Linked Exchange Rate System

Topics: United States dollar, Foreign exchange market, Currency Pages: 5 (1773 words) Published: November 17, 2013
In the face of rising inflationary pressure in Hong Kong, some people have suggested that the Linked Exchange Rate system is the root cause of the situation and that the Hong Kong dollar should no longer be linked to the US dollar. The Financial Secretary already stated in his blog on 14 August that the Link continues to be the most appropriate exchange rate arrangement for Hong Kong. I will elaborate further on a few related issues. Many people who advocate un-pegging the Hong Kong dollar from the US dollar claim that the recent downgrade of the sovereign credit rating of the US would inevitably lead to a substantial depreciation of the US dollar. They argue that Hong Kong’s risks of high inflation and an asset price bubble will heighten if the Hong Kong dollar continues to be linked to the US dollar. I do not agree with this proposition. As I have explained to the media on 8 August, the US dollar remains the most important international reserve currency as well as the main currency in which financial and trade transactions are denominated and settled. These roles can hardly be replaced overnight. So the downgrade of the US does not necessarily lead to one-way depreciation of the US dollar. In fact, the exchange rates among the major international trade and reserve currencies (the US dollar, the euro, the Japanese yen and the British pound) are the relative value of one currency against another. While the US economy might slow down and the US government has not yet fully solved its fiscal problems, the euro area, Japan and the UK are facing similar, or to some extent more severe, problems. Relatively speaking, the US economy has shown more vitality and stronger capability for adjustment. For example, the labour market in the US is more flexible than those in many European countries, and it has a younger population too. While the exchange rate of the US dollar will inevitably fluctuate in the short term, there is not enough evidence to support the view of a medium to long-term depreciation of the US dollar against the euro and the Japanese yen. Even though the Hong Kong dollar may weaken along with the US dollar during an economic cycle, inflation does not necessarily follow. Inflation in Hong Kong is affected by a number of external and internal factors, with food prices and rents being two major components. The recent increases in food prices are a global problem. It is not unique to Hong Kong where we adopt the Link. Furthermore, spending on services represents a substantial portion of consumption expenditure in Hong Kong, whereas spending on goods accounts for only 27% of the consumers’ basket in Hong Kong. In the services sector, business costs are mainly comprised of wages and rents, with imported goods accounting for only a small portion. Prices of the services sector are therefore less affected by exchange rate movements. So weakening of the Hong Kong dollar has never had a very visible impact on our inflation. As for the increases in rents, they have more to do with property prices. Some people think that linking the Hong Kong dollar to a weak US dollar is the culprit for the soaring property prices. I disagree. The premise of this theory is that whenever the US dollar or HK dollar is weak, property prices go up. We need to recognise that property prices depend on many factors, including the supply of land and housing units, affordability, demographic structure, the costs of mortgage lending, and investors’ expectations on movements in property prices and on the factors just mentioned. Looking at the economies in the Asia-Pacific region, there is no clear relationship between the exchange rate regime or exchange rate movements and local property prices. For example, while the exchange rate regimes of the Mainland and Singapore are clearly different from Hong Kong’s Linked Exchange Rate system, and the currencies of these economies have appreciated considerably against the US dollar in the...
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