Transcript From “One Country, Two Systems” to Monetary Integration?

From “One Country, Two Systems”
to Monetary Integration?
A Talk at the Hong Kong Institute for Monetary Research
(presenting parts of the findings of my research fellowship in
October-December 2001)
Tsang Shu-ki
Department of Economics
Hong Kong Baptist University
www.hkbu.edu.hk/~sktsang
31 January 2002
1
Introduction
• One country, multiple monetary systems
• Hong Kong and Mainland China: one
country, two currencies
• Hong Kong , Macau and Mainland China:
one country, three monetary systems
• And with Taiwan?
• Historical precedents of multiple currencies:
civil war times
2
The facts
• The dual system in Hong Kong-Mainland
China does have some novel features and
asymmetries.
• Hong Kong is an international financial centre,
with the 4th highest per capita GDP in the
world. Mainland China is a reforming socialist
market economy with capital controls and a
good deal of institutional rigidities remaining.
3
The facts
• The Hong Kong special administrative region
(SAR) is to decide its own monetary policies in
accordance with Articles 110-113 of the Basic Law.
• “The Hong Kong dollar and the Renminbi will
circulate as legal tender in Hong Kong and the
mainland respectively. The HK dollar will be
treated as a foreign currency in the mainland.
Likewise, the Renminbi will be treated as a
foreign currency in Hong Kong.” (Chen, 1996)
4
The facts
• “…. one country, two currencies, two monetary
systems and two monetary authorities which are
mutually independent" (Yam, 1996).
• Before 1978, the existence of the Hong Kong dollar as
a convertible currency served China well. As much as
¼ to 1/3 of Chinese foreign exchange earnings came
from/through Hong Kong.
• After the launching of the economic reforms, Hong
Kong has become China’s most important trading port
and “external investor” as well as a stepping-stone for
foreigners.
5
Currency substitution versus
transaction convenience
• In the earlier years of reforms, hoarding of HK
dollars by mainlanders might have been driven by
a fear of the devaluation of the Renminbi, and
therefore can be regarded as a form of “currency
substitution” .
• The situation now is more that of “transaction
convenience” with the credibility of the Renminbi
on the increase. The higher degree of economic
integration means that it would reduce transaction
costs for Chinese parties to accept and to store
Hong Kong dollars.
6
Currency substitution versus
transaction convenience
• The other side of the story must also be told:
Renminbi is also increasingly accepted for transaction
purposes in Hong Kong.
• Unlike China, of course, Hong Kong allows the
circulation of foreign currencies although the Hong
Kong dollar is the only legal tender.
• Table 1 gives an estimate of HK dollars circulating in
S. China. Y is the currency to GDP ratio, and X is the
series of years from 1966 to 1987. The assumption is
that the C/GDP ratio would converge to the long run
average of about 4% in mature economies.
7
8
Theories updated
• As Barandiaran and Tsang (1997) argued,
supporting the status quo amounts to addressing
critically the arguments for monetary unification,
the alternative to the coexistence of the two
currencies.
• To be politically correct, unification would mean
the demise of the Hong Kong dollar.
• The situation is unlike Europe's ongoing economic
and monetary integration, in which politics has
played a dominant role (Wyplosz, 2001).
9
Costs and benefits of monetary
unification
• The benefits of unification are related mainly to (a)
the transaction costs of currencies and (b) the risk
posed by exchange rate variations. Unification
would reduce the transaction costs and the risk of
exchange rate variations only between the Hong
Kong dollar and the Renminbi but not between
the Renminbi and other currencies.
• According to Barandiaran and Tsang (1997), the
net benefit could well be negative for Hong Kong.
10
Forms of monetary coexistence
• Barandiaran and Tsang (1997) distinguished
three forms of coexistence :
(1) spontaneous competition,
(2) legal competition, and
(3) monopoly.
• They characterised the status quo as (1)
spontaneous competition although it was
rather limited to southern China.
11
(1) Spontaneous competition
• It turns out that spontaneous competition
has continued after 1997 but currency
substitution is largely replaced by
transaction convenience.
• Further integration plus developments in
Hong Kong after the East Asian crisis:
“Let’s go north and consume and work!”
• Equalisation of factor and output prices?
12
“Failure” of (2) legal competition
and (3) monopoly
• Failure of options (2) (legal competition) and (3)
(monopoly) is not surprising.
• With rising confidence about the Chinese economy and
concern about “political correctness”, option (2), giving the
HK dollar the status of legal tender or legally allowing HK
dollars to circulate in parallel with the Renminbi in the
Mainland, is really a non-starter.
• Monopoly is the official position. But given the difficulties
of strict implementation and the informal benefits of
“transaction convenience”, in S. China at least, why bother
to crack down on spontaneous competition, a game in
which the Renminbi is not losing?
13
China-HK as an OCA?
• The theory of optimum currency areas
(OCAs) Pioneered by Mundell (1961) and
McKinnon (1963).
• The push towards euroisation in Europe
gave rise to a new generation of theories
and applied works (see Talvas, 1993 and
Lafrance and St-Amant, 1999).
14
The empirics of OCAs
• Methods to test where regions form an OCA range
from statistical analyses to cointegration and VAR
procedures. Given the constraints of short Chinese data
series, I can only apply two methods (Tsang, 2002):
– Variance analysis (VA): looking at the standard deviations of
different variables across the regions concerned. Growth and
inflation, e.g. should not show undue variations within an
OCA.
– Principal components analysis (PCA): examining the results of
a “common shock” to the different variables across the regions
concerned.
15
The empirics of OCAs
• The principal components analysis (PCA)
approach we have used aims at decomposing the
common shocks to an economic variable in
different regions into positive (symmetric) and
negative (asymmetric) shocks. This is
complementary to the von Hagen and
Neumann's (1994) individual shock approach,
and an extension of Caporale (1993) by Ma and
Tsang (1997).
16
The empirics of OCAs
• To generate estimates of the shocks or innovations
to a set of economies, one can use the following
vector auto-regression (VAR):
yt =  + .yt-1 + t
(1)
where yt is a vector of values for an important
economic variable, say GDP or RPI, over
different economies or regions,  represents a
vector of constants,  is coefficient matrices, and
t is vector of disturbance terms.
17
The empirics of OCAs
• The estimated t 's are subjected to principal
components analysis after they are normalised so
that their expected value is equal to 0 and their
variance equals 1 (et). The normalised
eigenvectors, f1, ... fM, of the correlation matrix
of the et's are called the loading factors. The
squares of the loading factors show the weight
applied to each component in expressing each
series as a function of the components.
18
The empirics of OCAs
• Hence the square of fij, which is the i-th
element of fj, represents the percentage of the
variance of region i's variable explained by j-th
principal component included in the model.
These squares show the percentages of the
fluctuation of the economic variable that can be
explained by "common shocks", i.e. the
"principal components", or shocks that have
economy-wide effects.
19
The empirics of OCAs
• As the eigenvectors, or the loading
factors, are normalised so that Σj1fij2=1 for
any given region i, the calculated
symmetric and asymmetric shocks for
each region are also normalised. The
decomposition into symmetric shocks for
region i is given as follows:
20
The empirics of OCAs
21
The empirics of OCAs
– If the symmetric reaction outweighs the asymmetric
reaction for a particular region, it would constitute a
piece of evidence that the region could derive net
benefit by being a member of the wider community,
say, an OCA.
– In contrast, if the negative (asymmetric) component
outweighs the positive (symmetric) component, the
region would react to a “common shock” in the
opposite (or very different) direction compared with
the other regions in the hypothetical OCA. It would
have suffered instability if it had joined the OCA.
22
The empirics of OCAs
– Some controversies surround this empirical
interpretation. Diversification may be good for
an OCA: if there are deep adjustment
mechanisms (e.g. fiscal smoothing or long-term
capital markets)--the two Mundell’s (1961
versus 1973a, b) a là McKinnon (2001).
– However, there is also the issue of the
“endogenous OCA” versus the “exogenous
OCA”.
– I adopt Mundell’s (1961) criteria here.
23
The findings for China-HK
• Five sets of variables are used in the empirical tests
which span the period of 1978 to 1999 or 2000
(remember they are all regional data):
– (1)GDP (annual);
– (2)Fixed asset investments (annual);
– (3)Export trade (annual);
– (4)Monetary variables: deposits and loans
(annual);
– (5)Prices: consumer price indexes (CPI’s)
(monthly) and stock prices (daily).
24
The findings for China-HK
• China now has 27 provinces and four
municipalities under central control
(Beijing, Tianjin Shanghai and Chongqing),
making up a total of 31 “regions”. But data
for some provinces or municipalities are too
short or sporadic to be of any use. I have
reported in each of the tables of the attached
paper about the regions used.
25
The findings for China-HK
• The preliminary results, as presented in the 14
tables of Tsang (2002), point to a picture which
is very sceptical of a positive answer. The
empirical findings based on disaggregated
historical data show some signs of real and
nominal convergence (GDP and inflation) only
between Hong Kong and some parts of Eastern
China, driven by trade (see Tables 2, 6 and 13
of Tsang (2002)).
26
The findings for China-HK
• This seems to be consistent with the actual
trajectory of economic integration, which is not
detected in Liang (1999) and Ma and Tsang
(1997).
• However, all other results, even those based on
higher frequency consumer and stock price data,
fail to provide evidence that Hong Kong and the
Mainland as a whole as yet constitute an OCA.
27
Forms of Monetary Integration
• I. The status quo
• II.The pegging of the HK dollar (or Macau’s
pataca and the New Taiwan dollar) to the
Renminbi
• III. A national currency, “chino”, could be
launched and the Renminbi, HK dollar, pataca and
NT dollar might be pegged to it at agreed rates
• IV. Reminbi-sation or chino-isation.
28
Forms of Monetary Integration
• Options I, II, and III would meet no legal
problems for Hong Kong (Tsang, 1999) and
Macau. Option IV would require the
amendment of their respective Basic Law.
• For Taiwan, the constraints are political as
well as economic. Option III is less
unpalatable than option IV.
29
Option II for Hong Kong?
• Should the HK dollar be re-pegged to the
Renminbi when the latter becomes convertible?
• The economic integration between Hong Kong
and Mainland has been phenomenal. On the
surface, they are one of the largest trading
partners and external investors to each other.
And the largest listed company in HK is China
Mobile, accounting for over 10% of total stock
market capitalisation.
30
Option II for Hong Kong?
• However, the integration should not be
exaggerated. Trade-wise, for example,
intermediate trade has dominated, while the
US remains a crucial market for end products
after the outward processing portions are
netted out, as shown in the following Table 2.
• From the Mainland’s perspective, Hong Kong
is also not its largest trading partner, as shown
in Table 3.
31
32
Table 3
Destinations and Sources of China’s Exports
and Imports in 2000 (%)
Exports
Japan
16.7
US
20.9
HK
17.9
S. Korea
4.5
Germany
3.7
Imports
18.4
9.9
4.2
10.3
4.6
Total trade
17.5
15.7
11.4
7.3
4.2
33
Option II for Hong Kong?
• There is also the problem of trade invoicing. Most
of Hong Kong and Mainland China’s external
trade transactions are invoiced in the US$ or the
Yen.
• The problem can be alleviated if both the
Mainland and Hong Kong’s external trade is
invoiced in similar proportions to the US$ and Yen
and other currencies and both sides practice the
same exchange rate regime.
• This does not seem to be case.
34
Option II for Hong Kong?
• So far, intra-trade and invoicing do not justify any
further strengthening of monetary integration.
However, a recent proposal is to have a Hong
Kong-Mainland China Free Trade Agreement.
That proposal, if implemented, would have the
end result of promoting intra-trade, and hence
enhancing the net benefit of monetary integration.
• Over the long term, what needs to be monitor is
the patterns and proportions of external and
internal trade, even after the Renminbi has become
full convertible.
35
Monetary union?
• Options III and IV represent steps towards a
monetary union. The highest common
denominator of the literature suggests that a
monetary union requires, amongst other things
such as political considerations:
• (1) real convergence;
• (2) nominal convergence;
• (3) risk-sharing mechanisms against asymmetric
shocks; and
• (4) factor mobility.
36
Real versus nominal convergence
• A monetary union requires economic convergence
(Mundell, 1961). However, there is a controversy
on what “convergence” means. The key contention
is that between the so-called “traditional view”
(De Grauwe, 1996) which stresses real
convergence (GDP growth, investment trends,
trade, factor mobility etc.) against the new view
(Mélitz, 1988) which emphasizes nominal
convergence for the monetary union (inflation,
interest rates, exchange rates etc.).
37
Real versus nominal convergence
• A compromised view is presented in the 2000 Annual
Report of the Eesti Pank (Bank of Estonia, 2001).
Both are necessary but there may be conflicts. One
example is that of real growth versus inflation.
• Economists in Estonia, one of the candidate countries
in the enlargement process of the EU, are talking
about real annual growth rates of about 3%, and
inflation rate of about 2%, above the EU averages.
One of the main reasons is the trade-oriented real
growth pattern of those candidate countries and the so
called “Balassa-Samuelson effect”. (UNECE, 2001).
38
Real versus nominal convergence:
the Case of the Mainland and HK
• Regarding real convergence, the prospects of look
“good” (for the Mainland, not for HK) in terms of
GDP. Other requirements will be discussed later.
• As to nominal convergence, the growth of both
Hong Kong and the Mainland has been externallyoriented. Both suffered from strong inflationary
bouts in the past two decades. That brings into
consideration:
• 1. The Balassa-Samuelson (B-S) effect; and
• 2. The Dutch disease.
39
Nominal convergence for
monetary union?
• Both arise from sharp increases in the demand for
tradables, which raises their prices. Price and
income effects spill over to nontradables, where
growth in productivity is slower. Hence export-led
economies tend to suffer from an inflation bias
(Sachs and Larrain, 1993).
• The difference between the B-S effect and the
Dutch disease is that in the latter, the demand is
for “new” tradables, which crowds out the
traditional tradables. The inflationary pressures
tend to be stronger under the Dutch disease.
40
Nominal Convergence in
Mainland China-HK?
• Imai (1999) investigates the case of inflation in
HK and comes out with the conclusion that it was
due to Dutch disease rather than the B-S effect. In
other words, HK’s tradables (services to an
opening China) were “new”.
• They may no long be so in the future. Hence the
inflationary bias in HK may disappear.
• Another consideration is the “equalisation of
factor prices” across an increasingly permeable
border.
41
Nominal Convergence in
Mainland China-HK?
• Guillaumont Jeanneney and Hua (2001), study
Chinese provincial inflation differentials in 199299 and find that the B-S effect cannot be rejected.
Although it is not a study of China as a whole visà-vis the rest of the world. It does not seem too
far-fetched to speculate that the BalassaSamuelson effect is also working in that context.
• With WTO accession and the further opening up
of China, the B-S effect may persist, which would
mean that price convergence between HK and the
Mainland may come in the future.
42
Risk-sharing in a monetary union
• In a monetary union, the giving up of monetary and
exchange rate policies need to be balanced by risksharing mechanisms among members, unless goods
and factor prices are very flexible, unlikely even given
nominal convergence. These include:
• (1) Fiscal smoothing mechanism such as either
independent fiscal policies among members (Beetsma
and Bovenberg, 1997) or fiscal federalism by a central
authority using taxation policies, fiscal transfers and
insurance schemes, e.g. progressive federal income
taxes (Hallett, Hutchison and Jenson, 1999).
43
Risk-sharing in a monetary union
• (2) Market-based mechanisms through the
functioning of financial and credit markets, which
share risk among different member regions
through cross equity holdings and borrowing and
lending, (Athanasoulis and van Wincoop, 1998).
• Smoothing through fiscal transfers and credit
markets is found to be higher in Canada than that
in the US (Antia, Djoudad and St-Amant, 1999),
while it is achieved mainly through capital and
credit markets in the US (Asdrubali and Kim,
1999).
44
Risk-sharing in a monetary union
• Independent fiscal policies and fiscal
federalism are actually two contrasting views.
Beetsma and Bovenberg (1997) and Fatás
(1998) stress that federalism may weaken
fiscal discipline consistent with a monetary
union, while Bayoumi and Masson (1997)
argue for the superiority of a nation-wide fiscal
stabiliser.
45
Risk-sharing in Mainland-HK?
• Independent fiscal policies are the norm under the
Basic Law, which rules out tax-transfers
mechanisms under fiscal federalism. However, the
fiscal policies of Mainland China and Hong Kong
are very different. In a monetary union, Hong
Kong might “suffer” from fiscal expansionism in
Mainland China, if the present trends continue.
Then Hong Kong may have to practice a more
pro-active fiscal policy to offset asymmetric
shocks, which is however constrained by Article
107 of the Basic Law.
46
Risk-sharing in Mainland-HK?
• Hong Kong would then have to rely on marketbased risk-sharing, through the capital and the
credit markets. Then it depends on the degree of
integration between the financial and credit
markets in the two economies. Presently, the
integration is relatively one-sided: Chinese
enterprises get listed in Hong Kong, absorbing
Hong Kong capital; while Hong Kong banks lend
to the Chinese side, more than the other way
around. A better two-way flow is required for
smoothing in a monetary union.
47
Labour Mobility in a
Monetary Union
• Factor mobility is a key to monetary union, as
stressed by Mundell (1961) and the traditional
view (De Grauwe, 1996) about real convergence.
Labour mobility is often stressed.
• Some would regard the lack of labour mobility as
the Achilles heel of the EMU in the multi-cultural
and multi-linguistic Europe.
48
Labour Mobility in a
Monetary Union
• No such cultural and language barriers exist
between Mainland China and Hong Kong.
What exist are political and economic
barriers. The 150/day inbound quota to
Hong Kong may have to be balanced with
labour mobility northwards to attain a real
convergence that is beneficial to Hong
Kong and aspiring migrants and renders a
monetary union an optimal choice.
49
Concluding remarks
• The empirical results presented here suggest that
Mainland China and Hong Kong are yet to
constitute an OCA, despite some limited evidence
of convergence with Eastern China.
• Various possible forms of monetary integration are
set out for the future in the eventuality of the full
convertibility of the Renminbi.
• Even for the re-pegging of the HK dollar to the
Renminbi (option II), there does not seem to be
any pressing need, unless intra-trade surges and
other conditions prevail.
50
Concluding remarks
• Further forward looking considerations throw
in a number of testing questions to answer for
the case of a monetary union (options III and
IV), involving real and nominal convergence,
public and private risk-sharing, and factor
mobility.
• The overall conclusion, albeit tentative, is that
there is no pressing case for any further
monetary integration between Hong Kong and
Mainland China.
51
References
• Antia, Zahir, Djoudad, Ramdane and St-Amant, Pierre
(1999), “Canada’s Exchange Rate Regime and North
American Economic Integration: The Role of RiskSharing Mechanisms”, Bank of Canada Working
Paper, 99-17, October.
• Asdrubali, Pierfederico and Kim, Soyoung (1999),
“Dynamic Risk Sharing in the United States and
Europe”, paper presented at World Conference of
Econometric Society, 2000. Downloandable from
netec.mcc.ac.uk/WoPEc/data/Papers/ecmwc20001621.
html.
52
References
• Athanasoulis, Stefano and van Wincoop, Eric (1998),
“Risksharing Within the United States: what Have
Financial Markets and Fiscal Federalism Accomplished?”
Research Paper 9808, Federal Reserve Bank of New York,
April.
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Country, Two Currencies: Monetary Relations Between
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53
References
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54
References
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55
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56
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57
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59
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60
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61