Chapter 13International Finance II--- The Linked Exchange Rate System in Hong Kong

Contents: Operation of the system in Hong Kong Effects on the economy

Operation of the System in Hong Kong

The system The linked exchange rate system in Hong Kong is actually a currency board system. Through the note-issuing mechanism, the fixed and the flexible exchange rate systems are linked together by licensed banks.

USDs and HKDs are exchanged between licensed banks and the Exchange Fund at a fixed rate (US$1=HK$7.8) Selling of USD for HKD

Buying USD with HKD

USDs and other currencies are exchanged between licensed banks and the non-bank public at flexible rates (determined by market demand and supply)Licensed Banks Non-bank Public

Arbitrage under the linked exchange rate system--- when the market rate > linked rateNon-bank Public(US$1=HK$9)USD is dearerExchange Fund (US$1=HK$7.8)USD is cheaper

Price of US$ (in HK$)Quantity of US$SD9.0Graphical illustration --- market rate > linked rateAs LBs sell USD in the market, supply of USD The market rate of USD until it is close to the linked rateForeign exchange market0

Arbitrage under the linked exchange rate system--- when the market rate < linked rateNon-bank Public(US$1=HK$6.5)USD is cheaperExchange Fund (US$1=HK$7.8)USD is dearer

Price of US$ (in HK$)Quantity of US$SD6.5Foreign exchange market0Graphical illustration --- market rate < linked rateAs LBs buy USD from the market, demand for USD The market rate of USD until it is close to the linked rate

Speculation under the linked rate system A bullish speculation on HKD

Once the market rate falls below the linked rate, licensed banks will make an arbitrage. A bullish speculation on HKDLBs will buy USDs from (sell HKDs to) the market and sell USDs to (buy HKDs from) the Exchange Fund until the market rate approaches the linked rate again. As LBs sells HKDs to the market, money supply of HKD increases and r in HKDs falls.The interest rate differential thus created will discourage the capital inflow & relieve the revaluation pressure.

Q13.1:What will happen if there is a bearish speculation against the HKD? What can the government do to relieve the devaluation pressure brought by speculators?

Differences between arbitrage and speculation

Price differentialRisk involvedArbitrage Exists between different marketsNoSpeculation Exists between the present price and the speculated future priceYes

Differences between the linked exchange rate system and the fixed exchange rate system

Market exchange rateMaintained by Linked exchange rate system Variable but close to the linked rateArbitrage of licensed banksFixed exchange rate system Fixed and equal to the pre-announced rateIntervention of the government

Effects on the Economy

1. No independent monetary policiesrYISLMr1Hong Kongr in HK

rYISLMr1Hong KongGraphical illustrationExp. MP Ms LM shifts rightwardArbitrage Ms LM shifts leftwarduntil r restores its initial value

The monetary authority cannot determine the money supply or the interest rate independently. Under the linked exchange rate system (or fixed exchange rate system) The monetary policy is completely ineffective.

2. Ms and r in HK follow those in the U.S.rYISLMr1The U.S.

rYISLMr1Hong KongGraphical illustrationArbitrage Ms LM shifts rightward

Hong Kong has to follow the monetary policy of the U.S. passively.Under the linked exchange rate system (or fixed exchange rate system) HKs money supply & interest rates will change simultaneously with those in the U.S.

3. Exchange Values of Other Currencies in HK Dollars Follow Their Corresponding Values in US Dollars It is cheaper to buy JPYs with USDs than with HKDs. As there exists a price differential, arbitrageurs will buy Jap. yens where they are cheaper (with USD) and sell Jap. yens where they are dearer (for HKD). HK arbitrageurs (with HKDs): Sell HKDs for USDs Buy yens (cheaper) with USDs sell yens (dearer) for HKDs (to reap P diff.)a. When US dollar appreciates against Japanese yen

Before appreciation of USD against yenMarket Rate HK$7.8 = US$1 US$1 = JP 125 HK$1 = JP 16.0After appreciation of USD against yenMarket Rate HK$7.8 = US$1 US$1 = JP 135 HK$1 = JP 16.0HK$7.8US$1JP 135HK$8.44=135/16Gain HK$0.64 HK arbitrageurs (with HKDs)

Price of yen (in HK$)Quantity of yenSDeHK arbitrageurs supply JPY for HKD HKD appreciates against JPYGraphical illustration--- For. Ex. market between Jap. yen & HKD

Under the linked (or fixed) exchange rate system, If the exchange value of a currency in US dollar changes, its exchange value in HK dollar must follow (until the price differential approaches zero).

b. When HK$ appreciates against yene.g. HKs export to Japan Supply of JPYPrice of yen (in HK$)Quantity of yenSDeHK$ appreciates against yen

When HKD appreciates against Jap. yen, it is cheaper to buy JPYs with HKDs than with USDs. As there exists a price differential, arbitrageurs will buy Jap. yens where they are cheaper (with HKD) and sell Jap. yens where they are dearer (for USD). HK arbitrageurs (with HKDs):Sell HKDs for JPYs (cheaper) Sell JPYs (dearer) for USDs sell USDs for HKDs (to reap P diff.)

Before appreciation of HKD against yenMarket Rate HK$7.8 = US$1 US$1 = JP 125 HK$1 = JP 16.0After appreciation of HKD against yenMarket Rate HK$7.8 = US$1 US$1 = JP 125 HK$1 = JP 20.0HK$1JP 20US$0.16=20/125HK$1.248=0.16x7.8Gain HK$0.248 HK arbitrageurs (with HKDs)

Price of yen (in HK$)Quantity of yenSSDeeHK arbitrageurs buy JPY with HKD HKD depreciates against JPY until the initial value is restoredGraphical illustration--- For. Ex. market between Jap. yen & HKD (by arbitrageurs)(by exporters)

Under the linked exchange rate system, If the exchange value of a currency in US dollar remains unchanged, its exchange value in HK dollar cannot be varied.

Correcting Misconceptions:1. The non-bank public can buy and sell US dollars with the Exchange Fund at the linked rate.2. Arbitrage is the same as speculation.3. The linked exchange rate system is the same as the fixed exchange rate system.

4. The interest rates in Hong Kong are always equal to the interest rates in the U.S. 5. The exchange rates of currencies other than the US dollar are flexible and are freely determined by the market.Correcting Misconceptions: