The Linked Exchange Rate System Between Us $ and Hong Kong $ Essay Example

increases in note issuance with sterling. In June 1972, the British Government decided to float the pound sterling, causing the Hong Kong dollar to briefly link with the US dollar at an initial rate of HK$5.

From February 1973, the Hong Kong dollar began decreasing in value from HK$5.085 per US dollar to a rate of 65 to 1. Nonetheless, in June 1972, the note-issuing banks were granted authorization to acquire Certificates of Indebtedness with Hong Kong dollars. By November 1974, as a result of the weakening US dollar, the Hong Kong dollar was permitted to fluctuate freely. Despite an acceptable performance during the first two years, adapting to a floating exchange rate system presented difficulties.

The prevailing monetary policy framework was inadequate to replace the external monetary anchor, resulting in considerable instability across different sectors. The absence of a defined goal for monetary policy and the absence of means to accomplish those goals led to a decline in real GDP growth to 0.3% in 1975, followed by a substantial surge to 16.2% in 1976.

Inflation saw a significant increase, with the rate rising from 2.7% in 1975 to 15.5% in 1980. At the same time, the Hong Kong dollar underwent a transformation as its value soared from HK$5.13 in 1981 to HK$9.60 against the US dollar by 1983.

In September 1983, the Hong Kong dollar depreciated due to speculative attacks and a crisis of confidence about Hong Kong's future. The currency reached an all-time low of HK$9.60 in just two days, experiencing a significant decline of 13%. Worries about bank stability and a currency panic grew, prompting the Government to implement a new policy on October 15, 1983.

This policy aimed to stabilize the currency and establish the foundation for Hong Kong's monetary system by pegging the Hong Kong dollar to the US dollar at a fixed exchange rate of HK$7.

The exchange rate is 80 to one US dollar. The Linked Exchange Rate system is significant for an open economy like Hong Kong's. It is a well-known and stable system that allows Hong Kong to adjust to unforeseen events without the negative effects of sudden currency decline.

The Link is a suitable choice for Hong Kong's economic conditions due to its externally oriented economy, open capital account, and large financial sector. The value of external trade in goods and services surpasses the GDP, making Hong Kong susceptible to financial shocks caused by fluctuations in global markets. By serving as a robust monetary anchor, The Link mitigates foreign exchange risk for importers, exporters, and international investors. Selecting the US dollar as the anchor currency is logical considering its predominant use in Hong Kong's external trade and financial transactions.

The effectiveness of the Link is supported by several economic attributes specific to Hong Kong. Firstly, Hong Kong's economy possesses a flexible and responsive structure. In various markets like labor, property, and retail, quick responses to changing circumstances enable adjustments in internal prices and costs. Consequently, these adjustments contribute to external competitiveness without requiring exchange rate movements. Secondly, Hong Kong's banking system is both strong and solvent, capable of managing fluctuations in interest rates that may arise within the Linked Exchange Rate system. Lastly, the Hong Kong Government follows a prudent fiscal policy, resulting in significant accumulated fiscal surpluses and a goal of medium-term budgetary balance.

Furthermore, there is

no concern about the potential impact on the exchange rate system due to government spending being funded by monetary means. Additionally, Hong Kong has sufficient foreign currency reserves to support the Link. These reserves, totaling US$122.8 billion as of September 2005, are held within the Exchange Fund.

They represent more than six times the amount of currency in circulation, which is one of the highest levels globally.

Limitations and Advantages of the Linked Exchange Rate System

The Linked Exchange Rate system, despite being favored by Hong Kong, has both limitations and advantages. It restricts the use of nominal exchange rate fluctuations for adjustment purposes. Consequently, economic shocks caused by external or internal events, such as significant devaluation of competitor currencies or a recession in export markets, may necessitate greater adjustments to the internal cost/price structure compared to if the exchange rate was freely adjustable.

While the exchange rate allows for rapid adjustment, internal adjustment is slower but may lead to more durable and necessary structural adjustments within the real economy. The Link connects Hong Kong to US monetary policy, even when their economic cycles are not necessarily synchronized. A Linked Exchange Rate system limits the ability to use interest rates independently for price stability and economic growth. If the economic cycles of Hong Kong and the US are misaligned, local interest rates that closely follow their US dollar counterparts may not be suitable for the domestic economy's macroeconomic conditions. For instance, increasing US interest rates to cool down an overheating economy could hinder Hong Kong's recovery from a recession. However, Hong Kong's flexible economic structure allows for quick adaptation to changing circumstances.

Hong Kong's economic growth has been

remarkable under the Linked Exchange Rate system since 1983.

Alternatives to the Link?

Occasionally, especially during financial and economic difficulties, there is a debate about the advantages of the Linked Exchange Rate for Hong Kong and suggestions for different exchange rate systems. It is essential to have an open and healthy discussion regarding this matter. However, how feasible are these proposed alternatives?

Can we link to the US dollar but at a different rate?

One argument proposes that a single change in the exchange rate could transfer some of the economic adjustment pressures to the nominal exchange rate, thereby minimizing the need for adjustments in nominal prices and wages. Nonetheless, modifying even just once the anchor of the nominal exchange rate would undermine confidence in the Currency Board system and lead to speculation about future changes.

The potential negative impact on Hong Kong's economic and monetary stability caused by the withdrawal of funds due to a loss in investor confidence could also hinder the pursuit of long-term benefits from productivity gains. This is because the devaluation of the currency would divert the economy.

Is it beneficial to establish a connection with another currency?

When considering an anchor currency, it is crucial to take into account factors such as the denomination of external trade and financial transactions, as well as the credibility and stability of the monetary regime governing that particular currency. In Hong Kong's case, it has benefited from a relatively stable monetary environment in the US and from the unparalleled credibility of US monetary policy under this Link.

The US dollar is the main currency used for trade and external finances in Hong

Kong. Should there be a link to a basket of currencies, the domestic economy would be less vulnerable to sudden fluctuations in exchange rates and interest rates of a specific anchor currency. However, this system would be more intricate and less transparent. If the monetary authority has the ability to adjust the weights of the component currencies, it would result in reduced transparency and predictability, potentially shaking confidence in the exchange rate system.

Freeing the Hong Kong dollar's floating status?

Under a free-floating exchange rate regime, the monetary authority would have