Hong Kong Linked Exchange Rate System

The just-released U.S. inflation data for April exceeded expectations. After the announcement, another news mentioned that the Hong Kong dollar hit the weak-side convertibility guarantee for the first time since 2019. So what is a weak-side redemption guarantee?

Hong Kong Linked Exchange Rate System

Hong Kong’s linked exchange rate system is the backbone of Hong Kong’s monetary and financial stability. It has been implemented in Hong Kong since October 17, 1983. Through a rigorous, stable and transparent currency board system, the exchange rate of the Hong Kong dollar has remained stable at 7.75 to 7.85 Hong Kong dollars to 1 US dollar within the range.

The linked exchange system in Hong Kong belongs to the currency board system and has the following characteristics:

Under the currency board system,

The Monetary Base is fully backed by U.S. dollar assets, and any movement in the Monetary Base must be fully matched by a corresponding change in U.S. dollar assets at a constant exchange rate.

The HKMA provides a convertibility guarantee, promising to sell Hong Kong dollars at the strong-side convertibility guarantee level of HK$7.75 to US$1 at the bank’s request, and to buy Hong Kong dollars at the bank’s request at the weak-side convertibility guarantee level of HK$7.85 to US$1.

The HKMA maintains the stability of the exchange rate of the Hong Kong dollar through an automatic interest rate adjustment mechanism and a firm commitment to honour the convertibility guarantee.

Funds flowing into Hong Kong dollars: If the market demand for Hong Kong dollars exceeds the supply, and the market exchange rate strengthens to the strong-side convertibility guarantee exchange rate of 7.75 Hong Kong dollars to 1 US dollar, the HKMA is ready to sell Hong Kong dollars and buy US dollars to banks at any time, so that the total balance ( A component of the monetary base) and the Hong Kong dollar interest rate fell, which brought the Hong Kong dollar exchange rate back from the strong-side convertibility guarantee rate level to the conversion range of 7.75 to 7.85.

Outflows of Hong Kong dollars: If the oversupply of Hong Kong dollars weakens the market exchange rate to the weak-side convertibility guarantee rate of HK$7.85 to US$1, the HKMA stands ready to buy Hong Kong dollars from banks, reducing the aggregate balance (a component of the monetary base) and Pushing up the Hong Kong dollar interest rate, the Hong Kong dollar exchange rate will then return to the exchange rate range from the weak-side exchange guarantee exchange rate level.

Reform History

Looking back on history, Hong Kong’s monetary policy has undergone several rounds of reforms, from the silver standard, the pound standard, the fixed exchange rate to the dollar, and the free floating until today’s linked exchange rate system:

silver standard

1863: The Hong Kong government proclaimed the silver dollar as legal tender, thus establishing a silver-standard monetary system: the currency is equivalent to silver and can be exchanged for silver.

Sterling Standard

December 1935: The global silver crisis, the Hong Kong government announced to abandon the silver standard and pegged the Hong Kong dollar to the British pound at 16 Hong Kong dollars to 1 British pound.

November 1967: The British pound depreciates sharply, and the exchange rate between the Hong Kong dollar and the British pound is adjusted to 14.55 Hong Kong dollars to 1 pound.

U.S. dollar pegged at a fixed exchange rate

July 1972: The Hong Kong dollar was pegged to the US dollar, and the exchange rate was set at HK$5.65 per US dollar, and the intervention range was ±2.25% of the core exchange rate.

February 1973: The official exchange rate of the Hong Kong dollar was changed to HK$5.085 per US dollar.

free float

November 1974: Markets lose confidence in the dollar, leading to the collapse of the Bretton Woods system. The Hong Kong dollar began to float freely.

Linked Exchange Rate System

October 17, 1983: Hong Kong began to implement the currency board arrangement, the Hong Kong dollar was pegged to the US dollar, and the exchange rate was set at 7.8 Hong Kong dollars per US dollar.

The formulation and closure of each system has the ebb and flow of an era lurking behind it.

This article is reprinted from: https://hijiangtao.github.io/2022/05/11/Linked-Exchange-Rate-System/
This site is for inclusion only, and the copyright belongs to the original author.

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