LC Paper No. CB(1)1106/98-99
(These minutes have been seen by the Chairman)

Ref : CB1/PL/FA/1

Legislative Council
Panel on Financial Affairs

Minutes of Special Meeting held on Saturday, 14 November 1998, at 9:00 am in the Chamber of the Legislative Council Building

Members present :

Hon Ambrose LAU Hon-chuen, JP (Chairman)
Hon Eric LI Ka-cheung, JP (Deputy Chairman)
Hon Kenneth TING Woo-shou, JP
Hon David CHU Yu-lin
Hon Cyd HO Sau-lan
Hon Albert HO Chun-yan
Hon NG Leung-sing
Hon Margaret NG
Hon Ronald ARCULLI, JP
Hon James TO Kun-sun
Hon Ambrose CHEUNG Wing-sum, JP
Hon HUI Cheung-ching
Hon SIN Chung-kai
Hon Jasper TSANG Yok-sing, JP

Members attending :

Dr Hon Raymond HO Chung-tai, JP
Hon LEE Wing-tat
Hon Emily LAU Wai-hing, JP

Members absent :

Hon James TIEN Pei-chun, JP
Dr Hon David LI Kwok-po, JP
Hon CHEUNG Man-kwong
Hon Bernard CHAN
Dr Hon Philip WONG Yu-hong
Hon Timothy FOK Tsun-ting, JP
Hon FUNG Chi-kin

Public officers attending:

Mr Bryan CHAN

Principal Assistant Secretary for Financial Services
(Securities)

Miss Clara TANG

Principal Assistant Secretary for Financial Services
(Banking and Monetary)

Miss Priscilla CHIU

Head (Monetary Policy)
Hong Kong Monetary Authority

Attendance by invitation:

Agenda item I

Study group on defending the linked exchange rate

Professor CHEN Nai-fu

Professor of Finance, Department of Finance
Hong Kong University of Science and Technology

Dr Alex W H CHAN

Assistant Professor, School of Economics
and Finance
University of Hong Kong

Professor CHAN Yuk-shee

Professor of Finance, Department of Finance
Dean, School of Business and Management
Hong Kong University of Science and Technology

Professor K C CHAN

Professor and Head of Department of Finance
Associate Dean, School of Business and
Management
Hong Kong University of Science and Technology

Dr Francis T M LUI

Associate Professor, Department of Economics
Director, Centre for Economic Development
Hong Kong University of Science and Technology

Professor Leonard K H CHENG

Professor and Head of Department of Economics
Hong Kong University of Science and Technology

Dr Fred Y K KWAN

Associate Professor, Department of Economics
and Finance
City University of Hong Kong

Agenda item II

Professor TSANG Shu-ki

Professor, Department of Economics
Hong Kong Baptist University

Agenda item III

Professor JAO Yu-ching

Professor, School of Economics and Finance
University of Hong Kong

Agenda item IV

Professor SUNG Yun-wing

Chairman of Department of Economics
Chinese University of Hong Kong

Agenda item V

Professor Richard Y K HO
Professor of Finance, Dean of Faculty of Business
Director, Asia-Pacific Financial Markets
Research Centre
City University of Hong Kong

Agenda item VI

Professor Merton MILLER

Professor at the Graduate School of Business
The University of Chicago

Clerk in attendance :

Ms Estella CHAN

Chief Assistant Secretary (1)4

Staff in attendance :

Ms Pauline NG

Assistant Secretary General 1

Ms Connie SZETO

Senior Assistant Secretary (1)1

MECHANISM FOR DEFENDING THE LINKED EXCHANGE RATE SYSTEM

The Chairman said that the meeting was the second of a series of special meetings of the Panel to study the mechanism for defending the linked exchange rate (LER) system. During the six sessions of the meeting, the Panel would be meeting academics, in groups or individuals, to solicit their views on the subject. Each session would commence with a short presentation by the invited guest(s), followed by questions from members. The Chairman invited member to refer to the written submissions provided by the academics already forwarded to members before the meeting.

I Study group on defending the linked exchange rate
(LC Paper No. CB(1)461/98-99(01))

2. The Study group on defending the linked exchange rate (SGDLER) was of the view that Hong Kong Monetary Authority (HKMA)'s seven technical measures introduced since September 1998 were a step in the right direction and had addressed some of the defects of the previous Currency Board arrangements, which were seen to have contributed to the interest rate volatility and the consequent recession in Hong Kong. Furthermore, the transferability of the Exchange Fund Bills and Notes into the Clearing Balance of the banking system allowed the monetary base to expand from HK$2 billion to about HK$32 billion which could absorb the shock of larger capital outflows without inducing high interest rates. HKMA's commitment made on 15 September that the Convertibility Undertaking was guaranteed for the next six months was equivalent to a six-month exchange rate insurance or a six-month put option, which concurred with what SGDLER or Professor Merton Miller had advocated respectively. The guarantee for the Convertibility Undertaking would instil confidence in the local currency. Indeed, market confidence was restored after the introduction of this additional measure, as evidenced by a net increase of HK$1 billion in the aggregate Clearing Balance of the banking system from 15 to 17 September 1998.

3. To address the shortcomings of HKMA's measures, SGDLER proposed to restructure the Currency Board system in Hong Kong and to establish a linkage between the existing credit creation in the banking system and the monetary base. The market interest rate should be determined by demand and supply for credit in the economy. Furthermore, it advocated a transparent and comprehensive allocation of the foreign currency reserves into its functional categories.

4. On the appropriateness of maintaining the LER system, SGDLER stressed that the LER was absolutely essential for the well-being of Hong Kong's economy at the moment as removing the US dollar peg might lead to an immediate confidence crisis on the local currency. Nonetheless, it was necessary to develop alternative strategies for coping with an extreme crisis. Dollarization could be the last option to be resorted to if there was a total collapse of the Hong Kong dollar monetary regime. Hence, more studies on the feasibility and technical implementation of this option should be undertaken.

5. Responding to Mr Eric LI Ka-cheung's concern that the proposal of allocating the foreign currency reserves into its functional categories might not be effective in withstanding severe attacks on the Hong Kong dollar, Professor K C CHAN pointed out that the important role of the foreign currency reserves in defending the Hong Kong dollar and combating currency attacks was not functioning properly under the traditional Currency Board system in Hong Kong where the outflow of capital was not off-set by a corresponding fall in foreign currency reserves, but was defended by raising interest rates to attract the inflow of capital. Under SGDLER's proposal, clear rules would be stipulated for apportioning the abundant currency reserves into its functional categories, such as, for backing the notes and coins in circulation, for backing the monetary base, for contingencies and as cushion against capital outflow, so that the market would receive the correct signals and react appropriately to different scenarios and there would not be any unnecessary panic when there were minor capital outflows. By doing so, the foreign currency reserves would be fully functional in defending the Hong Kong dollar.

6. On Mr Albert HO Chun-yan's concern that the restriction of private debt papers from access to the Discount Window would have negative impact on the development of the local debt market, Professor K C CHAN remarked that it was necessary for the Discount Window to accept only Exchange Fund Bills and Notes which were fund papers fully backed by foreign currency reserves. HKMA should issue new Exchange Fund papers only when there was an inflow of funds.

7. When asked whether HKMA should have reserved power in implementing the new measures, Professor N F CHEN considered that there should be as little discretion as possible on the part of HKMA as lest, this would undermine the effectiveness of the measures. For instance, discretion on determination of the Base Rate would be an obstacle to the transferability between the Exchange Fund Bills and Notes and the aggregate Clearing Balance, and defeat the purpose of the Convertibility Undertaking.

8. Miss Emily LAU Wai-hing asked whether HKMA should maintain its existing staffing structure after the restructuring of the Currency Board system which would leave the Authority with little discretionary power. Professor N F CHEN responded that SGDLER had not studied the structure and size of HKMA, which apart from performing the Currency Board functions, was also responsible for other monetary policies and regulation of the banking sector.

9. Commenting on the Government's operations in the securities market in August, Professor Y S CHAN expressed that notwithstanding that the operations were inevitable in the face of a crisis situation, the decision to intervene in the market was taken too hastily without fully assessing the implications on the local and international markets. On the disposal of shares acquired during the operations, SGDLER suggested that the Government should sell off the shares in an orderly manner as soon as possible. The sooner the Government disposed of its shares, the sooner it could be free from conflicts of interest in its dual role as the rule-maker and a player in the market.

10. As regards measures to improve Hong Kong's competitiveness, SGDLER was of the view that without devaluation of the Hong Kong dollar, Hong Kong had to regain its competitiveness through market adjustments in domestic prices and production costs. Increasing local productivity by means of technological advancement was recommended. It was also important for the Government to continue to enhance its status as an international financial centre, to implement appropriate fiscal policies for facilitating the LER system, and to stimulate economic growth in the current period of recession.

11. Concurring with Mr Ronald ARCULLI's view that some of the recent problems in the financial market could have been avoided if HKMA had put in place the measures to strengthen the Currency Board system earlier and adopted a pro-active approach to educate the public on the various issues, SGDLER stressed the importance of promoting greater public understanding of the Currency Board system in Hong Kong and the new technical measures introduced by HKMA. Enhanced disclosure of monetary information and related educational programmes would help to boost public confidence and stabilize the market.

II Professor TSANG Shu-ki
(LegCo Paper No. CB(1)461/98-99(02))

12. Professor TSANG Shu-ki expressed support for HKMA's seven measures and the Administration's 30-point measures for strengthening the order and transparency of the securities and futures markets. He commented that HKMA's two major moves of introducing the Convertibility Undertaking and the Discount Window were basically consistent with the principles of the AEL (Argentina, Estonia and Lithuania) model recommended by him but which was rejected by the Government in the Report on Financial Market Review in April 1998. If the seven measures were put in place earlier, Hong Kong's capability in fending off currency attacks and manipulative market plays could have been strengthened and the controversial move to intervene in the market might not have been necessary.

13. On the outstanding issues of moving the exchange rate under the Convertibility Undertaking and determining the Base Rate under the Discount Window, Professor TSANG proposed a gradual transition of the exchange rate from 7.75 to 7.80 in 500 calendar days and using the US Federal Funds Target Rate as a benchmark, with a premium reflecting the Hong Kong dollar risk. The premium could be adjusted by referencing the Hong Kong interbank interest rate. He also suggested a two-way Convertibility Undertaking allowing the conversion from Hong Kong dollars into US dollars or vice versa at the fixed exchange rate. A two-way Convertibility Undertaking would enhance the transparency of exchange rate arbitrage, thus enabling a stable exchange rate which would in turn dampen the interest rate hike caused by shortselling of the Hong Kong dollar. The risk of double-play in the financial markets would be reduced as shortselling of the Hong Kong dollar would not necessarily lead to an interest rate hike.

14. Regarding the appropriateness of maintaining the LER system for Hong Kong in the long run, Professor TSANG was of the view that whilst the benefits or otherwise of a fixed exchange rate or a variable exchange rate system was an issue subject to further debate, it was not opportune to abolish the US dollar peg at the moment. However, there might be growing doubts about the appropriateness of the fixed exchange rate of 7.80 in a possibly deteriorating external economic environment. In the long run, the issue might be considered in the next century if there was appreciation pressure on the Hong Kong dollar.

15. On possible ways to dispose of the shares acquired in the August operations, Professor TSANG disagreed that the Exchange Fund Investment Limited (EFIL) should unload the shares as quickly as possible as the holding of the shares might be perceived to have an influence in the market. Whilst EFIL should dispose of all the shares eventually, it should do so in an orderly and cautious manner so as not to cause downward pressure on the market.

16. Concurring with Mr Kenneth TING that a low and stable interest rate environment was vital to the recovery of the local economy, Professor TSANG remarked that nominal interest rate had continue to fall since September 1998 after the market had stabilized. With HKMA's seven technical measures, interest rate volatility would be dampened and if external economic environment remained stable, market sentiment would be conducive to further interest rate cuts. Indeed, the local interest rate had constantly been 3% to 4% higher than the US Federal interest rate, but the differential had narrowed to only 1% since HKMA's measures were introduced.

17. Responding to Mr Eric LI Ka-cheung's concern that the Convertibility Undertaking would encourage banks' currency arbitrage, thus incurring additional risk in the banking system due to increased competition, Professor TSANG explained that with the new measure, HKMA was no longer facing the whole community of speculators and skeptical investors alone, but was assisted by arbitrageurs in the banking sector. Instead of losing US dollar reserves directly when intervening in the foreign exchange market in order to alleviate further outflow of funds, the loss of reserves as a result of a capital flight from Hong Kong would be shared between the Government and the banking sector due to the latter's arbitrage activities. He was of the view that the strong and robust local banking system would be capable of sharing the burden of falling foreign reserves. Moreover, the Discount Window should provide sufficient liquidity support to banks.

18. As regards HKMA's six-month guarantee for the Convertibility Undertaking, Professor TSANG opined that it might not be appropriate to interpret the guarantee as an insurance scheme, since there was no premium or claims involved. He acknowledged that any open discussion by government officials on the appropriateness of maintaining the exchange rate at $7.80 would impact on market sentiment. However, as an academic, he wished to point out that in a possibly deteriorating economic environment, there would be doubts on the appropriateness of the exchange rate of 7.80, rather than on the official intention and ability to defend the LER system. He supplemented that a clear rule-based Currency Board system and enhanced transparency in operation were essential to market confidence and would contribute to currency stability.

III Professor JAO Yu-ching
(LegCo Paper No. CB(1)461/98-99(03))

19. Professor Y C JAO was supportive of HKMA's seven measures to strengthen the Currency Board system, the 30-point measures for strengthening the securities and futures markets and the Government's market operations in August 1998. He remarked that the Administration had succeeded in defending the Hong Kong dollar and the integrity of the financial system as evidenced by stabilization of the equity market, increase in public confidence and recovery of asset prices since September 1998. However, economic fundamentals in Hong Kong still remained weak. It was the Government's task to stimulate economic recovery and growth without jeopardizing currency stability by implementing appropriate expansionary fiscal, labour, income and housing policies.

20. On the issue of strengthening Hong Kong's competitiveness as an international financial centre, Professor JAO stressed that it would be more effective for Hong Kong to improve its own competitiveness than banning competition from other financial centres. Moreover, Hong Kong should not lower the standards and quality of prudential supervision over the financial sector in order to attract more business. He further suggested setting up a special task force comprising representatives of HKMA, Securities and Futures Commission, professional and trade bodies, scholars and experts to study measures for improving Hong Kong's position and reputation as an international financial centre.

21. As regards the Administration's proposal of granting the Chief Executive the power to give direction to the exchanges and clearing houses direct to ensure that the Government could react quickly whenever public interests were under threat, Professor JAO remarked that the proposal could be construed as political interventionism. He opined that it would be sufficient to grant the power to the Financial Secretary if such power was really needed in a crisis. He went on to explain that the Government's August operations in the securities and futures markets were necessary moves to combat serious "double-market plays" which could have triggered off a systemic crisis. The situation then was so serious and unprecedented that it warranted urgent and exceptional action by the Government. The purpose of the operations was not to maintain the stock market prices at a particular level. He quoted supporting remarks from overseas academics for the operations and referred to US Federal Reserve's bailing out of the Long Term Capital Management (LTCM) as a comparable move of the US Authority to prevent a possible financial crisis.

22. As regards determination of the Base Rate and transition of the exchange rate from 7.75 to 7.80, Professor JAO said that HKMA and the Exchange Fund Advisory Committee had considered proposals made by academics and were finalizing the details which would be announced in due course. On the matter of new issue of Exchange Fund Bills and Notes, Professor JAO was of the view that new fund papers should only be issued when there was an inflow of funds.

IV Professor SUNG Yun-wing
(LegCo Paper No. CB(1)461/98-99(04))

23. Professor SUNG Yun-wing disagreed with de-linking the Hong Kong dollar from the US dollar at the moment when the financial market was still volatile. Such a move would destroy public confidence in the Hong Kong dollar and make it more difficult to fend off speculative attacks. Without currency depreciation, Hong Kong had to lower costs to regain competitiveness. Rising interest rates and deflation would be part of the adjustment process, and higher interest rates might be necessary to attract capital inflows.

24. Agreeing that HKMA's seven measures had basically corrected the defects of Hong Kong's Currency Board system, Professor SUNG cautioned that the Hong Kong dollar would be still vulnerable to speculative attacks under a fixed exchange rate regime. Hong Kong being a small and open economy but also an international financial centre with large volume of equity trading was likely to attract speculative attacks on its currency. He considered dollarization and the Singaporean model as possible options in the long run for stabilizing the Hong Kong dollar. HKMA's package of seven measures was indeed a step further towards dollarization. Referring to the Singaporean model, Professor SUNG explained that apart from linking the Singapore dollar to a basket of currencies, the restriction on using borrowed Singapore dollars for conducting financial business off-shore had made it difficult for speculators to accumulate large amounts of Singapore dollars for shortselling, thus making the Singapore dollar less susceptible to speculative attacks. Whether such restrictions were appropriate for Hong Kong should be carefully assessed. The Hong Kong dollar, on the other hand, was more vulnerable to attacks in view of the rapid growth in trading volume of Hong Kong's equity market, in particular since Hong Kong had become an important capital raising centre for the Mainland. The greater use of US dollars in stock trading could be a solution to the problem.

25. Elaborating his proposal, Professor SUNG explained that whilst promoting the development of the local debt market, it would be advisable to consider adopting the Singaporean practices which would make it more difficult for speculators to engage in shortselling the Hong Kong dollar. On the other hand, in order to promote trading of stocks in US dollars, shares which were active in international stock markets could be selected for a trial scheme as a start.

26. On whether HKMA should retain reserved powers in its Currency Board operations, Professor SUNG opined that while a greater degree of transparency and disclosure on HKMA's operations would improve its accountability and help to enhance investor confidence, preserving the independence of HKMA was important. In this connection, HKMA's voluntary moves to disclose information about the size of the aggregate Clearing Balance and foreign exchange reserves, as well as the determination mechanism of the Base Rate, were welcomed.

V Professor Richard Y K HO
(LegCo Paper No. CB(1)461/98-99(05))

27. Professor Richard HO's presentation was mainly on the regulatory regime of the local financial services sector, in particular, its adequacy and readiness in meeting future challenges including keen competition, globalization, conglomeration, and the increased use of financial market instruments.

28. Professor HO called for initiation of an independent inquiry to review the entire financial system and its regulatory environment. In reply to Miss Emily LAU Wai-hing's enquiry about the manner in which the inquiry should be conducted, Professor HO used the inquiry conducted in Australia in 1996 as an illustration and said that the inquiry was commissioned independent of the regulatory bodies and comprised about six members including representatives from the industry and academics. The inquiry took the form of a comprehensive review of the entire financial system covering various aspects such as reviewing the existing regulatory framework, examining future needs, seeking views from other international financial centres on possible areas of improvement and recommending related policies to facilitate continuous development of the financial industry. Professor HO pointed out that fragmented studies on the local financial system made by the SAR Government in the past and the Review on the Financial Market conducted in early 1998 were mainly reactive in nature and marginal self-improving moves from within the Government and not forward looking.

29. In comparing the local financial regulatory system with those of other jurisdictions, Professor HO pointed out that while the world trend was moving towards a function-based regulatory system, Hong Kong was still following the traditional approach of an institutional-based regulation. Hong Kong's regulatory system had resulted in a simple financial activity being regulated by several un-related agencies and had led to more grey areas in regulation.

30. Noting that regulation of the local financial sector was undertaken by the Government, the Securities and Futures Commission and market bodies, Mr Albert HO Chun-yan asked about the pros and cons of having a regulatory system independent of the government structure. In response, Professor HO advised that in the United Kingdom's regulatory system, power was centralized at the Financial Services Authority, which was a government institution. A consultative document issued by the International Organization of Securities Commissions in early 1998 had pointed out that such a system would be more effective in regulating financial conglomerates. However, powers in the Australian and Canadian regulatory systems were more dispersed, where both the government and market financial institutions were responsible for regulatory functions. On the other hand, Professor HO also remarked that it would be necessary to provide public funds even for an independent regulatory body as a stable source of funding would be vital to the functioning of the regulatory body and was necessary in order to avoid conflicts of interest where market practitioners provided financial support for the regulatory body but at the same time were subjects of regulation by the regulatory body.

VI Professor Merton MILLER
(Note: A verbatim transcription of the discussion under this agenda item is at the Annex.)

VII Any other business

31. The Chairman reminded members that the next regular meeting of the Panel would be held on 7 December 1998 at 10:45 am to discuss proposed regulation on share margin financing and the Administration's response to views expressed by market practitioners and academics on the mechanism for defending the linked exchange rate system.

32. The meeting ended at 12:45 pm.

Legislative Council Secretariat
27 April 1999

Verbatim Transcription
LegCo Panel on Financial Affairs
Special meeting on Saturday, 14 November 1998, at 9.00 am in the Chamber of the Legislative Council Building
Mechanism for Defending the Linked Exchange Rate System

VI Professor Merton Miller

Hon Ambrose LAU (Chairman)

On behalf of the Panel, I would like to welcome Prof Merton Miller to attend our meeting. Prof Miller needs no introduction, everybody knows that he is a famous economist and is a Nobel Laureate in Economics. I would like to take this opportunity to congratulate him on the occasion of receiving his ninth honorary doctorate from the Hong Kong University of Science and Technology.

I am sure that everybody is very eager to hear his views, so I would like to call upon Prof Miller to give us his views, but leaving enough time for us to ask questions in the meantime.

Prof Merton Miller

Thank you very much, Mr. Chairman. I am proud and honoured to be here and especially to be considered an invited expert. We are kind of cynical of experts in the US. An expert has been defined as someone from out of town and that is certainly what I am.

To be sure to leave time, I am going to dispense with any formal remarks. People know where I stand, I think, on most of these issues. I would much rather react to your questions and try, if I can, to give my answers. So, we will start with Q & A.

Prof Merton Miller

Let me say that there are really two kinds of markets, actually more. But the two main ones are what we call the continuous markets, where a bunch of dealers standing around doing bids and offers, like the New York Stock Exchange or the Hong Kong Stock Exchange, and that is fine for dealing with small transactions of a few hundred shares at a time, and that is what it was designed to do. But there is another kind of market, where you are selling a large block, you want to sell a millions shares or a big chunk of shares, and you can't just go to the brokers, unload it and say "Get rid of it." There will be not only adverse market effects, but tremendous amount of uncertainty. When is the last shoe dropping?

So, what you do when you have a very large block to deal with is you have to use another kind of market mechanism. And that market mechanism is called the call market. The essence of it is that it is very open. You announce, "Hey, everybody, one month from today, a million of these shares are going on the auction block to the highest bidder." Actually, there are several technical ways to do that, but you announce it and everybody has a prospectus, and people from all over the world, not just Hong Kong but everywhere will say, "Gee, on December 20, there're going to be a big auction sale in Hong Kong. There're going to be bargains." Of course if everybody says there're going to be bargains, then you get a nice competitive price. The stocks will be sold essentially for what they are worth. This happens all the time. These big block sales are done. For example, the US government sells 15 billion of ten-year Notes, and it is done by an auction.

There is an interesting kind of auction called a single price auction, where everybody gets the same price. Or you can have what is called a discriminatory auction, where you just submit your bids. But in a single price auction, the one I want to recommend to you, you submit what amounts to a demand curve, ie "if the price is this, I will take so many, if it is this, I will take so many more" and so on down the list. The computer puts it all together, clears the market and everybody gets the same price. So, you can't say that this one has got an advantage over that one or anything like that. It is a fair and open system and will enable you to get out of the problem you've got there. You've got this big kitty and what are you going to do with it? It's hanging over the market. I don't say it's costless, I don't say it costs zero, but look, you've got into that mess and you have got to expect to incur some cost. You incurred some cost on the way up and now, unwinding, it is going to also incur cost, but at least you will get rid of it.

Prof Merton Miller

By several batches, you mean first the banks and then the utilities or what have you, or you could do it any number of ways. I favour getting it over with as quickly as possible. I don't know, you might want to talk, as you should, with investment bankers and get their opinions, but I would be careful. Remember, they are not necessarily always objective advisors. I personally favour, as long as it is open, what is called the "sunshine trade", all the cards on the table, everybody in the whole world knows what you are auctioning. The market will adjust immediately at that point and people will pay the price of it.

Incidentally, I like this idea of follow up on a question because there is so much, first there is one question and then somebody goes on to the next. So, I think everybody should be allowed two or three go's at me!

Hon David CHU

It is clear that you are advocating to get rid of these shares as soon as possible, but how about the opposite? Let's say if the government decides, for whatever reasons, to hold these shares for the longer term and also define a fairly long period, let's say, that the government will not release these share within the next ten years to give people sufficient assurance that this stock is not hanging over the market. Is there anything inherently wrong with this approach?

Prof Merton Miller

I don't deal in inherent rights and wrongs. All I'm saying is, I'm warning you, that nobody automatically believes what a government says anymore. And having done it the first time, people will say, "Well, they told us before that it would never happen, and it did." And now they'll say, "We'll never get rid of these shares." "Never? Maybe they mean it now, but things change over time and bang, down it will come." That's the problem with having that kitty there. If you don't have it, you can't be threatening to drop it on the market. It will have dropped all at once and it will be over with, and you can go on about your other business.

Hon David CHU

Just a short follow-up. The reason I am concerned about an auction of this amount immediately is that after the auction, the new holders of these shares may choose to release them at whatever rate they feel. And maybe at a rate too fast for the market to sustain at this volume, and may cause unnecessary turmoil in the market.

Prof Merton Miller

Well, if they release it too fast, why did they bid in the auction in the first place if they didn't want to hold them? Anyway, if they do sell on the market, that's their problem. I can't see that happening. Once you bid in the auction, it is presumably because you want to add these to your portfolio, and that is the way it should be.

Prof Merton Miller

Let me say something about the "put" option, which everybody associates with me, although the HKUST people are also heavily involved. First, the point about the puts, that's one way of putting it as it were, I call them structured notes, some people call it puts, some people call it HKMA bills. It's the same thing. So, the proposals that have been made to expand the monetary base are very similar. I was amused to hear one of the previous speakers say that it is altogether different. It is not altogether different, it is a different form, but essentially what ever you are doing with those bills, provided you set the base rate at the US rate, it is essentially a put. Modern finance is so flexible that the same thing can take different forms. So, although you don't call it a "put" and although my good friend, Joseph Yam, would never call it a "put", nevertheless it is a put! It is the same thing.

About dollarisation, the point about the put was to calm down the public about the seriousness of maintaining the peg, and also in the process to remove or substantially reduce the temptations of speculators that you are always so worried about. If they know they cannot make a lot of money, then they are going to go elsewhere. So, that was the function of it and once you do it, you don't have to worry for a moment about dollarisation. People like Joseph will say to me, "Yes, but what if it doesn't work? What if despite all these puts, everything that we do and say, they still insist on attacking the currency?" Then I say, 'then you can, there is one last ace in the hole that you can fall back on, and that is dollarisation. Attack and attack all you want and you"re not going to wind up with anything, because we can always dollarise."

When Argentina played that card a couple of years ago, all of a sudden attacks on the Argentinean peso diminished. That's a powerful weapon, but you never have to use it, you hope. It's just like a club in the closet. If necessary, you warn these people, we can play it, but you hope you don't have to.

Hon Albert HO

Prof Chen, who is now sitting next to you, mentioned to us this morning that you gave a very comprehensive and succinct explanation to Joseph Yam about the relationship between the interest rate and linked exchange rate. I hope I can hear it directly from you. I hope we can understand it and, hopefully, Joseph Yam did.

Prof Merton Miller

I hope I can reconstruct the epiphany that I must have had. Essentially what we were trying to do in talking with Joseph, we had a long chat. Actually we get on very well, we have somewhat different educational and professional backgrounds, and sometimes it turns out when we are discussing, he's talking about one thing and I'm talking about something else, even though the words are sometimes essentially the same words. What I was trying to do, if I remember correctly, what Prof Chen is talking about is that you have to separate out two problems, two separate roles that the interest rate plays in adjusting and equilibrating the economy. And I said, to make life simple, let's suppose that we cut away from all the very complicated details of your actual plans, we are in a simple world in which you just have currency and coins as part of the currency board arrangement. What's the point of that? It's just to get rid of these distractions so that you can focus on it. Consider a world in which everything is done with currencies and now, the Hong Kong economy suffers a depression because after all, let's face it, all over Southeast Asia, East Asia generally, including Japan, the countries are in depression. But what happens in a depression? In a depression, a normal one, interest rates would fall. Why would they fall in Hong Kong? They fall because the opportunities to invest are not very attractive, and currency would start to flow out of the country and interest rates would fall. Now, let's do it the other way around. Suppose there's a boom. Now, everybody wants to invest in Hong Kong and sure enough, interest rates will rise to attract foreign capital in. These are benign equilibrating moves of the interest rate that would occur even in a simple world.

That is not the kind of thing that happened last August, or whenever it was, when you had the interest rates shoot up several hundred percent. That is not the way, we are not talking about the economic function of interest rates now. We are talking about a special defect in your original version of the currency board that made you very vulnerable to certain kinds of speculative attacks, that you can only deal with by sharply increasing the interest rates because of the liquidity crisis. When, for example, if you run out of foreign exchange or something like that, or if you are determined, for one reason or another, to defend not just the peg but the total reserves that you have, there's only one weapon that you have left, ie to have the Monetary Authority raise the interest rates, whereas the previous moves I was talking about of interest rate, nobody raised it, the market will adjust it. But that is not the problem that you've gotten into. You ran out of space in terms of your currency board, you had no option, or at least he thought he had no option, but to defend it by raising the interest rate very high. Once you do that, though, speculators or what you call speculators, not just George Soros, a lot of people in Hong Kong are also pretty smart, they can figure out, "Look, if Joseph is going to raise the interest rates very high, we have got a couple of plays that we can put against him. First, we can sell short in the forward exchange market, and induce him to say "C'mon attack us," and raise the price. I am willing to concede at least in theory, that this double play mechanism could work. As long as you can be sure that the only weapon you have is raising the interest rates, you"re giving them a free pass in these other markets, in the forward exchange market for itself, plus the futures market, plus the stock market.

So, Joseph may not be entirely paranoid, that may have been one of the elements in it, but the cause of it was not the speculators, it was the fact that they knew you were vulnerable and had only one weapon left, namely raising interest rates. That's where our "put" scheme came from. Look, there must be another alternative that you have, and that is to use the power of modern derivatives to say "We are not going to change, we are not going to shoot those interest rates up." How can we deal then with the speculative attacks? There are two answers to that. First, we can deal with it by letting the horde of exchange reserves that we have go down somewhat, but the other thing is that we don't have to worry about it. If the speculators, or the so-called, feel that they have nothing to gain, then they won't attack it because they are in business to make money. And if they don't think they can make money by this policy, they won't do it. Let me give a little analogy on that. We have in the US, I've looked around here and I notice you don't have it, it's called 'the club". It's a metal bar that you put over the wheel of you car to discourage thieves. Have they hit Hong Kong yet? To any serious thief, this is laughable, they know how to break those things easily. So, why are people selling it? Because they reason like a thief, ie thief sees the club on the wheel and says "Well, yeah, maybe I can get it, but it's easier to go to the next car." And that's the same way with these so-called speculators, once they realise that there are large amounts of reserve that the authority is willing to bring to bear against us, they will go on to the next one, they won't bother.

Hon SIN Chung-kai

The attack on the Hong Kong dollar was followed by the Asian financial crisis. There are some new suggestions that Asian currencies should become a single currency. There are also suggestions that this new Asian currency should be tied up with the Japanese yen, probably because the Japanese economy will have a great impact on Asian countries. How do you react to this kind of suggestions?

Prof Merton Miller

I think that is a very good point. I am surprised I sat through all this discussion earlier and nobody even mentioned the Japanese yen. That's a key element in all of this. When talking about the Asian financial crisis, I hope I'm not the only one, but I am certainly one of the ones who pointed out that much of that traces to the Japanese. They are getting away with a pass here, people aren't criticising "What happened to this?" Their economy went into the tank, their banks were suffering and one of the things the Ministry of Finance did to help pull their banks out, there are other things they should have done and could have done, but they said "Let's lower interest rates." And boy, did they lower it! But the point about lowering interest rates was to give a term structure play to the banks, so that the banks could borrow at short term or only have to pay very low interest rates and can invest in longer term securities. They thought, "Aha, that way the banks will make more profit and they can write off some of those loans"" I don't say it was totally implausible, it was, if you look at history.

So, down they drove short term interest rates in Japan, to levels we haven't seen since the 1930s. In fact, recently there was a period for a while when it was actually negative short term interest rates in Japan. It can happen! But in any event, that is what they did, and they didn't realise, or they didn't care or maybe they did, that when you drive down interest rates, you also drive down the value of the yen. That is a way of cutting the Japanese exchange rate " the yen. These countries in Southeast Asia were at least, some of them entirely, some of them are wholly linked to the Dollar. When the yen goes down, the Dollar goes up, and all of a sudden if the yen goes way down, and your exchange rate is linked to the Dollar, it's over valued relative to the yen which is the major economy in this area, and certainly a major competitor. I always warn people in Hong Kong, "Look, if the yen is going to drop to 160 to the Dollar or something like that, forget it." You"re going to be hurt hard and not only you but everybody else in Southeast Asia. No matter what you do, policies or forums like this, there are just too big shockwaves coming across your bow. Similarly, if it goes the other way, if the yen appreciates, you will be all right, you will make it out of the crisis one way or the other. So, you have got to realise that you are part of a bigger picture and not entirely a matter of being in charge of your own fate. Don't confuse yourselves with the US here. You are a small, but very interesting, country. But you can't, if the tidal wave is coming from Japan, don't kid yourself that there is anything you can do to stand up against it.

Hon SIN Chung-kai

I am not suggesting, but because the effect from the Japanese is the greatest, is it more logical that Hong Kong is linked to the Japanese yen rather than the Dollar?

Prof Merton Miller

For other Asian countries, the answer is yes. Some of them have de facto been doing that. They won't call it that but they move a little more inclined with that. So, I would say that the countries in Southeast Asia, many of them ought to adopt "currency board"- type programmes because why do they need a central bank and that kind of money supply for? Only, they should hook on to the yen. The reason is that way the Japanese can never exploit them with their "beggar-my-neighbour" policy, which is what the Japanese are doing. They are in a big drive, some of them, some people including some American economists, they want the Japanese yen to drop so that Japan can export its way out of its troubles. If Japan does that, though, they are just exporting their way into trouble in the other countries.

This is a problem with floating exchange rates that people don't often realise. They think of them one country at a time, but it's not. We have got a whole system of exchange rates and if the Japanese yen falls, it is going to affect all the other exchange rates accordingly. So, I would say some of them ought to hook to the yen, and that raises a question. What about China and Japan? China can't hook to the yen and the yen can't hook to the yen, it is the yen. Well, I suggested that the model China and Japan are to look to is Europe, the European Monetary Union, on the grounds that Europe was plagued with these competitive devaluations for decades. The French were quite convinced that the Italians, to use a slang phrase, were eating their lunch! The Italians were continually cutting the value of the lire and taking away business from the French. They believe that firmly and they may very well be right! Finally, and if you start with them on the subject and say, "What about the French versus this?" They"d say "What about the Greeks and so on?" There was a tremendous feeling of that we are all subject to this competitive devaluation, we can't take it anymore. Hence, the pressure to form the EMU.

There were political pressures too because of the natural antagonisms that have gone on for hundreds of years, and I don't say it will be easy to do it here in East Asia by any means. But I think at least it should be considered, that you get rid of all this competitive devaluation that is going on by having a single currency for the whole area.

Hon Emily LAU

Thank you, Chairman, Prof Miller has been very critical of the government's intervention in the stock market in August and said that it has tarnished Hong Kong's free market image. But of course, events subsequently silenced some people because they looked at the fact that the stock market rose and we had made a profit, at least on paper, and they talked about the Federal Reserve bail-out of Long Term Capital Management, and said that there are all these problems in other countries as well.

I would like to ask Prof Miller whether he would agree with some people who said that the end justifies the means. Would you say that with hindsight, the government's intervention was not that far wrong, and the damage done to Hong Kong is really not that significant.

Prof Merton Miller

I would like to take that one up because this view which is so common is essentially a fallacy. And it is so ancient a fallacy that it even has a Latin name. We call it the "Post hoc, ergo propter hoc" fallacy, that because something happens at first and then something else happens, then there is a causal relation there. The classic example of that is every morning the rooster crows and every morning the sun comes up. What do we conclude? The rooster crowed and the sun came up, it's as simple an example of causation as you can find. Similarly, they intervened and about half the time, the market goes up and about half the time, the market goes down. Other things are happening all over the world and so it didn't turn out in this case that that was the bottom. But that doesn't affect the matter of principle here at all.

Hong Kong used to be known as a country with an economy where the market rules, you don't have the government intervening all over the way they used to do in Singapore and other countries. And that attracted foreign investment, people were willing to deal with Hong Kong as a financial centre. You don't have to worry about the government robbing you from time to time by arbitrary actions. Well, you've compromised that now. And that is why I'm recommending that you sell (the shares), that's a way of saying "OK, we won't do that again. We"re back to the old Hong Kong you all knew and loved." It's a signal. To say that "we intervened once and it worked fine" is just telling the market that you are going to do it again.

Hon Emily LAU

A short follow up. I would like to ask Prof Miller what is his assessment of the damage that has been done. You say foreign investors are very wary now, and you think we are going to have this problem because we are not going to be able to get rid of the shares in the short to medium term.

Prof Merton Miller

Yes, you are. That's what I've been trying to tell you! It's very easy, it's the easiest thing in the world. You have an auction and you get rid of it, we do it all the time in the US. I don't know why you can't do it here. Large block trades. That's easy. Don't kid yourself" that's another one of the problems with that policy. You've got this tie and now you can't seem to let go off it. You can if you are really serious in wanting to get rid of it, we can get rid of it for you. Nobody will be disadvantaged, nobody is going to pocket huge sums because of this. All the cards are on the table, there's a public auction and nobody gets any special benefits from that, everybody benefits.

Let me follow up myself on another thing. I am more and more sick and tired of hearing about Long Term Capital Management as a justification for what you did. It isn't. The two cases are entirely distinguishable. I'll use an analogy I got from Prof Chen, in one case the government was acting as a minor traffic cop, the reason of which I will explain in a minute, and in another case the referee was participating in the action. The story I always tell is about a fighter who's being pounded away and he says to his handler at the end of the round, "Boy, I'm suffering." And the handler says, "No, relax, he's not laying a glove on you." And the fellow says, "Well, keep an eye on the referee because somebody is sure beating the hell out of me." And that's the problem, when you have the referee get into the market, it's one thing. All the Federal Reserve did, in the first place, there was not a single dollar of taxpayer money involved, but you had (US)$15 billion that you gambled. OK, you flip the coin and the coin has a head and a tail and about half the time heads will come up and half the time tails. So, you flip the coin and you've got, no thanks of your own, but to developments elsewhere in the world, you've got a favourable outcome. But you did intervene. The Fed did not. Let's be careful about the LTCM, not only was there no money involved, but under US bankruptcy law, we have two kinds of things that can happen to a firm in bankruptcy. One is called "Chapter 11", in which you preserve the assets of the firm, and you get rid of the equity owners, of course. But you preserve the assets because you say "Look this firm is worth more alive than dead." The other is called "Chapter 7", which is liquidation, ie this firm is beyond saving no matter what you can do.

Chapter 11 is a way of saying the existing owners are out. So, in LTCM, everybody says 'the Fed bailed out LTCM." No they didn't. The people who were investors in LTCM lost all their money. Well, 90%, because in Chapter 11 you usually leave a little bit of equity to the original debtors because you want them to have an incentive to help you in the reorganisation. But a reorganisation that was definitely not the same kind of intervention that you had. What did the Fed do? It did even less than it did after the 1987 crash when Alan Greenspan got up and said, 'the Fed stands ready as it always does to prevent the markets from seizing up. We will provide whatever loans that are necessary to the banking and brokerage community." Now, they never said anything in this case. All they said was there is a portfolio here and everybody is trying to get a piece of it. It would be better if you did a reorganisation and went about it systematically. No more bail-out than that and I don't see that as a bail-out.

Prof Merton Miller

There are two parts to that. First you mentioned hedge funds. They are very much in the news these days. What are the hedge funds? There are dozens of different kinds. A simple definition, if you want one, it is the way rich people invest their money. There is nothing special about them. I would say that if I had $20 million, I probably would have invested in LTCM too, because I know the people involved. I just don't have $20 million! But that is the point. There"re hundreds of different kinds of them. When you hear the call for regulation of hedge funds, you say "What are they talking about? If there are so many different kinds, who would regulate them? What is it?" It is just usually the regulators are very defensive about them. There was a big splash in the papers, it wasn't very well understood. But people will say to the regulators and Congress, "LTCM went belly up, where were you, what were you doing? You"re supposed to be a regulator." And they say, "Yes, I guess you"re right, we'll have to do something." But what it is, is by no means clear. There is no regulatory body that can take charge of this mass of 400 different kinds of organisations. Some are like mutual funds, some are not.

On the other hand, they'll say, "Look at all the leverage they have." Who gave them the leverage? Some of them the banks did. Why did they do it? The banks are among the most heavily regulated segments of society. That's defensive talk by the regulators. And, they will always react in crises, that's the way they do, and they may even make some changes. That, again, is the way regulators are, they will react to the last crisis. There is nothing in their mechanism that allows them to think of the next crisis because we don't know what that is going to be. So, they don't react to the crisis to come but to the one we just had. I also say that we are lucky that that is the case. Can you imagine what the rulebooks would be like if the regulators were reacting to crises that haven't happened yet, but that might, that they imagine might happen.

As for disclosure, let me make another point about LTCM. You must understand that disclosure sounds like a great word and in some contexts it makes sense, but if you've got a portfolio of debts long and short, I can tell you what will happen. You've heard about Warren Buffett who made an offer for the portfolio, but it was what we would call a low-ball offer. It was $250 million for a portfolio which is probably worth $3-4 billion. That is why he's the richest man in the world, he doesn't overbid for things. He made this up, the natural response of people involved is let's have some competition here. That is why I recommend the auction, get competitive. So, they called some other people and they say, "We've been offered $250 million, what will you offer for it?" They say, "Well, we've got to see what you've got in there." And so you show them what you have in there and they say, "We"re not interested." Of course, they go out the back door and they start selling short against you. So, by tipping off your hand as to what is in your portfolio, you just encourage the market to take the position against you. So, disclosure of these positions is not so obvious and automatic and is not a solution to any problem. If you say "you must disclose you positions", investors will move to regulatory areas where they don't have to disclose them.

Did I not mention whether Japan is responsible enough for people to tie their currency to. No. I think for the smaller countries in East Asia, yes. But it's not a question of responsibility, in fact, it is Japan's irresponsibility that leads to that. You don't want them to keep exploiting you with a falling yen. So, Malaysia, Indonesia, countries like that and above all, Korea, which is a competitor of Japan, may very well tie their currency to the yen. For Hong Kong, no, I don't think the urgency of that is at all clear.

Hon Kenneth TING

I think everybody is really worried that we are in the market, I am not commenting on whether we are right or wrong, but everybody is really concerned about getting rid of the shares. And some people are really concerned that if we go out, definitely, we are going to lose. But according to your analysis, by having an auction it can be good and, it can be bad, it is not absolute.

Prof Merton Miller

I am not urging you to speculate for profit in the market. In fact, I'm urging you not to do it, because if everybody understands that one of the players against us in the market is the Hong Kong government itself, which has a huge kitty and is standing ready to exploit us at any moment, they are just not going to go in. So, I am urging you to sell the stocks not to make a profit but to get out and to say to the public, "Look, hands free, we"re neutral in this."

Another thing you have to keep in mind, by having such a big ownership of a lot of individual stocks, they are not just faceless numbers, they are banks, property companies and so on, you are distorting the relative prices of those investments and I don't know if you want to do that.

Hon Kenneth TING

The only question is that everybody's fear is that once we get out, or the way we get out, we are definitely going to lose money.

Prof Merton Miller

Well, that's the fault of going in. You lost money on the way up, you"re going to lose money on the way down. That's an inevitable result of a bad policy. You happen to be lucky that at the moment events in the world have been such that, I hope you don't think that Hong Kong has done it" That's again my story of the rooster and the sun" Hong Kong has benefited from the general calming down of world markets, which buying the shares had really nothing much to do with it.

Hon Margaret NG

Prof Miller, you haven't scaled the heights of our ambition. We are not trying to get rid of these shares. We thought it is jolly good that we are putting some of the exchange fund to much more cost effective use, we think that since we are facing a deficit budget, we might actually make use of this large block of shares to get us some money. Don't you think that this is a brilliant plan?

Prof Merton Miller

No, I clearly don't. If I have left the opposite impression, I've done something wrong. I think it's a mistake. In the first place, you must understand about investments, ie you get what you pay for. It's what we call a risk return trade-off. You can make more money at any time by taking more risks, but why are you taking risks? You've probably got too much in that foreign exchange portfolio anyway, and we are kind of advocating that you let it run down a little bit to take some of the pressure off your interest rate. But the idea that you would use your ability to buy stocks, to pick stocks to earn money for the government, I don't know" You have more confidence in the stock picker's abilities than I do. You will end up, one of these days, losing it all. It pretty much happens that way, I'm afraid.

Prof Merton Miller

Let me point out something that is often overlooked, about a currency board. A currency board is dollarisation of one kind. Let me give an example. I was just in Poland and when I was there I decided to talk about Russia because when you"re in a country you don't like to talk about its own problems but about somebody else's, which is usually even worse. I said, one of the Chicago newspapers heard that the ruble was collapsing in Russia and said, "How can people live when the currency is collapsing?" So they sent this team of reporters over there and found to their astonishment that life was going on as usual. There were crowds and queues in McDonalds, there were all sorts of activities going on. The answer is very simple, currency serves several functions; it's a unit of account, it's a medium of exchange and above all, to store value. What had happened in Russia was that the dollar was the store of value, if you are a Russian and you had some money, you quickly put it into dollars because you knew you weren't going to get robbed by inflation that way. Suppose you needed a cab fare or make local purchases, you might take a $20 bill and break it up into rubles. What we do in the US is you take a $20 bill and you break it up into four fives when you go shopping. So, they were breaking up the $20 into local rubles. So, they are effectively dollarising, but what is a currency board? It is a way, and why I recommend it for Russia, because it is a way you can recognise the dollarisation and still save face, ie there will still be a ruble because you hooked it to, and there's a ratio, as you know, of 7, 7.5 or 7.8 or whatever the ratio is, you hook the two currencies together so that although the dollar is the effective currency, it will look for reasons... the double eagle and so on" it will look for reasons of face as if there is such a thing as a ruble.

And the beauty of the currency board is that you don't give up too much of the 'seigniorage" because you"re earning interest on your reserves. In dollarisation you give it up, there may be some other advantages but basically, dollarisation gives up the 'seigniorage" whereas the currency board does not. What happens though is that if the attacks on the currency board get so strong that you"re losing all your reserves anyway, rather than going through this interest rate policy and push the whole economy into the tank, you say, "Look, forget it, you want dollarisation, we'll give you dollarisation." And that will stop it. Then you have the US interest rate because you have the US currency.

Prof Merton Miller

You have got to separate these problems, if you've got a cartel arrangement on interest rates, you ought to break it, but it is quite apart from the attacks on your currency. I would recommend, and I always get stoned by the locals when I do this, is let the foreign banks in. Let them accept local deposits and let them do whatever they want. Then all this hullabaloo goes up and say, "We are not going to let foreigners into our market." Frankly, the US in some ways is just as bad as everybody is. But the more international banking you get in the area, the freer the system is in that respect, the less you have to worry about these interest rate cartels.

As for the base rate being the Fed rate plus a little bit, the point is the Fed rate is so that this conversion principle will work and the interest arbitrage can work, and that is what you want to happen. The idea that you use the Hong Kong rate as the base rate is just to defeat the whole point of it.

Hon Ambrose LAU (Chairman)

On behalf of the panel, I would like to thank Prof Miller for his precious time in giving us his valuable views, and his interesting parables. I understand that you will be going to the Mainland shortly and we wish you a pleasant trip.