Money and Banking FIN 243 Sec 1 (Group 1)

Money and BankingFIN 243Sec 1 (Group 1) Challenges encountered and prospects towards Hong Kong Linked Exchange Rates System Members Lists:Yip Sai Keung, Kenneth 053065 Liu Hoi Yan, Veronica 053140 Cheung Yiu Hong, Keith 053143 Yip To Chun, Kev 053148 Tsang Ka Ho 053155

Content • Introduction • The importance and mechanism of HKLERS • The impact of Renminbi reform towards HKLERS • Whether Renminbi, RMB replace the role of USD • The future towards HKLERS • Conclusion • References

Introduction • The linked exchange rate system (LERS) in Hong Kong is a currency board system • The monetary base can be divided into three parts • (1) Certificates of Indebtedness and coins issued • (2) The net balance of clearing accounts of the licensed banks held with the Hong Kong Monetary Authority (HKMA) • (3) The outstanding amount of Exchange Fund Bills and Notes

Hong Kong dollars (HKD) is officially linked to the US dollar at the rate of 7.8 HK dollars to one dollar since 17 October 1983 Introduction HK Dollars to 1 USD in 2006

Introduction • LERS plays an important part in supporting Hong Kong’s role as a trading and financial center • The resources of monetary base for backing up with US dollars are kept in Hong Kong’s Exchange Fund • LERS enables Hong Kong's economy to adjust to external shocks without the damage and volatility of a sudden currency collapse

The Mechanism of HKLERS • A Currency Board Arrangement (CBA) to fix the exchange rate at HK$7.8 per U.S. Dollar • Banks must deliver to the Exchange Fund an amount in U.S. dollars that is equivalent to the local currency issued • Keep the market rate in line with the linked rate • Through an automatic interest rate adjustment mechanism to make HKD Exchange Rate Stability

The Mechanism of HKLERS Demand for HKD ↑ • Automatic interest rate adjustment mechanism Demand for HKD ↓ Exchange Rate↓ Exchange Rate ↑ HKMA purchase HKD from bank Bank purchase HKD from HKMA Monetary Base ↓ Monetary Base ↑ Interest rate (i) ↑ Interest rate (i) ↓ Exchange Rate Unchanged Exchange Rate Unchanged

The Mechanism of HKLERS E.R. E.R. S S $8.0 $7.8 $7.8 $7.6 D D 0 0 The Automatic interest rate adjustment mechanism of HKLERS

The Importance of HKLERS • Improve external competitiveness of Hong Kong • The monetary financing of fiscal policy bring no effect to the exchange rate • The highest ratio of foreign currency reserves all over the world • Hong Kong dollar exchange rate remained stable facing several various shocks. (1997 Asian Financial Crisis)

Impact of RMB reform towards HK LERS • The reform of RMB exchange rates mechanism on 21 July 2005 • central government re-valuated the currency by 2% against the USD to 8.1100 • un-pegged the Yuan from the US dollar • referred the Yuan to a basket of currencies

The impact towards HK linked exchange rates system Raised a problem whether pegging with RMB or USD Trade between China and Hong Kong is inevitable Visible trade between Hong Kong and the Mainland Impact of RMB reform towards HK LERS

Impact of RMB reform towards HK LERS • External trade • HK$ ↓ → Import$ ↑ Export$ ↓ • boost to economic growth • higher inflation

Impact of RMB reform towards HK LERS • Hong Kong domestic exports to the Mainland only 1.6% of Hong Kong's total exports • Offset of re-export • The appreciation will be neutral for export • Imported inflation • seventy percents of Hong Kong's food is imported from the Mainland • HK government need to minimize food price volatility caused by factors

Impact of RMB reform towards HK LERS • Gain in consumption market • Mainland tourists: purchasing power bolstered • Hong Kong consumers: become more inclined to stay in the home market

Impact of RMB reform towards HK LERS • Speculation about possible revaluation of RMB • Huge funds flows into HK last 2 years • H-shares → options for investor gain exposure to Mainland

Whether RMB replace the role of USD RMB vs USD

Renminbi ’s viewpoints • Mainland’s economy becomes one of the largest in the world as the size of population already rank first • the fourth largest in terms of GDP since 2005 • the amount of foreign reserves ranks first • economy currently growing around 10% a year in real terms that is faster than many developed economies

Renminbi ’s viewpoints The GDP of China ranks the top three in 2006

Renminbi ’s viewpoints China ranks first in the amount of foreign reserves

Renminbi ’s viewpoints China economy grows faster than U.S.

Renminbi ’s viewpoints • Economic and Financial integration factors • Mainland shocks explain over one third of Hong Kong's price movements • Mainland’s economy (stock market) affects HK economy (stock market) but not so apparently • the Hong Kong market tends to follow the trends of mainland rather than the US in the future, but not now

Renminbi ’s viewpoints • the Mainland is developing into one of the major economic powerhouses of the world • strengthen its own ability and power • make RMB becoming a vital reserve currency, just like the role of US dollars in HK LERS

USD ’s viewpoints • HK: small and highly open economy • it offers exchange rate stability> Hong Kong's primary first choice • Enhance the trade and investment between HK and other countries • overseas traders trade with HK without worrying the fluctuation of exchange rate • HK rate will always stay stable toward the USD

USD ’s viewpoints • The most stable currencies in the world • USA is the world largest financial and economic center • However..If Hong Kong LERS link to the RMB…. • overseas traders have less confidence to trade with HK • most worry about the linked exchange rate in HK • they afraid the chance of HKD being fluctuatedall the time • RMB does not provide them a stable image till now

USD ’s viewpoints • The acceptance level of USD is higher than RMB all around the world • most countries accept USD more than RMB • USD has a stable rate that do not have great fluctuation so easy

USD ’s viewpoints • Developments in the US affecting both China and HK • co-movements of business cycles • 60% of shocks in the US affect over 45% of the variations in price changes in Hong Kong • little correlation between the business cycles attributable to domestic shocks in Hong Kong and the Mainland • this data refutes the results that are in RMB’s viewpoints

USD ’s viewpoints Foreign Exchange Reserves from 1995-2006

The future of linked exchange rates system in Hong Kong

The future of linked exchange rates system • Now, RMB appreciation brings out an effect to HK linked exchange rates system • RMB can respond on Hong Kong linked exchange system in some different ways • link a basket of currency with HKD • only link with RMB and replace U.S dollar • can all use RMB in Hong Kong > reduce the transaction cost of currency exchange

The future of linked exchange rates system • So RMB is the future trend of HK exchange system development • However, RMB still have many problems • can’t freely exchange with other currencies • since the economic development in China is not stable • If the bubbles explode again, it can certainly affect HK’s exchange system • so suitable period to have changes for HK exchange rates system should be considered carefully

China’s trade surplus and the US trade deficit The future of linked exchange rates system

The future of linked exchange rates system • In the foreseeable future, • the US remains the largest economy in the world • the USD is still the primary reserve currency • As a result, RMB simply will not be able to replace USD • There is a comprehensive advantage of USD that still exists

The future of linked exchange rates system Exchange trends between RMB and USD in 2006

The future of linked exchange rate system • Hong Kong needs to maintain its uniqueness • to avoid being marginalized as well as to maintain and leverage on our own advantages • such as high degree of internationalization and economic freedom • so Hong Kong linked exchange rates system could be a symbol of our characteristics: Internationalization and Economic freedom

The future of linked exchange rate system • HK will not have a great change between 2047 and even 2097 • Old : ‘one country, two systems’ • New : ‘one country, two currencies, two monetary systems and two monetary authorities’

Conclusion • Since LERS was established in 1983, it faced many challenges and difficulties to now • Because of reform and appreciation of RMB, starts to discuss • “Should RMB replace the USD in Hong Kong ‘s linked exchange rate system soon?” • Comparing the advantages and disadvantages between the RMB and USD: • Hong Kong should not change LERS in the foreseeable several years • It is workable after the RMB exchange rate system getting mature and well developed all around the world

References • http://www.yearbook.gov.hk/2003/english/chapter03/03_01.html • http://www.news.gov.hk/en/category/businessandfinance/060921/html/060921en03004.htm • http://www.news.gov.hk/en/category/businessandfinance/061130/html/061130en03013.htm • http://webpage.hssc.edu.hk/~hkcung/ExchangeRateSystems • http://www.newsobserver.com/business • http://www.xinhuanet.com/politics/

That’s the end Thank you very much

Money and Banking FIN 243 Sec 1 (Group 1)