Pacific Economic Review, 4: 2 (1999) pp. 215±232 PERSPECTIVES ON PUBLIC POLICY AN INTERTEMPORAL CURRENCY BOARD ALEX CHAN  The University of Hong Kong NAI-FU CHEN University of California Irvine, USA Abstract. The paper shows that the traditional wisdom of raising interest rates to defend a currency enriches rather than punishes the speculators. Furthermore, using high interest rates as a currency defense tool often produces the opposite effect in times of crisis. A new approach is proposed of using Hong Kong dollar ``put'' options as an explicit commitment by the government. The put option itself acts like an intertemporal currency board in keeping the linked exchange rate over time. This costly signaling produces a separating equilibrium that distinguishes the strength of the Hong Kong dollar from the other Asian currencies that were under pressure in 1997. 1. INTRODUCTION The devaluation of the Thai baht in the summer of 1997 set off the Asian currency crisis. The crisis substantially affected many other currencies: the South Korean won, the Indonesian rupiah, the Malaysian ringgit, the Philippine peso, and others. There were two questions facing decision-makers in Hong Kong: * Should the Hong Kong dollar (HK$) maintain its link with the US dollar (US$)? * If so, how to defend the Hong Kong dollar when the surrounding currencies are falling? The answer to the first question is obvious ± Hong Kong should not devalue its currency. Faced with the decrease in value of the surrounding currencies, Hong Kong has two choices in maintaining its competitiveness: (a) to allow the Hong Kong dollar to float, or (b) to allow its domestic prices to deflate. At first glance, option (a) may be easier because the other option means substantial pain to the local economy. However, option (a) can quickly lead to a bottomless pit with competitive devaluation all around. Thus it is far better to anchor the HK$ to the US$ and allow the domestic price structure to find its level (option (b)) than to allow the HK$ and the domestic price structure to fall freely. Furthermore, the economic foundation of Hong Kong lies in its value as an international finance center and a world trading post for China. Both of these roles require a stable currency so that investors and traders do not have to bear any additional currency risks. Thus the prosperity of Hong Kong depends # Blackwell Publishers Ltd 1999. 108 Cowley Road, Oxford OX4 1JF, UK and 350 Main Street, Malden, MA 02148, USA  Address for correspondence: School of Economics and Finance, The University of Hong Kong, Pokfulam Road, Hong Kong, Tel: (852)-28578510; E-mail: alexchan@econ.hku.hk. We thank K. C. Chan, Yuk-shee Chan, Leonard Cheng, Francis Lui, Fred Kwan and especially Merton Miller for their helpful comments on earlier versions of this paper.