The Expectations of a Hong Kong Dollar Devaluation and their Determinants
During the Asian financial turmoil over the 1997-1998 period, only the Hong Kong dollar peg escaped the wave of huge devaluations which hit Asian currencies. But speculative pressures did not spare the Hong Kong currency board. Indeed, several attacks were launched against the Hong Kong dollar and the expectations of a devaluation fluctuated sharply over the period. The motivation of the paper is threefold. Three major conclusions can be drawn. First, only two channels of shock propagation are plainly robust and significant in explaining the formation of expectations on the HK dollar: the external effect, captured by the value of the dollar/yen exchange rate and the pure contagion relying on the reassessment of risk by international investors. Second, the presence of a double play is made clear. The impulse response functions underline the circularity of expectations: the expectations of a HK dollar devaluation fuelled speculation in the stock futures and options markets, which in turn was conducive to fears of an impending demise of the currency board. Third, the reflexivity in the formation of expectations led the HKMA to engage in unusual interventions, departing from its traditional free-market philosophy. All the discretionary measures adopted by the HKMA to break this self- fulfilling speculative scheme proved to be ineffective. In contrast, when the HKMA undertook reforms to introduce a more rule-based system in September 1998, it succeeded in dampening the pressures against the HK dollar.
Currency Board; Hong Kong; speculative attack; probability density functions; contagion
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