Hong Kong dollar peg: why the city’s linked exchange system is an important buffer against financial crisis

South China Morning Post 發布於 2019年12月09日13:12 • Karen Yeung karen.yeung@scmp.com
  • Ongoing anti-government protests have led to some speculation that Hong Kong could be forced to sever its peg to the US dollar
  • But the city’s de facto central bank has stressed the importance of the linked exchange system, which was introduced in 1983 to avert a financial crisis
Months of anti-government protests have caused some observers to speculate on the future of the Hong Kong dollar peg. Photo: KY Cheng

This is the first article in a three-part series looking at the outlook for Hong Kong's dollar peg system under the city's current political uncertainty.

Hong Kong's dollar peg has been thrust into the spotlight as a result of six months of anti-government protests that have roiled the semi-autonomous city. The protests, which were sparked by a now-withdrawn extradition bill but morphed into wider calls for democratic freedoms and an investigation of alleged police brutality, have taken a sharp toll on the local economy.

Some economists have suggested that a prolonged political crisis could spell the end of the peg. But the Hong Kong Monetary Authority (HKMA), the city's de facto central bank, says in a time of crisis, it is more important than ever.

"The monetary policy objective of Hong Kong is currency stability," said a spokesperson for the HKMA. "The LERS (Linked Exchange Rate System) has proved to be highly resilient, weathering many economic cycles and crises, and has continued to operate smoothly notwithstanding massive fund inflows and outflows in the past decade."

The LERS has proved to be highly resilient, weathering many economic cycles and crises, and has continued to operate smoothly notwithstanding massive fund inflows and outflows in the past decadeHKMA

Why was the Hong Kong dollar peg introduced?

On a sweltering hot summer day in September 1983, a long queue of people stood outside a Hong Kong supermarket waiting to snatch whatever groceries they could get their hands on. The scene, complete with its empty supermarket shelves and frustrated customers, was another sign of plummeting public confidence in Hong Kong's financial system and underlined the challenges that the government faced in restoring it.

On September 24, 1983, months of consumer and investor anxiety over the rapid depreciation of the Hong Kong dollar, coupled with concern over Chinese and British negotiations about the city's return to mainland rule, culminated in the so-called "Black Saturday" crisis. Panic selling of the local currency drove its value to an all-time low of 9.6 per US dollar, down from 6.5 per US dollar at the start of the year, under the floating exchange rate system. Shops began to quote prices in US dollars and refused to accept Hong Kong dollar notes.

Faced with public unrest and wavering confidence in Hong Kong's banks, which was exemplified by a run on Hang Lung Bank a year earlier, then financial secretary John Bremridge announced the introduction of the linked exchange system, which pegged the currency to the US dollar on October 17, 1983. The Hong Kong dollar was originally set at a rate of 7.8 per US dollar, although it has been allowed to trade between 7.75 and 7.85 per US dollar since 2005.

The peg's introduction was an effort by the Hong Kong government to re-establish confidence among individuals, investors and corporations, while sending an implicit message that the city's financial system was maintaining some distance from mainland China.

How does the Hong Kong dollar peg work?

The linked exchange system automatically self-corrects to maintain the stability of the Hong Kong dollar exchange rate. If capital flows out of Hong Kong result in a weakening of the local currency to 7.85 per dollar, the lower end of the trading band, the HKMA will buy Hong Kong dollars held in reserve by banks, causing a reduction in banking liquidity that pushes market interest rates up to a level that attracts money back into the city.

Conversely, if money flows into the city and the exchange rate strengthens to 7.75 per dollar, the upper end of the band, the HKMA will sell Hong Kong dollars to banks, causing an increase in bank liquidity and putting downward pressure on local interest rates that discourage capital inflows.

The Hong Kong dollar is backed by a war chest of HK$4.188 trillion (US$535 billion) held in the HKMA's Exchange Fund, one of the world's largest foreign exchange reserves, that it can use to defend the currency.

The design of the peg means the HKMA raises or cuts the city's benchmark interest rates in lockstep with rate cuts by the US Federal Reserve, thereby giving up its independence to adjust monetary policy in response to changing economic conditions.

Why is it important?

The peg's fixed exchange rate allows the free movement of capital that suits a small and open economy like Hong Kong, the HKMA said. Without the peg, it is doubtful whether Hong Kong's economy would ever have complete control over its monetary policy, since its financial system is subject to volatile fluctuations in interest rates and exchange rates caused by changes in monetary policies by the world's major economic powers.

The peg saved Hong Kong from financial ruin in 1983 and, 36 years on, the peg has provided a stable exchange rate environment that has allowed the city to develop into an international financial centre. It has successfully withstood a series of daunting crises, including the stock market crash in 1987, Asian financial crisis in 1998, the severe acute respiratory syndrome outbreak in 2003, as well as the global financial crisis in 2008.

In his book Economic System of Hong Kong, the late author YC Jao said should a crisis of confidence occur again due to political uncertainty, the peg regime would be the one currency mechanism most likely to survive a massive capital run. Indeed, the Hong Kong dollar has not fallen to the weak end of its trading band since protests began in June.

At this stage (the peg) is very important for Hong Kong's confidence, especially in the aftermath of the protestsCliff Tan

Cliff Tan, East Asian head of global markets research at MUFG Bank, said that the peg has become so ingrained in Hong Kong financial affairs " with acceptance from the government, property tycoons and the general of chambers of commerce " that it has acquired an exalted status independent of both its history and its actual use.

Maintaining the peg was needed for psychological as well as economical reasons, Tan argued. If the government were to severe the peg from the US dollar in response to the current protests, it would spark the type of capital flight it is trying to avoid and make other problems worse, he said.

"At this stage (the peg) is very important for Hong Kong's confidence, especially in the aftermath of the protests," Tan added.

The second instalment will look at the risks on the Hong Kong's dollar peg system from the United States-Hong Kong Policy Act

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