The Linked Exchange Rate System was implemented in Hong Kong in 1983. It is a Currency Board System in essence, which requires both the stock and the flow of the Monetary Base to be fully backed by foreign reserves. As Hong Kong's de facto central bank, Hong Kong Monetary Authority (HKMA) authorizes the three note-issuing banks to issue Hong Kong dollar (HKD) notes provided that they deposit an equivalent value of US dollars (USD) at a rate of HKD 7.80 = USD 1. A market rate lower than 7.80 will induce the banks to convert USD for HKD from HKMA, and then HKD supply will increase, the market rate will climb back to 7.80 subsequently. Similarly, a market rate which is higher than 7.8 will convert HKD for USD with the same mechanism.
The Benefits of Hong Kong’s Linked Exchange Rate System
First of all, as a typically open economy, Hong Kong is highly export-oriented, which has a huge international capital inflows and outflows. A stable exchange rate can reduce the risk faced by the importers and exporters to a large extent, and is also beneficial to free international capital flows, which further cement Hong Kong’s position as an international financial center.
Secondly, under the effect of British classical economics, Hong Kong’s government has implemented “ laissez-faire ” and “ positive but non-intervention ” policies since the British era. Under the Currency Board System, the only object of Hong Kong's monetary policy is to maintain the stability of HKD’s exchange rate. This straightforward monetary policy rule reduces the currency volatility which is caused by speculation, as well as the uncertainties in economic activity, thus diminishes transaction costs. At the same time, the Linked Exchange Rate System binds the government to a great degree.
In addition, as Hong Kong has a close relationship with United States, the economic policies of US has a great influence on HKD, that is, USD plays an important role in Hong Kong's foreign trade and financial exchanges. With the highly speedy development of China's economy, US is still the fourth largest importer and the largest exporter of Hong Kong, although US’s dominant position has been declined relatively in recent years. It shows that it is a wise choice for Hong Kong to link USD as its pegged currency at the very beginning.
Last but not least, the continuous increase in reserves of foreign exchange assets provides a good economic environment for Hong Kong .This large foreign reserves is also an important tool for Hong Kong government to maintain the stability of financial market. With a highly flexible economic system, an abundant labor market and an adjustable real estate market, Hong Kong could easily stabilize its exchange rate regardless of the external competitiveness. It is the good economic environment that provides a strong guarantee for the implementation of Hong Kong’s Linked Exchange Rate System.
The Costs of Hong Kong’s Linked Exchange Rate System
However, each coin has its two sides. In order to stabilize the exchange rate, Hong Kong's economy must pay for the corresponding costs in the following aspects:
First of all, the absence of independence and flexibility of Hong Kong’s Linked Exchange Rate System results in a money supply’s out of control. Under the Currency Board System, the Hong Kong government has to maintain a fixed exchange rate as well as a free capital flow. If the Hong Kong government implements expansionary monetary policy by lowering its local interest rates, then capital will flow out and HKD will face the pressure of depreciation. In order to keep the exchange rate constant, HKMA has to sell the foreign exchange reserves to recover currency in the foreign exchange market. However, it operates against the original purpose of the Currency Board System, and cannot meet the government’s goal of expanding money supply. Consequently, Hong Kong has to follow FED’s monetary policy