1

The Linked Exchange Rate system of Hong Kong

2

1 April 1993

Exchange Fund Office

Hong Kong Monetary Authority

Banking Commissioner

Office

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

As an international financial centre, exchange rate volatility affects capital allocation decision of foreign investors

Hong Kong is a small and highly-open economy

As an international trading centre, external trade equals to 4 times GDP

6

US Dollar as the Anchor Currency

Business cycle synchronisation between Hong Kong and the US is the highest

US dollar is the most commonly used currency for international trade and financial transactions

US is Hong Kong’s second largest trading partner

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

Monetary Base fully backed by foreign exchange reserves

Components of Monetary Base：Currency in circulation

Aggregate Balance

Exchange Fund Bills and Notes

Currency Board system

9

Currency in circulation

HKD banknotes issued by the three note-issuing banks are fully backed by USD reserves

fixed exchange rate

USDHKD Banknotes

HK$7.8=US$1

10

Aggregate Balance

Sum of clearing accounts maintained by

banks with the HKMA

= interbank liquidity condition

HKMA

Bank Bank Bank Bank Bank Bank Bank

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

Automatic adjustment mechanism (1)

Downward pressure on Hong Kong dollar

exchange rateCurrency Board buys

Hong Kong dollars

Monetary Base contracts

Interest rate rises

Market participants sellHong Kong dollars

Capital outflow

Market participants buy or sell fewer Hong Kong dollars

because of higher Hong Kong dollar interest rates

Hong Kong dollar exchange rate stability

14

Automatic adjustment mechanism (2)

Capital inflow

6

Market participants buy Hong Kong dollars

expandsCurrency Board sells

Hong Kong dollarsInterest rate falls

Hong Kong dollar exchange rate stability

Upward pressure on Hong K

ong dollar exchange rate

Market participants sell or buy fewer Hong Kong dollars because of lower

Hong Kong dollar interest rates

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Resilence Against External Shocks

5.0

5.5

6.0

6.5

7.0

7.5

8.0

8.5

9.0

9.5

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09

HK$/US$

World StockMarket Crash

(Oct 87)

Gulf Crisis(Aug 90)

Closure ofBCCI (HK)

(Summer 91)

ERMTurmoil

(Sep 92)

MexicanCrisis

(Jan 95)

AsianCurrency

Turmoil (July97-98)

Announcementof the passingaway of Deng(20 Feb 97)

Introduction ofthe LinkedExchange

Rate system(Oct 83)

Abandonmentof Argentine

Currency Boardsystem (Jan 02)

11thSeptember

2001

Reform of RMBexchange rateregime (Jul 05)

Collapse of LehmanBrothers and Global

Financial Crisis (Sep 08)

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Reform measures

September-1998

( seven measures )

May-2005

( three refinements)

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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

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Interest rates movement during the Asian Financial Crisis

0

10

20

30

40

50

60

70

80

90

100%

0

10

20

30

40

50

60

70

80

90

100%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

O/N HIBOR

1M HIBOR

First-round attack

Second-round attack

Third-round attack

Fourth-round attack

Introduction of the seven technicalmeasures (7 Sept)

Free floatingof Thai baht(2 July)

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Seven technical measures

Introduced in September 1998 to strengthen

the Currency Board arrangement

Seven technical measures

Convertibility Undertaking

Discount Window

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Weak-side Convertibility Undertaking

US dollar

Hong Kong dollar

BankHKMA

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

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7.60

7.65

7.70

7.75

7.80

7.85

7.90

7.95

8.00

7.60

7.65

7.70

7.75

7.80

7.85

7.90

7.95

8.00

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1

2002 2003 2004 2005

FX market development in 2002-05 HK$/US$ HK$/US$

HKD exchange rate

Weak-side Convertibility Undertaking (CU)

Triggering of weak-side CU

23

Background on three refinements in 2005

Expectations on renminbi appreciation

Hong Kong’s economic recovery

Depreciation of the US dollar

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0

10

20

30

40

50

60

0

10

20

30

40

50

60

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2003 2004 2005

Aggregate BalanceHK$ billion HK$ billion

Aggregate Balance (exclude interest payments on

Exchange Fund paper)

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-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

%

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0%

2003 2004 2005

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4

HKD & USD interest rates

LIBOR

HIBOR

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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

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Three refinements

Three refinements

Strong-side Convertibility Undertaking

Weak-side Convertibility Undertaking

Convertibility Zone

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Three refinements (1)

The HKMA undertakes to buy US dollar from banks at HK$7.75/US$1

7.70

7.75

7.80

7.85

7.70

7.75

7.80

7.85

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Three refinements (2)

Gradually move the weak-side Convertibility Undertaking from 7.80 to 7.85

23/5 20/6

7.70

7.75

7.80

7.85

7.90

7.70

7.75

7.80

7.85

7.90

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Three refinements (3)Establish a Convertibility Zone, within which the HKMA can conduct discretionary monetary operations

7.70

7.75

7.80

7.85

7.90

7.70

7.75

7.80

7.85

7.90

Convertibility

Zone

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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

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Hong Kong dollar exchange rate

7.60

7.65

7.70

7.75

7.80

7.85

7.90HK$/ US$

7.60

7.65

7.70

7.75

7.80

7.85

7.90HK$ / US$

Convertibility Zone

HKD market exchange rate

Weak-side Convertibility Undertaking

Strong-side Convertibility Undertaking

2004 2005 2006 2007 2008 2009 2010 2011

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

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12-month interest rate spreads

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

%

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3

%

2004 2005 2006 2007 2008 2009 2010 2011

12-month HIBOR-LIBOR spread

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ConclusionThe Linked Exchange Rate syst

em is a cornerstone for maintaining economic stability

Economic underpinningsAmple forex reservesFlexible economic structurePrudent fiscal policy stanceSound banking system