INTERBANK RATE BEHAVIOR AND FINANCIAL CRISIS: The Case of

Hong Kong has long been under a fixed exchange rate regime, relying on the currency board to maintain currency stability. Currency board is a rule-based system, but because of the gradual dilution of the rules started in the late 1980s as a result of a number of monetary reforms, the currency board has gradually emphasized more on discretion in setting its policy. Such change in the board’s policy led to corresponding changes in the performance of interest rates. During the 1997–1998 Asian crisis, the volatility and high values of interest rates had triggered serious credit crunch, causing a downturn of the economy and an escalating pressure on the currency. The Hong Kong’s government was forced to revert to a rule-based system to strengthen the currency board system. With use of the interest rate differential between the Hong Kong dollar and the U.S. dollar, this paper attempts to examine empirically the impacts of these institutional changes on the Hong Kong’s interest rate, and to evaluate the relative merit of rules versus discretion over three distinct regimes. Our results suggest that the stance of policy making is associated with stability of the interbank market and thus the credibility of the currency board. We employ a structural break model under the Bayesian framework so as to determine the number and the type of structural breaks that are unique to the series under consideration. In the sense that the timing of a regime change is estimated by the model, rather than given ex ante. Finally, our empirical results should shed a light on implications for monetary policies in Hong Kong and the dynamics of interest rate.