There have been concerns and discussions in the market about the recent weakening of the Hong Kong dollar (HKD). Based on the discussions it is apparent that there are some misunderstanding and queries about the mechanism of the Linked Exchange Rate system (LERS). I would like to have them clarified with the following Q&As.
1. As the HKD exchange rate has dropped below 7.80 recently, is the HKMA worried about the HKD weakening and will the HKMA intervene in order to prevent the HKD from depreciating?
The view as implied in the question is incorrect. As an international commercial, trade and financial centre, there are always a large amount of funds flowing freely into and out of Hong Kong. However, under the LERS, the HKMA acts as a “super money changer”. When there are fund inflows, the HKD exchange rate against the US dollar (USD) will not go beyond 7.75 as there is strong-side Convertibility Undertaking. On the other hand, when there are fund outflows and the HKD weakens, the HKMA will sell USD and buy HKD at 7.85 so that the HKD exchange rate will not fall below the weak-side Convertibility Undertaking.
The US Federal Reserve has raised interest rates five times since December 2015, widening the spreads between HKD interest rates and their USD counterparts and thereby encouraging funds to flow from the HKD into the USD. It is only natural that the HKD would weaken as a result. However, this should not cause any concerns, as the HKMA will take action when the HKD exchange rate touches the weak-side Convertibility Undertaking (7.85) to ensure that it will not fall below 7.85.
2. The HKD exchange rate dropped to 7.836 yesterday, the weakest in 33 years. Why didn’t the HKMA intervene?
As mentioned above, the HKMA will take action when the HKD exchange rate touches 7.85. This is the design of the LERS following the refinements to the system in 2005. After the implementation of the LERS in 1983, except for some isolated cases in the early stage, the HKMA in general took action when the HKD exchange rate fell to the 7.80 level. The weak-side Convertibility Undertaking has been adjusted from 7.80 to 7.85 following the refinements to the system in 2005. The HKD has since leaned towards the strong side for most of the time. So when the exchange rate fell below 7.83 recently, there was some saying about the HKD falling to its lowest level in 33 years.
3. If the HKMA is not concerned about the weakening of the HKD, why did it issue additional Exchange Fund bills when the HKD was weakening last year? Was it intended to prevent the HKD from depreciating as suggested by some market players?
This is not true. The issuance of additional HK$80 billion worth of Exchange Fund bills by the HKMA last time was solely in response to market demand for highly liquid instruments and had nothing to do with the strengthening or weakening of the HKD. We do not have plans to issue additional Exchange Fund bills for the time being and hope that market players will not take it wrongly that the HKMA does not want the HKD to weaken. In fact, with the widening of the spreads between HKD and USD interest rates, we are looking forward to funds flowing from the HKD into the USD, causing the HKD exchange rate to reach 7.85, a level where the HKMA will take action. This will allow the Monetary Base to contract gradually and create an environment conducive to the normalisation of HKD interest rates.
4. Will the HKMA be capable of supporting the HKD?
Yes, of course. First of all, one must understand how the Currency Board system operates. Since the introduction of the Quantitative Easing by the US in 2009, there have been roughly US$130 billion worth of capital inflows into Hong Kong which were then converted into Hong Kong dollars through the banking system and the HKMA. After receiving these funds which are equivalent to HK$1 trillion, the HKMA has placed them entirely in the Backing Portfolio (BP) of the Exchange Fund. The BP primarily holds highly liquid, high quality US dollar-denominated assets, such as US Treasuries, which can be readily converted into USD cash. The HKMA can therefore act as a “super money changer” to meet the conversion demand arising from any significant fund outflows in extreme circumstances.
5. Will significant fund outflows within a short span of time disrupt the normal functioning of the banking system and even the overall economy of Hong Kong?
Maintaining banking stability in Hong Kong is always among the first and foremost priorities of HKMA’s work. The robustness of the banking system hinges crucially on the sufficiency of its liquidity and capital. Under the rigorous supervision by the HKMA, the average capital adequacy ratio of local banks in Hong Kong was 18.7% at the end of Q3 in 2017, a very high level by international standard. Banks also held more than HK$4 trillion in highly liquid assets (of which over HK$3 trillion being foreign currency assets) at the end of 2017. This is several times higher than the HK$1 trillion inflows into Hong Kong since 2008, providing a strong buffer against any fund outflows.
Besides, the HKMA conducts stress tests on banks from time to time to ensure they are able to cope with extreme cases of significant fund outflows within a short span of time.
6. Will the continued weakening of the HKD and huge fund outflows lead to systemic risk and even trigger a financial crisis?
The resilience of banks and financial system in Hong Kong has been greatly enhanced. The Exchange Fund of Hong Kong holds over HK$4 trillion worth of assets, more than 80% of which being foreign exchange reserves, providing a powerful line of defence for our financial stability. Besides, the HKD Monetary Base amounted to about HK$1.7 trillion, providing a strong buffer in the event of fund outflows. In the past years, the HKMA has enhanced the robustness of the local banking sector through rounds of counter-cyclical and other regulatory measures. Hong Kong has weathered through the Global Financial Crisis in 2008 and the European Debt Crisis in 2011 unscathed. We are confident that Hong Kong can rise up to future challenges from potential asset market volatilities and fund outflows.
Previous inSight articles on the LERS are available for those interested in further reading.
- -“Linked Exchange Rate System” by Mr Norman Chan, published on 15 August 2011
- -“The Recent Inflow of Funds into Hong Kong and Operation of the Linked Exchange Rate System” by Mr Norman Chan, published on 9 November 2012
- -“The Linked Exchange Rate System – 30 Years On” by Mr Norman Chan, published on 14 October 2013
- -“The Hong Kong Dollar Linked Exchange Rate System" by Mr Howard Lee, published on 27 January 2016
Hong Kong Monetary Authority
8 March 2018