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The Linked Exchange Rate system of Hong Kong

The Linked Exchange Rate system of Hong Kong. Banking Commissioner Office. Exchange Fund Office. Hong Kong Monetary Authority. 1 April 1993. Main Functions. Keeping the Hong Kong dollar stable Managing the Exchange Fund in a sound and effective way

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The Linked Exchange Rate system of Hong Kong

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  1. The Linked Exchange Rate system of Hong Kong

  2. Banking Commissioner Office Exchange Fund Office Hong Kong Monetary Authority 1 April 1993

  3. Main Functions • Keeping the Hong Kong dollar stable • Managing the Exchange Fund in a sound and effective way • Promoting the safety and stability of Hong Kong’s banking system • Developing Hong Kong’s financial infrastructure

  4. Monetary Policy Objective Currency stability, defined as a stable external exchange value of the currency of Hong Kong, in terms of its exchange rate in the foreign exchange market against the US dollar, at around HK$7.80 to US$1.

  5. Importance of Exchange Rate Stability • Hong Kong is a small and highly-open economy • As an international trading centre, external trade equals to 4 times GDP • As an international financial centre, exchange rate volatility affects capital allocation decision of foreign investors

  6. US Dollar as the Anchor Currency • US dollar is the most commonly used currency for international trade and financial transactions • US is Hong Kong’s second largest trading partner • Business cycle synchronisation between Hong Kong and the US is the highest

  7. Historical Background • In 1982-83, Sino-British talk on the resumption of Hong Kong's sovereignty after 1997 triggered a confidence crisis, leading to sharp depreciation of the Hong Kong dollar • In response, the HK Government established the Linked Exchange Rate system on 17 October 1983 • A currency board system

  8. Currency Board system • Monetary Base fully backed by foreign exchange reserves • Components of Monetary Base： • Currency in circulation • Aggregate Balance • Exchange Fund Bills and Notes

  9. Currency in circulation HKD banknotes issued by the three note-issuing banks are fully backed by USD reserves fixed exchange rate HKD Banknotes USD HK$7.8=US$1

  10. Bank Bank Bank Bank Bank Bank Bank Aggregate Balance HKMA Sum of clearing accounts maintained by banks with the HKMA = interbank liquidity condition

  11. Exchange Fund Bills and Notes • Direct and unconditional obligations of the HK Government under the Exchange Fund Account • Introduced in March 1990 • Tenors of the Bills are 91, 182 and 364 days, while those of the Notes are 2, 3, 5, 7, 10 and 15 years

  12. How does the Linked Exchange Rate system operate?

  13. Market participants sell Hong Kong dollars Capital outflow Downward pressure on Hong Kong dollar exchange rate Currency Board buys Hong Kong dollars Monetary Base contracts Hong Kong dollar exchange rate stability Market participants buy or sell fewer Hong Kong dollars because of higher Hong Kong dollar interest rates Interest rate rises Automatic adjustment mechanism (1)

  14. Market participants buy Hong Kong dollars Capital inflow Upward pressure on Hong Kong dollar exchange rate Currency Board sells Hong Kong dollars Monetary Base expands Interest rate falls Hong Kong dollarexchange rate stability Market participants sell or buy fewer Hong Kong dollars because of lower Hong Kong dollar interest rates Automatic adjustment mechanism (2) 6

  15. Resilence Against External Shocks

  16. Reform measures • September-1998 ( seven measures ) • May-2005 ( three refinements)

  17. Background on seven technical measures in 1998 Market concerns： • Asian financial crisis • Rumours of renminbi devaluation, market scepticism on the commitment to the Link • A lot of Hong Kong dollar short-selling activities, tight interbank liquidity and high interest rate volatility

  18. % % 100 100 90 90 80 80 First-round attack O/N HIBOR 70 70 Second-round attack Free floating 60 60 of Thai baht Third-round attack (2 July) 50 50 Fourth-round attack 40 40 Introduction of the seven technical 30 30 measures (7 Sept) 20 20 1M HIBOR 10 10 0 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Interest rates movement during the Asian Financial Crisis

  19. Seven technical measures Introduced in September 1998 to strengthen the Currency Board arrangement Seven technical measures Discount Window Convertibility Undertaking

  20. Weak-side Convertibility Undertaking HKMA Bank US dollar Hong Kong dollar US$1 = HK$ 7.80 Clarify commitment to the Linked Exchange Rate system

  21. Discount Window Bank HKMA Banks can use Exchange Fund paper as collateral to arrange repo agreement with the HKMA for liquidity management (4:30 p.m. daily) Avoid excessive interest rate volatility and allows orderly adjustment

  22. FX market development in 2002-05 HK$/US$ HK$/US$ HKD exchange rate Weak-side Convertibility Undertaking (CU) Triggering of weak-side CU 2002 2003 2004 2005

  23. Background on three refinements in 2005 • Expectations on renminbi appreciation • Hong Kong’s economic recovery • Depreciation of the US dollar

  24. Aggregate Balance HK$ billion HK$ billion Aggregate Balance (exclude interest payments on Exchange Fund paper)

  25. HKD & USD interest rates HIBOR LIBOR

  26. Impact of easy monetary conditions • Risk of inflation and formation of asset bubble • Destabilising effect associated with realignment of HKD interest rates with USD rates

  27. Three refinements Strong-side Convertibility Undertaking Weak-side Convertibility Undertaking Convertibility Zone Three refinements

  28. Three refinements (1) The HKMA undertakes to buy US dollar from banks at HK$7.75/US$1

  29. 7.90 7.90 7.85 7.85 7.80 7.80 7.75 7.75 7.70 7.70 Three refinements (2) Gradually move the weak-side Convertibility Undertaking from 7.80 to 7.85 23/5 20/6

  30. 7.90 7.90 7.85 7.85 Convertibility Zone 7.80 7.80 7.75 7.75 7.70 7.70 Three refinements (3) Establish a Convertibility Zone, within which the HKMA can conduct discretionary monetary operations

  31. Effects of the three refinements • Remove uncertainty about appreciation potential of the Hong Kong dollar • HKD interest rates closer to USD rates • Strengthen the operation of the Linked Exchange Rate system

  32. Hong Kong dollar exchange rate

  33. 12-month interest rate spreads

  34. Conclusion • The Linked Exchange Rate system is a cornerstone for maintaining economic stability • Economic underpinnings • Ample forex reserves • Flexible economic structure • Prudent fiscal policy stance • Sound banking system

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