Hong Kong How does the present situation in Hong Kong match up against these various considerations? Hong Kong is in several respects exceptional, if not unique. It has no specific central bank law of the type common in other jurisdictions (although a number of laws, such as the Exchange Fund Ordinance and the Banking Ordinance, govern particular aspects of the Monetary Authority’s functions). It has no mainstream government debt. It operates a currency board rather than a discretionary monetary policy. And it has only quite recently become familiar with the idea of a budget deficit persisting for longer than an isolated year or two. Although the absence of a law to explicitly prohibit monetary financing of the budget deficit – of the sort which has been adopted in many economies, both new and old, in the course of the past couple  BIS Review 70/2002  3  of decades – may be thought a weakness, it need not be so in reality. Whether or not it has a formal legal basis, the proscription of monetary financing has nowadays become so firmly established as part of the policy landscape in the developed financial economies, that any of them which dared breach it would be immediately crucified by the markets, the world media, the IMF and so on. One could class this as a sort of de facto law of nature, which is likely to be at least as effective and durable as any law passed by a legislature, if not more so.
Between these two extremes – the US and the no-hoper – there are of course many cases where the situation is less clear-cut or less predictable. Euroland provides an interesting example. Given the careful steps which were taken before the advent of the euro to ensure the insulation of monetary from fiscal policy and to outlaw monetary financing of budget deficits, we might wonder why the news of impending budget overruns should cause the euro to weaken. It seems that not only do credit spreads faced by individual deficit countries widen (presumably for fear, however slim, of sovereign default), but also the currency weakens for fear of governments conspiring with the central bank to abandon its mandate against inflation or to break the rules against monetary financing. A rather different interpretation could be that foreign exchange markets are merely exhibiting a pavlovian reaction: having been brainwashed to the effect that a deficit is inherently bad if it surpasses certain preannounced limits, the reaction when such a breach does occur is bound to be negative, even if analysis of the substance underlying the breach provides little or no justification for such a reaction. In the context of trying to identify a relationship between the fiscal position and the exchange rate, these examples demonstrate that there is no simple, pre-ordained relationship. The outcome depends on a wealth of factors, including the nature of the disturbances affecting public finances, the policy regime and policy responses, and the state of sentiment in financial markets.