Linked Exchange Rate in Hk

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Central Banking (FIN10908)
Hong Kong Linked Exchange Rate System

Hong Kong Linked Exchange Rate System Introduction

Hong Kong’s Linked Exchange Rate system is a currency board system, which requires both the stock and flow of the monetary base to be fully backed by foreign reserves. It is the exchange rate system implemented in Hong Kong to stabilize the exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD). This means that any change in the monetary base is fully matched by a corresponding change in foreign reserves at a fixed exchange rate. (1)(2)

The Hong Kong Monetary Authority (HKMA) is Hong Kong's currency board and central banking authority. And it authorizes note-issuing banks are to issue new banknotes provided that they deposit an equivalent value of US dollars with the HKMA. (3)

The Reasons for Choosing Anchor Currency and The Advantages of US Dollar Being Anchor Currency in Hong Kong

When we select the anchor currency, we should take into account the currency denomination of external trade and financial transactions, as well as the credibility and stability of the monetary regime governing that currency. Therefore, the US dollar is suitable for being HK dollar’s anchor currency, because US dollar is the predominant currency in which trade in Hong Kong and external financial transactions are denominated. (4)

The choice of the US dollar as an anchor is logical, since it is the predominant foreign currency in which our external trade and financial transactions are denominated

Also, link to US dollar, Hong Kong can benefit from a largely stable monetary environment in the US and the unparalleled credibility of US monetary policy.

The Disadvantages of US Dollar Being Anchor Currency in Hong Kong

Interbank interest rates in Hong Kong normally follow closely the movements of United State under the Linked Exchange Rate system. It ties Hong Kong to US monetary policy at times when the economic cycles of Hong Kong and the US may not necessarily be moving in tandem. A Linked Exchange Rate system leaves little scope for an autonomous interest rate policy to achieve the objectives of price stability or promotion of economic growth. If there is a misalignment between Hong Kong and US economic cycles, local interest rates, which closely track their US dollar counterparts, may not be best suited to the macroeconomic conditions of the domestic economy. For example, recently, a decrease in US dollar interest rates to excite an economic recession in United States might bring a huge inflation in Hong Kong. Although there have high rates of inflation in Hong Kong, the Hong Kong government cannot use open market operations such as increase interest rate to influence money supply to control the inflation, they only can use the non-efficiency way like issue ibond to help people resist inflation.

Pros and Cons of Linked Exchange Rate System in Hong Kong in Achieving Monetary Stability

Pros
The Linked Exchange Rate system suits the needs of a highly open economy. It is simple, consistent and well understood. It helps a small open economy, such as the Hong Kong’s, to reduce the cost of exchange rate volatility. The exchange rate can be very volatile particularly for Hong Kong as it has no control over capital movement. It enables Hong Kong to adjust to shocks without the damage and volatility of a sudden currency collapse. (5)

The Link suits Hong Kong’s economic conditions. Hong Kong is a very externally oriented economy, with a completely open capital account and a large financial sector. These factors leave us heavily exposed to financial shocks stemming from volatilities in external markets. The Link provides Hong Kong with a firm monetary anchor which, among other things, reduces the foreign exchange risk faced by importers, exporters and international investors. Below are four main fundamentals that Linked Exchange Rate System can achieve monetary stability in Hong...
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