The Linked Exchange Rate System


15 Aug 2011

The Linked Exchange Rate System


In the face of rising inflationary pressure in Hong Kong, some people have suggested that the Linked Exchange Rate system is the root cause of the situation and that the Hong Kong dollar should no longer be linked to the US dollar. The Financial Secretary already stated in his blog on 14 August that the Link continues to be the most appropriate exchange rate arrangement for Hong Kong. I will elaborate further on a few related issues.

Many people who advocate un-pegging the Hong Kong dollar from the US dollar claim that the recent downgrade of the sovereign credit rating of the US would inevitably lead to a substantial depreciation of the US dollar. They argue that Hong Kong’s risks of high inflation and an asset price bubble will heighten if the Hong Kong dollar continues to be linked to the US dollar.

I do not agree with this proposition. As I have explained to the media on 8 August, the US dollar remains the most important international reserve currency as well as the main currency in which financial and trade transactions are denominated and settled. These roles can hardly be replaced overnight. So the downgrade of the US does not necessarily lead to one-way depreciation of the US dollar. In fact, the exchange rates among the major international trade and reserve currencies (the US dollar, the euro, the Japanese yen and the British pound) are the relative value of one currency against another. While the US economy might slow down and the US government has not yet fully solved its fiscal problems, the euro area, Japan and the UK are facing similar, or to some extent more severe, problems. Relatively speaking, the US economy has shown more vitality and stronger capability for adjustment. For example, the labour market in the US is more flexible than those in many European countries, and it has a younger population too. While the exchange rate of the US dollar will inevitably fluctuate in the short term, there is not enough evidence to support the view of a medium to long-term depreciation of the US dollar against the euro and the Japanese yen.

Even though the Hong Kong dollar may weaken along with the US dollar during an economic cycle, inflation does not necessarily follow. Inflation in Hong Kong is affected by a number of external and internal factors, with food prices and rents being two major components. The recent increases in food prices are a global problem. It is not unique to Hong Kong where we adopt the Link. Furthermore, spending on services represents a substantial portion of consumption expenditure in Hong Kong, whereas spending on goods accounts for only 27% of the consumers’ basket in Hong Kong. In the services sector, business costs are mainly comprised of wages and rents, with imported goods accounting for only a small portion. Prices of the services sector are therefore less affected by exchange rate movements. So weakening of the Hong Kong dollar has never had a very visible impact on our inflation. As for the increases in rents, they have more to do with property prices.

Some people think that linking the Hong Kong dollar to a weak US dollar is the culprit for the soaring property prices. I disagree. The premise of this theory is that whenever the US dollar or HK dollar is weak, property prices go up. We need to recognise that property prices depend on many factors, including the supply of land and housing units, affordability, demographic structure, the costs of mortgage lending, and investors’ expectations on movements in property prices and on the factors just mentioned. Looking at the economies in the Asia-Pacific region, there is no clear relationship between the exchange rate regime or exchange rate movements and local property prices. For example, while the exchange rate regimes of the Mainland and Singapore are clearly different from Hong Kong’s Linked Exchange Rate system, and the currencies of these economies have appreciated considerably against the US dollar in the past two years, they are also facing similar problems of over-heating in the property market, and have had to introduce various measures to cool down the market.

Some other people note that with the Link and the US’s accommodative monetary policy in place, Hong Kong has no choice but to maintain an extraordinarily low interest rate environment, which has fuelled the rising property prices. But they should also note that interest rates in Hong Kong would not be much higher even if we pegged the Hong Kong dollar to a basket of major reserve currencies. Currently, the three-month interbank rate of the euro, at around 1.5%, is already the highest among the major currencies, not to mention the 0.3% in Japan. Moreover, overseas experiences show that raising interest rates does not necessarily have an impact on property prices, because once the expectation of a one-way bet takes hold, the momentum and dynamics formed are difficult to be reversed unless interest rate rises very substantially. But a very sharp interest rate hike could hurt the general economy too. For this reason, there has been an increasing international recognition of the importance of macro-prudential policies in recent years. Many Asian economies (such as Singapore and Malaysia) have to rely on macro-prudential measures, like what we have been undertaking in Hong Kong, as they try to curb property speculations and enhance risk management on mortgage business, even though these economies are free to deploy interest rate policies.

Some other people think that the Hong Kong dollar should no longer be linked to the US dollar because the importance of the US economy to Hong Kong’s economy has already been replaced by that of Mainland China. While it is true that the Hong Kong economy is increasingly more affected by the Mainland, the economic cycles of Hong Kong, being an international commerce and trade intermediary centre, are more driven by movements in trade and capital flows between Mainland China and the rest of the world, rather than domestic demand of the Mainland. In fact, consumer goods account for only a small portion (about 10%) of Hong Kong’s exports to the Mainland. The rest are mostly raw materials or semi-finished products to be processed on the Mainland before they are exported to overseas markets, with the US being a main market. Put simply, Hong Kong’s exports are still mainly driven by demands from overseas markets, especially the US. As for Mainland visitors coming to Hong Kong, they certainly play a role in stimulating our retail sector. But the contribution to Hong Kong’s economic output is not as significant as many people would have thought because the cost of goods sold, which are mostly imported from abroad, account for as much as two-thirds of total turnover in the retail sector. Shopping tops the list of activities of Mainland tourists in Hong Kong, accounting for nearly 80% of their consumer spending. This percentage is higher than that of the tourists from any other country. As a result, judging from the business turnover alone one may overestimate the contribution of Mainland visitors to Hong Kong’s economic output. More importantly, the global economic and financial environment is still to a great extent affected by the US. As an international financial centre, Hong Kong’s economic cycles are heavily influenced by the global economic and financial environment.

We must recognise that there is no one-size-fits-all exchange rate regime. All options, including linking the Hong Kong dollar to the US dollar or a basket of currencies, or even letting the Hong Kong dollar float freely, have their own pros and cons.

Some people suggest that Hong Kong should adopt a floating exchange rate regime so that we can have a discretionary interest rate policy. However, they are not able to put forward arguments and evidence to show that such a change would curb the inflationary pressure and cool down the property market. More importantly, these people have not thoroughly analysed the disadvantages of a floating exchange rate regime and the risks it would bring to Hong Kong. Hong Kong is a small and externally oriented economy where no foreign exchange control policies shall be applied according to Article 112 of the Basic Law. A floating exchange rate regime would create much volatility in the exchange rate of the Hong Kong dollar. The Hong Kong dollar may appreciate in the good times, attracting volatile “hot money” into the Hong Kong dollar and at the same time weakening Hong Kong’s competitiveness, while not necessarily helping to contain inflation. When the economy and asset markets become overheated, the economic cycle will reverse, resulting in capital outflows and sharp depreciation of the Hong Kong dollar. It will also lead to a credit crunch or even a confidence crisis. Our economy will suffer from great swings. Is this what we want to happen? A floating exchange rate regime is not a panacea for economic problems. On the contrary, it can also create new problems. For example, the recent appreciation of the Swiss franc is already undermining the export and competitiveness of the country. According to recent media reports, Switzerland was considering a short-term peg of the Swiss franc to the euro in order to contain the appreciation pressures, following the central bank of Switzerland’s failure to do so despite repeated interventions in the foreign exchange market and lowering the interest rates.

Some people have suggested that the Hong Kong dollar should be pegged to a basket of currencies instead of the US dollar alone. But under such an arrangement Hong Kong would still lack discretion in its interest rate policy as interest rates would have to follow the weighted average of the interest rates of the basket of currencies. Moreover, pegging the Hong Kong dollar to a basket of currencies would lose the benefits of transparency, simplicity and efficiency offered by the Link with the US dollar.

As regards the suggestion of a link to the renminbi, I have repeatedly pointed out that the conditions for contemplating this option are not there because the renminbi is not yet freely convertible.

I think readers will now understand that many arguments for abolishing the Link have their own flaws and shortcomings. In fact, there is no other exchange rate regime that is more appropriate for Hong Kong than the Link. I therefore reiterate that the Hong Kong Special Administrative Region Government has no intention to change the Link, which has served Hong Kong well since its introduction in 1983.


Norman T.L. Chan
Chief Executive
Hong Kong Monetary Authority
15 August 2011

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Last revision date : 18 August 2011