Macaos Reform: Money and Growth

() Xinhua Gu 1 () Faculty of Business Administration, University of Macao 2008

Abstract ()
This paper analyzes the feasibility and necessity for a shift in Macaos currency anchor from the HKD to the RMB. This monetary reform, made possible by its deeper economic integration with Mainland China than with Hong Kong, is required urgently to recover Macaos lost monetary stability and to minimize the unfavorable effect of RMB appreciation on its welfare. Having already suffered a significant loss from depressed terms of trade and depreciated financial wealth under the rapid RMB appreciation which is driven by long-term international economic imbalances, Macao must take the proposed reform seriously to avoid persistent, larger losses in real income and to curb worsening monetary instability (i.e., a painful freefall in the internal and external values of domestic currency).

Keywords: Monetary reform, Macau, Hong Kong, Mainland China

1. Introduction After opening up casino gaming by the local government in 2002 and permitting Free Travel Scheme (FTS) by the Beijing central government in 2003, the Macao economy has undergone tremendous changes and witnessed massive capital formation, quick employment surge, and fast output growth. The recent period saw the best GDP performance in Macaos history, with real growth ranging from 10.1 via 14.2 to 28.4 in 2002-2004 and panting down to 6.9% only in 2005 before bouncing back up to 17.0% in 2006. The economic booming has given rise to a substantial increase in tax revenues and in balance-of-payments (BOP) surpluses. The accumulation of foreign exchange (forex) reserves has swollen even further under the sustained expansion in exports (of
Email: xhgu@umac.mo; Phone: +853-8397-4705; Address: Dr. X.H. Gu, FBA, University of Macao, Taipa, Macao, China.
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tourism services), rising fiscal surpluses, and the rushed influx of FDI. What then are the implications of this enormous reserve accumulation for Macaos monetary stability in particular and its entire economy in general? Some annoying problems emerging from the current economic booming have become increasingly serious. The most annoying among them are internal and external monetary imbalances, i.e., Macaos domestic currency (pataca measured in MOP) has been losing its value very fast both internally and externally. The internal value loss is reflected by asset bubbles and high inflation, and the rate of inflation escalated from 1.7% in 2004 through 4.8% in 2005 and 6.0% in 2006 to 6.2% in 2007(3rd quarter). The external value loss is brought about by continued large appreciations of the Mainland currency (RMB measured in yuan), and Macao has already suffered a significant loss due to a deterioration in its terms of trade and an effective depreciation in its financial wealth. A question arises: how can we correctly assess the nature of this monetary instability before finding an effective way to lessen it? Several anomalies have appeared on the scene. (a) It is not unusual to see high inflation accompanying strong growth, but it is puzzling that Macaos money supply has grown much more slowly than its real GDP (Chan 2007). Macaos monetary regime is a currency board arrangement (CBA) (Pao 2003a), so rising forex reserves should have contributed directly to fast growth in the money supply (Ho 2007). Yet substantial fiscal surpluses, along with weak domestic credit to private sectors, partly offset that contribution (Chan 2004). What factor has caused inflation to take off now that swelling reserves did not make trouble? (b) Mounting reserves are supposed to put upward pressure on the exchange rate of domestic currency but the value of the pataca is firmly fixed against its CBA anchor, Hong Kongs currency (HKD). What is more weird is that Macaos currency backed up by enormous forex reserves is not rising but falling relative to its largest trading partners currencythe yuan. Is it sensible for Macao to maintain the HKD-based, fixed exchange rate which has caused large real losses? The loss of this sort is bound to get increasingly larger with the RMB appreciation as Macaos fiscal surplus continues to accumulate and its reserve holdings swell further. Although there have been a few papers dealing with the management of reserves (Pao 2003b and Chan 2007), curiously many local elite are less sensitive than ordinary people to the unfavorable impact on Macao welfare of the RMB appreciation which is likely to remain much longer and go even further. Also, the related problem of high inflation, though very pressing, has yet to receive close attention from local economics profession; much of it still remains silent about that problem while always getting excited only about gaming-biased, unbalanced growth. Resolving these problems requires a monetary reform of changing the patacas anchor from the HKD to the RMB

within the CBA. This proposal for reform is not a new idea but was voiced before (p.44, Pao 2003a, and Xu 2006); why then is this voice so weak as to have gone unnoticed? We readdress this reform issue in a more elaborate manner in hopes of arousing attention to its importance by local economists and decision-makers. Admittedly, the issue is not an easy question with a ready answer; for Macao, the government has a justifiable reason to ignore monetary instability. This is so because the CBA takes monetary policy completely out of the hands of politicians while the Monetary Authority of Macao (AMCM), in theory, cannot affect the money supply to lower inflation and defend the pataca from falling vis--vis the yuan. Note that the AMCMs only responsibility under the current regime is to maintain the fixed exchange rate between the pataca and the HKD. It seems that monetary instability has become a nomans land in Macao. Yet one cannot continue to ignore the patacas sinking in deep water, and something must be done to save it from being drowned. We strongly believe that the pataca can only be rescued by a shift in its anchor from the HKD to the RMB since the HKDs relative depreciation to the RMB is by no means a temporary phenomenon. In this paper, we explore what monetary policy can or cannot do under a loose CBA to mitigate or even remove monetary instability. The Macao monetary system has long been dollarized by the HKD; some refer to this as non-harmful currency substitution (Ho 2003), though one may have a different view (Gu and Sheng 2007). Now a genuine process of currency substitution, the yuan for the pataca (called yuanization), is taking place in town, caused by the fast appreciation of the former relative to the latter. Macao residents (Macaonian) are exchanging their idle pataca cash for the yuan to preserve its real purchasing power. However, part of inflation caused by the RMB appreciation is not escapable since Macao has to import heavily from the Mainland building materials and consumption goods. There may be more than one cause for high inflation; we are concerned with all root causes of this problem and with what can be usefully done to get it contained effectively. An insightful paper in the literature investigates Macaos practice of central banking even under the CBA (not a pure one) (Chan 2004). This may shed light on the proposed reform to rescue the pataca and alleviate instability. The AMCM used to do well in defending the pataca by means of monetary bills (M-bills) under HK-dollarization, but this time it is too costly to do so due to yuanization on the top of HK-dolarization. Now that the AMCM has acted comfortably as a lender of last resort (LOLR) thanks to its reserve holdings more than enough to cover the full backing of pataca liabilities, why not go a step further -- deviate more from the CBA and behave more like a central bank? The AMCM may be able to cope with monetary instability through the more innovative use of existing policy tools such as M-bills, LOLR, and required reserves (Gu and 3

Sheng 2007). The reform in this direction can hopefully remove all sorts of dollarization if revaluing the pataca slightly above the yuan and resolve the persistent weakness of pataca credit while restoring monetary stability. The rest of the paper is structured as follows. Sections 2 to 4 present three justifications for the proposed change in the patacas anchor from the HKD to the RMB. Section 5 concludes the paper. This reform, though somewhat limited within the framework of a CBA, would be of particular significance since it could attenuate noticeable macroeconomic imbalances and improve the Macaonian well-being. 2. The Reform Is Required due to the Changed Economic Relations Shifting the patacas anchor from the HKD to the RMB is monetarily sound and financially feasible, and it is in Macaos interests to seriously consider this transition sooner rather than later. The shift in the anchor currency is seen as an indispensable monetary reform for three reasons to be explained below. Let us look first at why the Mainlands rising but Hong Kongs falling importance to Macaos economy requires the CBA to be reformed. The change in the relative importance of both economies to Macao is the most fundamental support for the proposed shift in the patacas anchor. In many economic aspects, Macao has grown tied more closely to Mainland China while the relevance of Hong Kong to healthy Macao growth is relatively diminishing, thereby making the pataca-HKD link somewhat groundless but a pataca-yuan peg practically meaningful. The most important among these aspects is in tourist arrivals for Macaos service sector. Since yuan receipts from its Mainland-related service activity provide enough reserve currency for its monetary reform, there will be no problem for Macao to have the yuan as an anchor for the pataca. In 2006, 68% of Macao GDP came from the tourism sector while 55% of visitors were Mainlanders many of whom also bought expensive Macao apartments, so that about 40% of GDP was earned in terms of the yuan. In addition, about 30% of merchandise trade was with the Mainland while only 12% with Hong Kong in terms of total volume of exports and imports. Output of services differs from that of goods in such a way that for any operating capacity of services, no customer, no output; this is because services are not storable or transportable. Unlike physical goods whose production can be separable from their consumption in the sense that production precedes consumption, the production of services is inseparable from their consumption. Any output to be realized is determined jointly by customer arrivals and production processes; that is, production and

consumption must take place at the same time and in the same place. This is true for Macao as well; tourist arrivals are most important for its service-dominant economy.
Chart 1: Mainlands and Hongkongs Shares in the Total Number of Macao Visitor Arrivals
70.00 60.00 Percentage % 50.00 40.00 30.00 20.00 10.00 0.00
20 7 03 -1 20 7 04 -1 20 7 05 -1 20 7 06 -1 20 7 07 -1 1 20 02 -7

M ainland H ongkong

Y ear/ M h ont

Evidence shows that Chinese Mainlanders become the main customer source of its tourist industry. According to Chart 1 plotted with the monthly data from 2002 to 2007 (Nov.), the Mainlands share in total visitor arrivals rose but Hong Kongs fell at first, and the former has taken over from the latter as of August 2003. Since Nov. 2003, Mainlander arrivals have been around 55% of total arrivals while Kong Kongs 30%; this trend seems quite stable across time if excluding seasonal effects. Clearly, the FTS together with the CEPA was the turning point for economic relations among Macao, Mainland China, and Hong Kong. Chart 2: The Contribution to Macao Real GDP by Mainlander Arrivals
(from 2002Q1 leftmost to 2007Q3 rightmost)
35000 30000 R a G P (in M P m n el D O illio ) 25000 20000 15000 10000 5000 0
28 87 35 77 24 94 21 90 10 74 15 34 13 38 24 85 26 51 29 78 37 49 87 3

Mainlander Arrivals (in 1,000)

Since its tourist sector (including hotels/restaurants, transport, gaming/recreational, and other related services) accounts for 68% of Macao GDP in 2006, visitor arrivals play a key role in affecting economic performance. As depicted in Chart 2 using quarterly data in 2002Q1-2007Q3, Mainlander arrivals make a significant contribution to Macaos real

GDP. The two variables appear to be highly correlated with each other (apart from certain cyclical fluctuations), but the truth is that this is a unidirectional causal link from Mainland arrivals to GDP performance since tourist spending in Macao is observed as a primary determinant of its aggregate output. This empirical linkage is consistent over time without much systematical error, which can be quantitatively verified by running regression. Furthermore, the steady growth of GDP (not just the level of GDP) may also be significantly related in a positive way to the growth of Mainland visitor arrivals, and econometric techniques can be used to detect if this claim is correct. The Mainland is a major financier of some sort for Macao growth, and this can be seen from Chart 3 on the basis of end-June 2007 data on the international assets and liabilities of Macaos banking sector (RSD 2007). The two items in its balance sheet are 40-42% of their respective totals for the Mainland but only 11% for Hong Kong. Also, the Bank of China is one of the two pataca-note issuing banks (the other the Banco Nacional Ultramarino), though Macao has a partially HK-dollarized currency board with the HKD taken as its anchor money 2 . Also, the Mainland is a major origin of nonresident workers, which occupied a proportion of 57.8% in 2006, followed by Hong Kong taking 18.9% (MLAB 2006). Chart 3: International Items in Balance Sheets by Nationality
(Assets in the Upper Panel and Liabilities in the Lower Panel)
HongKong 11% MainlandChina 40% Portugal 28% Macau 11%

Others 4%

UK 6%

UK Others 4% 7% Portugal 26% MainlandChina 42%

Macau 10%

HongKong 11%

Although the bulk of Macaos FDI still comes from Hong Kong with an outstanding stock of MOP 41.4 billion at the end of 2005, its share in total Macao FDI inflows fell
Dollarization refers to a situation where an economy (dollarized) abandons its own currency altogether and adopts a sound currency of another (dollarizing) country, like the USD, for all its domestic transactions. What this term actually means is the use of any other nations currency, not just the USD, as legal tender. About 1/2 of Macao M2 money is the HKD while 1/4 the other foreign currencies (OFCs), and the extensive presence of foreign currencies in Macaos monetary system is not the phenomenon of currency substitution but rather a partial sort of dollarization (Gu and Sheng 2007).
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from 70.7% in 2001 to 61.5% in 2005 (Vong 2007). Mainland China was the third largest direct investor in Macao with a share only at 9.4%, which had to do with the bad-externality-averse policy of the Mainland towards gaming (prohibited by law in there). The U.S. FDI in Macao, soaring to MOP 7.4 billion and taking up a share of 18.0% in 2005, was all devoted to the low-tech, socially costly gaming sector since casinos usually induce or recklessly encourage pathological gambling. Plenty of Hong Kongs FDI has gone to real estate development, helping create skyrocketing property bubbles and contributing greatly to high inflation in Macao. Much of the local population has been and will continue to get hurt by unhealthy bubble growth, with inflation being expected to persist. It might have been too early to think of a change in the patacas link away from the HKD onto the RMB before 2003 without the FTS or the CEPA. But now it is surely rational to talk about this issue, and Macao may need to take it seriously before it is too late or forced to do so under market pressure from private economic agents. With excess liquidity flooding in various parts of the Chinese territory (including Macao, Hongkong, and the Mainland), Macao itself has much more savings than its investment and there is no shortage of money for project undertaking. Thus the Mainland as an unlimited source of customers to the Macao economy is, of course, far more important to its healthy growth than speculative investors from Hong Kong and foreign sources. The change of Macaos monetary system from a HKD currency board to a RMB currency board is bound to be conducive to its real development due to its weakening dependence on Hong Kong and its deepening integration into the Mainland, a world economic giant. As a matter of fact, there are many examples of monetary changes in pace with altering economic or even political conditions. Lithuanias CBA that was set up in 1994 with a link to the USD changed its anchor to the euro in 2002. This is because its trade with the EU rose with its approaching EU accession while its initial anchor (the USD) appreciated vs the euro around 1999 so as to make it less competitive on the EU market. After abandoning the Sterling Exchange Standard and the subsequent USD peg, Hong Kong adopted a floating exchange rate in 1974 which had lasted until 1984. Because of a confidence crisis arising from the Sino-British dispute, the system was then changed to a USD-based CBA. The pataca had originally pegged to the Portuguese escudo until the latters sharp devaluation due to some revolution in 1977, and Macao then changed its pegging onto the HKD but failed to set the pataca at par with the HKD (p.43, Pao 2003a). Now it is Macaos pataca which has been depreciating sharply vs the yuan (the currency of its largest economic partner) along with the freefall of its anchor. A major monetary change is obviously needed for Macao to be better adapted to the new circumstances. 3. The Reform Is Required under Continued Substantial RMB Appreciations 7

The appreciation of the RMB to be continuing indefinitely and substantially will have a long-lived adverse impact on Macaos economic welfare if it still sticks with its patacas link to the HKD which in turn is linked to the continually depreciating USD. The prospects of RMB appreciation must be put into a broader perspective in order to have a more insightful thinking about Macaos CBA transition from the old anchor currency to a new one (the yuan). The key to this thinking is to recognize that the substantial appreciation of the RMB vis-vis the USD will be a long-term international economic trend. The arguments for this prediction are supported by the fact: a) that the permanently low U.S. saving rate results in the twin-deficits that induce America to pressure China for more RMB appreciations; b) that the rapidly declining U.S. trade competitiveness makes China a scapegoat for U.S. economic problems and brings forth U.S. demands for greater RMB appreciations; c) that the euro appreciation vs the RMB exacerbates the Sino-EU trade imbalance so that the EU joins the U.S. to push for quicker RMB appreciations; d) that the interest rates being lowered in the U.S. to prevent a recession and raised in China to curb high inflation encourage more hot money to enter China, hastening RMB appreciations; e) that the similarity between China Bashing and Japan Bashing by America shows, according to Japans experience (MacKinnon 2004), that the yuan appreciation has only reached the early stage of a 20-year process; and f) that Chinas high saving rate, along with its cheap yet skilled labor and its heavy dependence on exports for growth, leads to huge forex reserves and large RMB revaluations whereas all this can hardly be reversed any time soon. Chart 4: Correlation between Forex Reserve Accumulation and RMB Appreciation
16 14 12 10 8 6 4 2 0
--1 --1 --1 --1 10 10 10 4 4 7 7 4 7 4 04 05 06 07 7

20

20

20

AccumulativeAppreciations(%pts)

ForexReserves(US$100bln)

See Chart 4 for synchronic growth in both Chinas forex reserves and accumulative RMB appreciations. The U.S. has been the worlds largest debtor for more than 20 years, and China has now become its largest holder of forex reserves (amounting to USD 1.53

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trillion at the end of 2007, about 25% of the world total) with a legacy of strong trade growth for almost 30 years. This big international economic imbalance that will remain for many more decades is a fundamental force to drive a long-term, quite large RMB appreciation. Given this long-lasting prospect of big RMB appreciations, what will happen to the economic welfare of Macao if its monetary system remains unchanged? We may as well look first at what has happened to Macao under the largely dollarized, HKD-anchored CBA since the RMB rose in July 2005. There are two points, among other things, worth examining here. First, Macao has suffered a significant loss of depreciation in its financial wealth from the RMB appreciation; how much is that loss of wealth depreciation? Second, Macaos terms of trade have been deteriorating while its competitiveness will be under threat if its inflation becomes more severe than the appreciation and inflation combined of the RMB; how serious is that terms-of-trade deterioration? These two results will remain robust with bigger losses to be incurred in the future if Macao sticks to its current monetary regime. Chart 5: The Loss from Wealth Depreciation due to the RMB Appreciation
M P in billion O 250 200 150 100 50 0
20 05 -1 20 05 -7 20 06 -1 20 06 -7 20 07 -1 20 07 -7 20 08 -1 20 08 -7 20 09 20 1 09 -7 20 10 -1 20 10 -7
M2 DepreciatedM2

A realistic calculation of the existing loss (starting with July 2005) and a plausible simulation of future losses (up to 2010) are presented in Chart 5 to reflect wealth depreciations on the basis of semi-yearly data 3 . The simulation part for the future
3

According to the definition by the AMCM about the consolidated monetary and financial balance sheet, M2 money on the liability side, consisting of M1 money, savings deposits, notice deposits, time deposits, and certificates of deposits, is balanced by net foreign assets (NFAs) plus domestic credit minus sundries on the asset side. The NFAs are held by both the AMCM and banks, and domestic credit equals loans/advances to the private sector less the bank deposits of surplus funds owned by the public sector. If adding domestic deposits (liabilities) to official forex reserves (assets), duplication counting will occur so as to miscalculate the loss of wealth depreciation (Xu 2006). We use data from the liability side rather than the asset side due to the latters informational limitation. The public deposits should have been placed on the liability side but were not, so we may thus have underestimated the wealth depreciation loss.

Currency structure in Ho (2007) is employed to extract information about the share of OFCs in the total stock of money used in Macao, but we still lack data to distinguish between appreciating and depreciating currencies under the category of OFCs. Thus we roughly assume a 50%:50% scenario for some OFCs like the yuan as a benchmark and the other OFCs like the USD which are depreciating relative to the benchmark. Since the average share of OFCs in M2 was 20.27% between 1985 and 2006, we use 10% as the benchmark OFCs share in Macaos M2 from 2007 onwards in our simulation about future in Chart 5. Macaos M2 money growth, widely fluctuating, had averaged

period of 2008-2010 is based on the assumption that Macaos M2 money will grow 6.7% every six months while the RMB that takes a share of 10% in Macaos portfolio of financial wealth will appreciate 2.5%. Chart 5 reveals a gloomy prospect that the loss of wealth depreciation would reach MOP 56.5 billion for five years up to July 2010, on the top of a stunning fact that for two years up to July 2007 Macaos real income worth of MOP 13.6 billion has been lost already in the whirlpool of RMB appreciations starting in July 2005. This numerical assessment of wealth depreciation loss, very rough though it is 4 , indicates the increasingly serious nature of the situation, as reflected by a scissors-like gap in Chart 5. What then are you waiting for? why hold on to that damaging HKD-based CBA? 5 We look now at the same problem from a different perspective, i.e., impacts of RMB appreciation on Macaos terms of trade and external competitiveness. According to the official data, its terms of (merchandise) trade (excluding exports of services) were 100.9, 99.0, 95.1, 92.4, and 89.8 in 2003-2007(Q1~Q3), 6 and this consecutive fall must have consistently depressed real income. The terms of trade had declined prior to the RMBs appreciation for some other reasons, but this tendency would likely remain in the future and be reinforced due mainly to the rising RMB. The statistical data on Macaos external trade are incomplete because neither visitor consumption of local services (e.g., taking a taxi, a Macao export) nor Macaonian purchase of goods in ZhuHai (say, having a dinner there, a Macao import) is included in trade statistics; yet this amount is not trivial at all. If incorporating the fact that resident consumption in ZhuHai becomes more expensive while Mainlander consumption in Macao relatively cheaper and that people on both sides buy more and more real property across the border, the drop in the terms of trade would turn much larger than indicated by the official data. No one is sure

14.0% a year in 1984-2006 and 6.7% every six months in 1984-2007(June). This semi-yearly growth in the money supply is to be used for future-M2 simulation. The RMB had appreciated 11.09% in July 2005-MidDec 2007, and foreign pressure will fiercely push it to rise faster while China will strongly resist big appreciations. Thus it is reasonable to assume the RMB to rise 2.5% once in half year from 2008 on, and this expectation will be incorporated in the simulation for future.
4

The loss of wealth depreciation may have been understated here since the Macao government deposits, appearing as a negative item on the asset side, are large and rising (p.100, footnote 51, Chan 2007). Much of this surplus fund, excluded from M2 money, will be used sooner or later to make purchase from the Mainland and hence subject to the RMB appreciation. Incidentally, it is not our responsibility to come up with an accurate enough estimate of the real income loss from the America forced RMB appreciation. Our estimate here is just aimed at calling for attention to the issue, and the AMCM is well equipped to set about this meaningful task for itself.
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With gaming included in calculation, the change in the terms of trade (a broad measure) may be different from those numbers (a narrow measure) in the text. Given Macaos monopolistic position in the Chinese gaming market, its terms of trade can be improved upon by increased visitor arrivals but are adversely affected by more casino openings (this can be proven by means of an intermediate-level microeconomic analysis). Thus Macaos terms of trade, given many casino openings in the city, will be greatly deteriorating if the FTS policy is tightened to attenuate pathological gambling ruthlessly encouraged by greedy foreign casinos via their VIP services.

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about the exact amount of these cross-border transactions, but one thing is certain that Macaos loss of real income from the worsening terms of trade is substantial and increasing with continual RMB appreciations. Fortunately, this loss can be avoided if a RMB link is adopted. Table 1: The Structure of Macao External Trade in 2006 % Exports Imports Mainland 15.40 42.57 U.S. 40.48 5.74 EU 18.03 15.84 HK 13.02 10.05 Japan 1.13 8.97

The composition of Macaos external trade in 2007 (up to Nov.) is shown in Table 1. The U.S. remains the largest buyer of Macao exports taking a share of 40.5% in total while Mainland China the largest supplier of Macao imports accounting for 42.6% of total. Seemingly, the patacas indirect link to the USD poses no problem for trade with the U.S., while its effective depreciation vs the RMB strengths Macao competitiveness over the Mainland. Note that an economys competitiveness, hard to observe directly, rises with a real depreciation or a higher level of its real exchange rate , which is defined to be its nominal exchange rate E (the domestic-currency price of foreign currencies) times its trading partners price levels P* divided by its own price level P. The problem facing Macao is that it has to import much of building materials and consumption goods from the Mainland, just as the entire world does this, too. The appreciation plus inflation of the RMB greatly increases the price of Macao imports and contributes directly to Macao inflation, and the net effect (with respect to all trading partners) in the future could be that P may rise more than E and P* combined such that will be going not up but down, a drop in competitiveness. One cannot be optimistic about Macaos prospects of merchandise competitiveness 7 simply on the basis of the patacas effective depreciation against the yuan and the euro. This is so because its monetarily linked economies (the U.S. and Hong Kong) now have lower inflation, the EU with low inflation will no longer tolerate the current euro appreciation, China will fight emerging inflation (say, by certain temporary price controls being exercised now) while not permitting fast RMB appreciations, and Macao seems to have no effective means to crack down on its high inflation. If all traded goods and services (such as gaming) are included, we conjecture that the gain from supposedly increased competitiveness, if any, due to the patatcas effective depreciation would fall

To be precise, the AMCM may need to calculate a proper index of Macaos overall competitiveness and cross-time trend by including all trading partners and all traded services as well as goods; this is beyond the scope of our paper.

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well below the loss of real income because of deteriorating terms of trade 8 . In this case a monetary reform will be efficiency-improving for Macao. 4. The Reform Is Required to Avoid Prolonged Monetary Instability Since the problem of increasingly higher inflation in Macao than in any other rich economies has destroyed local monetary stability, Macao will have to do something urgent and sound to avoid a worsening of the problem, and the shift in the patacas link from the HKD to the RMB may prove a good way to get Macao out of trouble. The main components of the general price level such as wages, oil prices, import prices, and housing prices are all on the rise in Macao, and fast growing NFAs may also be exacerbating the problem of high inflation. The situation is really serious, yet a more serious problem is that this situation is hard to handle under the current monetary regime. The government is in no position to cope with inflation simply because the CBA adopted prevents it from having any monetary influence. The AMCM, though able to perform some central bank functions such as LOLR owing to the massive influx of BOP surpluses, cannot affect (reduce) the money supply or (raise) interest rates, either, so that inflation is beyond its reach. The economic theory provides no ready solution to the problem of inflation under a CBA with passive monetary policy and the only goal to defend the linked exchange rate. It seems that high inflation becomes a no-mans land in Macao. However, the general public not knowing much about monetary economics would rather hold the government, esp. the AMCM, accountable for the problem of inflation. They think that it is your responsibility to lessen inflation, so it is difficult for you to find an excuse for ignoring the problem altogether. A puzzling anomaly has now appeared on the scene. Modern CBAs are made to reduce incentives for devaluation, yet the pataca under the HKD- anchored CBA now has been depreciating effectively and persistently (against the yuan, the currency of Macaos largest trading partner). Dollarization is employed to import anti-inflation credibility from the dollarizing economy with a low-inflation reputation, yet the deeply dollarized Macao economy presently has experienced a rate of inflation well above Hong Kongs

Intuitively, the increased import prices under the yuan and euro appreciations increase the cost of production in Macao, so that it needs to charge its U.S. and HK customers a high price. But a higher export price makes Macao less competitive among those customers, and thus to stay competitive requires it to keep its selling price lower. Then buying higher and selling lower, a worsening in Macaos terms of trade, will cause its real income to be lower than before. The reasoning along this line from the patacas relative depreciation via the forced position of competitiveness to the depressed terms of trade, is more than half correct; this is because, in 2007 (up to Nov), Macao bought 58.4% of its imports from two currency-appreciating economies (China and the EU) and sold 53.5% of its exports to two monetarily linked economies (the U.S. and HK). The AMCM can be expected to make a more correct analysis of impacts of the relatively depreciating pataca on Macaos competitiveness and terms of trade with all traded goods and services included.
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and others. According to Edwards (2001), dollarized economies usually have lower rates of inflation than similar non-dollarized economies, and the cost of this lower inflation appears to be a slower rate of output growth. An amazing irony, however, is that Macao growth is not slower and its inflation is not lower, either. The question then becomes whether its socio-economic stability would be in danger if it lost monetary stability for too long. What we are concerned with in relation to this question is whether the current anomaly is a temporary exception to the rule set by the doctrine of economics that a CBA or dollarization should deliver low inflation. Macao witnessed inflation at a terrible rate of 8.6% in 1995 which quickly faded away and turned to deflation due to the 1997 Asian financial crisis; is it possible for current inflation to die away at no cost of recession? Macao is now regarded as a booming town with no risk of falling into a recession in any foreseeable future; does this imply that high inflation will persist indefinitely? Given that the pataca is now in deep water in the form of internal inflation and external depreciation, can the AMCM find some way to save it from being drowned? A conundrum with the rescue, by the theoretical orthodoxy, is that as a CBA, the AMCM is equipped with no tool to overcome high inflation unless it changes its anchor currency and re-adjusts its fixed exchange rate. If the problem turns out to be persistent to cause socioeconomic instability, the government can no longer hold on to its original position of non-interference without tackling the inflation trouble. Let us now explore what the government can usefully do to address this tough problem. To do this, one needs to identify the main sources of high inflation, and statistical data in 2007Nov convey some useful information on the determinants of inflation as depicted in Chart 6. There are at least five causes for Macaos ongoing inflation. Chart 6: Contribution to Inflation Based on Data in 2007Nov
67.46 70.00 60.00 50.00 40.00 30.00 23.14 % 20.00 11.36 6.41 10.00 1.24 1.46 0.78 0.05 0.10 2.36 -10.00 -14.36 -20.00 Transport Communication Miscellaneous Food and non- Clothing and Housing and footwear fuels goods and alcoholic services beverages

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1) Crude oil prices have been soaring, pushing up oil-related prices of fuel, electricity and transport. But there is nothing Macao can do about this external shock. 2) Booming casinos offer high pay and put upward pressure on wages of non-gaming sectors. The government, though averse to the risk of a wage-price spiral, should be happy about high income for its citizens. So nothing can be done in this regard. 3) In theory, inflation is ultimately determined by money growth in the long run. In reality, Macaos money growth is directly affected by its BOP surplus which has been accumulating rapidly with economic booming. While we may be concerned with how seriously the accumulation is adding fuel to inflation flames, one must notice that there is no way for the government to influence the over-heated economy since the AMCM is only a CBA. 4) Import prices have risen so much that food and clothing become the 2nd largest contributor to inflation by 30%. Obviously, this has much to do with the appreciation and inflation of the RMB since those goods are mainly imported from the Mainland, and the government may be able to do something effective to mitigate this adverse external impact. 5) The housing price now skyrocketing under rampant real estate speculation has positioned itself as the largest contributor to high inflation by 68% (along with fuels). Evidence clearly shows that property bubbles will definitely continue and balloon even bigger. Should the AMA, though, in theory, having no responsibility for such bad matter, look on unconcerned about inflation driven by those bubbles? But many local people are thinking what the government can do to alleviate this bubble growth to avoid inflations going from bad to worse. Let us deepen our analysis for the last three causes of inflation. Unlike other economies where the money supply is largely driven by domestic credit, Macaos money growth under its special monetary regime is mainly caused by expanding NFAs 9 stemming from strong external account performance. Note that domestic credit is defined as total bank lending to the private and public sectors in Macao. Weak domestic credit that depresses money growth arises from a rising fiscal surplus and a falling pataca-loan business, while the fiscal surplus along with BOP surpluses due to economic booming contributes greatly to NFAs and hence to money growth. The net effect of these two opposing aspects is a moderate (rather than over-expansionary) rate of money growth lower than GDP growth in 2002-2006 (annually, M2 rose 14.3% while real GDP 16.4%) (See a similar result on p.100, Chan 2007).
This is evidenced by the fact that the correlation coefficient between M2 money (including all currencies) and forex reserves is as high as 97.52% in 1984-2006.
9

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That implies that money growth is not responsible for soaring inflation in Macao. By the quantity theory of money, it seems that the rising income velocity of M2 (See Chart 2, p.118, Ho 2007) has helped cause trouble, a puzzle. Yet the truth is that it is high inflation which leads to a greater velocity since money is changing hands faster to buy real things for avoiding inflation losses. Also, other authors claim that a low correlation (or no causal relation) exists between Macao money growth and nominal GDP growth (pp.117-118, Ho 2007). Usually, money growth precedes income growth with a time lag in a time-series data display, but this is not the case for Macao. Noting that inflation can be derived from GDP deflator, one finds it difficult to conclude that money growth has aroused inflation, an anomaly. Chart 7: Impacts of Changing RMB/USD on CPI
12 11.8 11.6 11.4 11.2 11 10.8 10.6 10.4 10.2 10 9.8 7.2 7.4 7.6 7.8 yuan/$ 8 8.2 8.4 Macau and Mainland: CPI

Macau Mainland

What are then left for review are the last two causes for inflation: increased import prices and ballooning asset bubbles. To find out the impact of changes in the RMBs external and internal values on Macaos inflation, one may put these three variables together for comparison as depicted in Chart 7 where CPI has been scaled up by 10 to make the picture clearer. A significant message extracted from this Chart is that Macaos inflation is more sensitive to the RMB appreciation than the Mainlands itself. The reason for this sensitivity difference is that much of Macao consumption involves tradable goods imported from the Mainland but the latters does not, and that Macao bears the burden of both the RMB appreciation and its induced Mainland inflation. Intuitively, when, for example, the RMB exchange rate rises from 8.28 to 7.6 yuan/USD, the CPI increases to 106 in the Mainland and 114 in Macao from the same level, 102, of their initial CPIs if assuming away the other determinants of inflation. That is, the rise in Macaos CPI by 12 percentage points can be decomposed into 8 points in relation to the RMB appreciation itself and 4 points associated with the appreciation-triggered Mainland inflation. That implies that of the contribution to

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Macao inflation by the rising yuan, 2/3 is due to the appreciation and 1/3 to Mainland inflation. This interpretation about Macao inflation is quite rough but somewhat convincing. Thus on the anti-inflation front, our proposed shift of the patacas anchor from the HKD to the yuan will be beneficial since 2/3 of the Mainland-related effect on Macao inflation can be eliminated in total or at least reduced in part. Even so, Macao will still have to take the remaining 1/3 since in theory, the CBA, after anchored by the yuan, is supposed to automatically transmit the yuans inflation to the pataca; nevertheless, Macao can then get the yuan-related part of inflation under control. The asset bubble, as the chief contributor to inflation detrimental to monetary stability, cannot be let to balloon freely without restraint. This problem is insolvable without a tough monetary reform since a huge amount of funds flowing through the real estate sector bypasses the local monetary system but makes big trouble to Macao in terms of inflation. One picture of related transactions, among others, is that outside real estate developers bring in money to construct apartment buildings, then external buyers pour money into housing units, and these speculators making big fortunes will finally take money out. Those flows of money in and out of Macao are not the pataca, and nobody knows exactly how this hot money moves. In the process, local banks earn service fees for fund transfer, the government receives stamp duties and land-lease revenues, corrupt officials take large bribes or kickbacks, and there is only a small gain in employment (working as estate agents) while the local public, left holding the bag, is burdened with asset bubbles and high inflation. The monetary reform of enforcing a strict CBA (to repress dollarization), imposing certain capital controls, changing the patacas anchor to the yuan, and revaluing the former above the latter (far dearer than the HKD) would make it more difficult and less profitable for outsiders to engage in speculative realestate activity in Macao (Gu and Sheng 2007). The monetary reform may be necessary but far from being sufficient to restrain property bubbles under free capital mobility. The government will have to do more (say, imposing an 80% tax on profits from any housing deal) for the sake of avoiding inflation out of control, given that 68% of inflation is attributable to asset bubbles (plus fuels) and that the composite CPI is almost perfectly positively correlated with the housing/fuel price index (at 99.43% in 2006-2007). While the vested interests boast about a vivacious property market in Macao, the frustration of failing to have a decent housing unit has developed among the working-class public, as evidenced by several violent street protests. Hongkong real estate developers in collaboration with the foreign moneyed interests (p.90, Un 2007) have created the widely hated property bubble, plundering Macao residents and new immigrants out of their wealth. This privately greedy and socially costly behavior is rendering Macao growth increasingly unhealthy; high inflation is only one of bad consequences some of which have emerged and others of which will come about. 16

Many, if not all, of the past financial crises were caused by asset bubble bursting, and the boom and bust cycle of real estate has given rise to economic volatility for decades around the world (Stiglitz 2002) (e.g., the subprime mortgage crisis now in the U.S.). If the social unrest that has arisen in Macao is taken seriously, there is nothing the government cannot do to correct the asset markets distortions created by its manipulators. Bear in mind that high inflation cannot be brought down without beating asset bubbles. The AMCM cannot stand aside to watch the pataca sink in deep water without providing policy recommendations for the government. Monetary stability was lost and policy credibility is being damaged, so something will have to be done to rebuild the CBAs reputation as an inflation fighter. 5. Conclusion We have partly explained in this paper why an urgent currency reform is required on the financial and monetary front. Three significant reasons for the reform are summarized below. (1) The declining relevance of Hong Kong to the healthiness of Macao growth in conjunction with the rising importance of the Mainland to the sustainability of Macaos prosperity is the fundamental justification for the shift of the patacas anchor from the HKD to the yuan. Massive Mainlander arrivals, not FDI afflux, have become the major engine of Macao growth, and one also sees rising links between Macao and the Mainland in merchandise trade, international finance, and factor mobility. Large amounts of RMB cash brought in by Mainland visitors provide enough reserve currency for Macao to take the yuan as its monetary anchor. (2) The large RMB appreciation having been carried out for two and a half years will be a persistent international economic phenomenon. Resisting the yuan-link of the pataca has incurred a heavy loss from wealth depreciation and will make Macao lose more and more as its fiscal and BOP surpluses get bigger with output growth. Seemingly improved competitiveness from the patacas effective depreciation probably cannot outweigh the loss of real income caused by the deteriorating terms of trade. Macaos special trade structure is that it has to carry on large net merchandise importing from the Mainland while its citizens consume substantially in ZhuHai. Changing the currency anchor will then largely be welfare-improving. (3) The pataca has been losing both its internal and external values very fast for two and a half years. Its fixed exchange rate with the HKD becomes less meaningful since Hong Kong is less relevant to Macao growth, whereas its exchange rate against the yuan matters most to Macao. The theory of a CBA or dollarization as a popular scheme to 17

fight inflation and stabilize exchange rates, now goes bankrupt in the case of Macao since its monetary instability is expected to persist with a risk of causing socioeconomic instability. Rising import prices and asset bubbles are identified as the root cause for high Macao inflation, and the escalating BOP surplus seems to have not been responsible for monetary instability. Shifting to the yuan-link can effectively lower import costs and help bring inflation down. Also, suppressing dollarization plus certain tax codes can hopefully have some restraining impact on property bubbles. To rebuild its policy credibility, the AMCM may need to persuade the Administration to get really tough on bubble growth. The Macao monetary reform is required for other important reasons. Reason (4) is also on the financial front; that is, the reform can revive the chronically sickly domestic currency and resolve persistently weak pataca credit (see Gu and Sheng 2007). Reason (5) is on the political-economy front; that is, the reform can reinforce long-term economic autonomy by establishing a sovereign wealth fund, and ensure healthy growth, real development, and sustainable prosperity for Macao (this point entails a deepened research in another paper).

References
Census and Statistics Macao, (up to 2007), Most of the Data Used Are from This Source, see its website at: www.dsec.gov.mo/e_index.html. Chan, S.S., (2007), The Basic Framework for International Reserves and Its Application to Macao, Macao Monetary Research Bulletin, Issue No.02, Jan. Chan, S.S., (2004), The Practice of Central Banking in Macao, Macao Monetary Research Bulletin, Issue No.12, Jul. Edwards, S., (2001), The False Promise of Dollarization, Financial Times, May 11. Gu, X.H. and Sheng, L., (2007), A Freefalling Currency vs. a Skyrocketing Economy: Macao, Forthcoming at the Journal of Macao Polytechnic Institute (2008 Issue). Ho, N.W., (2003), Currency Substitution and the Case of Macao, Macao Monetary Research Bulletin, Issue No.7, Apr. Ho, N.W., (2007), Money Supply and Its Relevance to Macao, Macao Monetary Research Bulletin, Issue No.04, Jul.

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MacKinnon, R.I., (2005), Currency Wars, The Wall Street Journal. Friday, July 29. AMCM (Monetary Authority of Macao), (2007), Annual Reports for Year 2006, see its website at: www.amcm.gov.mo/Annual_Reports/Report.htm. MLAB (Macao Labor Affairs Bureau), (2006), Origins of Non-resident Workers of Year 2006, see a website at: www.dsal.gov.mo/english/otherstat.htm. Pao, J.W., (2003b), Foreign Reserves Management: the Case of Macao, Macao Monetary Research Bulletin, Issue No.8, Jul. Pao, J.W., (2003a), The Currency Board Arrangement and the Macao Experience, Macao Monetary Research Bulletin, Issue No.9, Oct. RSD (Research & Statistics Department, AMCM), (2007), Report on International Banking Statistics, the 1st Half of 2007, Macao Monetary Research Bulletin, Issue No.05, Oct. Stiglitz, J., (2002), Lessons from the Financial Crisis in Asia, DLS, held on 18 March, ECMC/WP/001, FSSH, University of Macao. Un, P.S., (2007), House Price Developments in Macao, Macao Monetary Research Bulletin, Issue No.03, Apr. Xu, X., (2006), The Pataca Must Be Linked to the Yuan Immediately, Ref: 2006.06.01, the International Business Information of Asia, see a website at: www.aiou.edu/banews/062006/04062006.doc

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