Explain of how the Linked Exchange Rate System works in Hong Kong.
A Linked Exchange Rate systems function is to keep a currency stabile to another. In this manner, the HK Dollar has been linked to US Dollar at the rate of 7.8 HKD to 1 USD, since 1983. In order to maintain this exchange rate, any change in the monetary base is fully backed by a corresponding change in the respective currency at this exchange rate.
Most banknotes in HK are issued by three note-issuing banks. So for example, if one prints 7.8 million HKD, they by law are required to deposit 1 million USD to an exchange fund, held by the Hong Kong Monetary Authority (HKMA). Similarly, if 7.8 million HKD is deposited to this exchange fund, 1 million USD will be received. The deposit is done by a purchase of a “Certificate of Indebtedness”, which exactly back the bank notes issued. The HKMA is Hong Kong’s currency board and central bank authority, founded in 1993. This is unlike a “Fixed Exchange Rate system”, where the government or central banks are to control the supply and demand of the currency to influence the exchange rate. The interest rates, rather than the exchange rate, adjust the inflow and outflow of funds. If a market participant want to buy HKD (capital inflow), an upward pressure on the HKD exchange rate appears. To remove this pressure the HKMA sells HKD and the monetary base will increase. Initially, the interest rates will fall and make it less lucrative to hold HKD. This leads to exchange rate stability.
The Linked Exchange Rate system for the HKD dates further back than 1983. Both linked to the pound sterling and USD. But from 1974 to 1983 the HKD was a free floating currency. In this period the HKD went from HKD 4.965 to 9.6 for one USD. Due to such huge fluctuations, the government announced a new policy to stabilize the currency again.
The Linked Exchange Rate system has shown resilience against external shocks, such as world stock market crash in 1987, gulf war...
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