance at 5% level; *** AIC = Akaike Information Criterion.

35

For Figures (1&2): HKREER: Hong Kong Dollar Real Effective Exchange Rate; HKNEER:Hong Kong Dollar Nominal Effective Exchange Rate; SREER: Singapore Dollar NominalEffective Exchange Rate; SNEER: Singapore Dollar Nominal Effective Exchange Rate. Index1990 = 100. An increase in the curve implies an appreciation of the local currency againstaround 22 major trading partners� currencies. Sources of the data are JP-Morgan�s Web-Page

and Choo Lay Har (2000).

Figure 1: Figure 2:

Figure (3 & 4): HKTEX, HKDEX & HKREX (in billion of HK$) represent Hong Kong�s totalexport, domestic export and re-export. STEX, SDEX & SREX (in million S$) captureSingapore�s total export, domestic export and re-export.

90

100

110

120

130

140

150

84 86 88 90 92 94 96 98

HKNEER HKREER

80

90

100

110

120

130

140

84 86 88 90 92 94 96 98

SNEER SREER

36

Figure 3: Figure 4:

Figure 5: Singapore REER Figure 6: Hong Kong REERand ERER-4 (moving average-4)) and ERER-2 (moving average-2))(average 1990 = 100) (average 1990 = 100)

37

Figure 7: Misalignment (%): ((reer - erer) / erer) * 100

-12

-8

-4

0

4

8

86 88 90 92 94 96 98

HKRER SGRER

CIES DISCUSSION PAPER SERIES

The CIES Discussion Paper series provides a means of circulating promptly papers ofinterest to the research and policy communities and written by staff and visitorsassociated with the Centre for International Economic Studies (CIES) at the AdelaideUniversity. Its purpose is to stimulate discussion of issues of contemporary policyrelevance among non-economists as well as economists. To that end the papers arenon-technical in nature and more widely accessible than papers published in specialistacademic journals and books. (Prior to April 1999 this was called the CIES PolicyDiscussion Paper series. Since then the former CIES Seminar Paper series has beenmerged with this series.)

Copies of CIES Policy Discussion Papers may be downloaded from our Web siteat http://www.adelaide.edu.au/cies/ or are available by contacting the ExecutiveAssistant, CIES, School of Economics, Adelaide University, SA 5005 AUSTRALIA.Tel: (+61 8) 8303 5672, Fax: (+61 8) 8223 1460, Email: cies@adelaide.edu.au. Singlecopies are free on request; the cost to institutions is US$5.00 overseas or A$5.50 (incl.GST) in Australia each including postage and handling.

For a full list of CIES publications, visit our Web site athttp://www.adelaide.edu.au/cies/or write, email or fax to the above address for our List of Publications by CIESResearchers, 1989 to 1999 plus updates.

0031 Rajan, Ramkishen S., and Reza Siregar, "The Vanishing Intermediate Regimeand the Tale of Two Cities: Hong Kong versus Singapore", July 2000

0030 Rajan, Ramkishen S, " (Ir)relevance of Currency Crisis Theory to theDevaluation and Collapse of the Thai Baht", July 2000. (Forthcoming inPrinceton Study in International Economics, International Economics Section,Princeton University, 2000)

0029 Wittwer, Glyn and Kym Anderson, "Accounting for Growth in the AustralianWine Industry between 1987 and 2003", July 2000

0028 Rajan, Ramkishen S., "Currency Basket Regimes for Southeast Asia: the WorstSystem with the Exception of All Others", June 2000

0027 Jones, Ronald W. and Henryk Kierzkowski, "Horizontal Aspects of VerticalFragmentation", June 2000

0026 Alston, Julian M., John W Freebairn, and Jennifer S. James, "Beggar-thy-Neighbour Advertising: Theory and Application to Generic CommodityPromotion Programs", May 2000

0025 Anderson, Kym, "Lessons for Other Industries from Australia's Booming WineIndustry", May 2000

0024 Farrell, Roger, "Research Issues in Japanese Foreign Direct Investment", May2000

0023 Peng, Chao Yang, "Integrating Local, Regional and Global Assessment inChina's Air Pollution Control Policy", May 2000

0022 Maskus, Keith E., "Intellectual Property Rights and Foreign Direct Investment",May 2000 (Forthcoming in Research Issues in Foreign Direct Investment,edited by Bijit Bora, Routledge, London, UK)

0021 Nielsen, Chantal and Kym Anderson, "GMOs, Trade Policy, and Welfare inRich and Poor Countries", May 2000

0020 Lall, Sanjaya, "FDI and Development: Research Issues in The EmergingContext", April 2000 (Forthcoming in Research Issues in Foreign DirectInvestment, edited by Bijit Bora, Routledge, London, UK)

0019 Markusen, James R., "Foreign Direct Investment and Trade", April 2000(Forthcoming in Research Issues in Foreign Direct Investment, edited by BijitBora, Routledge, London, UK)

0018 Kokko, Ari, "FDI and the Structure of Home Country Production", April 2000(Forthcoming in Research Issues in Foreign Direct Investment, edited by BijitBora, Routledge, London, UK)

0017 Damania, Richard, and Per G. Fredriksson, "Collective Action and Protection",March 2000

0016 Hertel, Thomas W., Kym Anderson, Joseph F. Francois, and Will Martin,"Agriculture and Non-agricultural Liberalization in the Millennium Round",March 2000

0015 Dean, Judith M., "Does Trade Liberalization Harm the Environment? - a NewTest", March 2000

0014 Bird, Graham and Ramkishen S. Rajan, "Restraining International CapitalMovements: What Does it Mean?", March 2000 (Forthcoming in GlobalEconomic Quarterly, 2000)

0013 Schamel, Günter, and Harry de Gorter, "More on the Welfare Effects ofDistortions via Environmental and Trade Policy", March 2000

0012 Bird, Graham and Ramkishen S. Rajan, "Resolving the Interest Rate PremiumPuzzle: Capital Inflows and Bank Intermediation in Emerging Economies",March 2000

0011 Stringer, Randy, "Food Security in Developing Countries", March 2000(Forthcoming in Contemporary Issues in Development, edited by B. N. Ghosh)

0010 Stringer, Randy and Kym Anderson, "Environmental and Health-RelatedStandards Influencing Agriculture in Australia", March 2000

0009 Schamel, Günter, "Individual and Collective Reputation Indicators of WineQuality", March 2000

0008 Anderson, Kym, "Towards an APEC Food System", February 2000 (Sincepublished in Australian Agribusiness Review, 2000 and on the New ZealandGovernment's website at www.mfat.govt.nz/images/apecfood.pdf).

0007 Francois, Joseph F. and Will Martin, "Commercial Policy Variability, Bindings,and Market Access", February 2000

0006 Francois, Joseph F. and Ludger Schuknecht, "International Trade in FinancialServices, Competition, and Growth Performance", February 2000

0005 James, Sallie, "An Economic Analysis of Food Safety Issues Following the SPSAgreement: Lessons from the Hormones Dispute", February 2000

0004 Francois, Joseph and Ian Wooton, "Trade in International Transport Services:the Role of Competition", February 2000

0003 Francois, Joseph, and Ian Wooton, "Market Structure, Trade Liberalisation andthe GATS", February 2000

0002 Rajan, Ramkishen S., "Examining a Case for an Asian Monetary Fund", January2000 (Abbreviated version forthcoming in World Economics, 2000)

0001 Mataloni Jr., Raymond J., "A Method for Improved Comparisons of USMultinational Companies' Manufacturing Production Abroad", January 2000