Linked Exchange Rate System
The Linked Exchange Rate System was established in 1983. It is in essence a Currency Board system, which requires both the stock and the flow of the Monetary Base to be fully backed by foreign reserves. Any change in the size of the Monetary Base has to be fully matched by a corresponding change in the foreign reserves. In Hong Kong, the Monetary Base comprises the following components:
- Certificates of Indebtedness (as backing for banknotes) and government-issued notes and coins
- the sum of balances of banks' clearing accounts (Aggregate Balance) maintained with the HKMA for the purpose of clearing and settling transactions between the banks themselves, and also between the banks and the HKMA
- the outstanding amount of Exchange Fund Bills and Notes.
Banknotes in Hong Kong are issued by the three note-issuing banks When issuing banknotes, the note-issuing banks are required to submit US dollars (at HK$7.80 = US$1) to the HKMA for the account of the Exchange Fund in return for Certificates of Indebtedness (which are required by law as backing for the banknotes issued). The Hong Kong dollar banknotes are therefore fully backed by US dollars held by the Exchange Fund. In the case of government-issued notes and coins, which are issued by the Government through the HKMA, transactions between the HKMA and the agent bank responsible for storing and distributing the coins to the public are settled against US dollars at the rate of HK$7.80 to one US dollar.
Operating under the rule-based Currency Board system, the Aggregate Balance varies in accordance with the flow of fund into and out of the Hong Kong dollar. The HKMA operates Convertibility Undertakings on both the strong side and the weak side of the Linked Rate of HK$7.80 to one US dollar. The HKMA undertakes to buy US dollars from licensed banks at HK$7.75 to one US dollar (strong-side Convertibility Undertaking) and sell US dollars at HK$7.85 to one US dollar (weak-side Convertibility Undertaking). Within the Convertibility Zone between 7.75 and 7.85, the HKMA may choose to conduct market operations consistent with Currency Board principles with the aim of promoting the smooth functioning of the money and foreign exchange markets.
The proceeds from the issue of Exchange Fund Bills and Notes have over time been switched into US dollar assets. The HKMA has also undertaken that additional Exchange Fund paper will only be issued when there is an inflow of capital. This ensures that all new Exchange Fund paper will be fully backed by foreign currency reserves. Starting from 1 April 1999, interest payments on Exchange Fund paper are allowed to expand the Monetary Base. Additional Exchange Fund paper is issued to absorb such interest payments. This procedure is consistent with the Currency Board discipline, since interest payments on Exchange Fund paper are backed by interest income on the US dollar assets backing the Monetary Base. It also allows the Exchange Fund Bills and Notes programme to grow in a non-discretionary manner.
For a general discussion on the Linked Exchange Rate System, please see also Background Brief No. 1: Hong Kong's Linked Exchange Rate System.