The Linked Exchange Rate System – 40 Years On

1. The biggest headline forty years ago today was that Hong Kong had introduced the Linked Exchange Rate System (LERS). As a student reading business administration at the Chinese University of Hong Kong, I was of course more alert to news about the economy.  However, I was at best a bystander then.  What never crossed my mind was that I would join the Office of the Exchange Fund (the predecessor of the HKMA) eight years later.   For the ensuing thirty years or so, my work involved the LERS, directly or indirectly.   It is fair to say I have established a long-lasting and strong relationship with this important part of Hong Kong’s financial regime.
2. The LERS is a good system. It is the cornerstone of monetary and financial stability in Hong Kong.  Since its introduction in October 1983, it has provided Hong Kong with the stable monetary environment necessary for the continuous development of our economy and community.  During this period, the LERS has helped Hong Kong weather a succession of shocks and crises, and the many severe challenges that we have encountered, highlighting the system’s resilience and robustness.  The LERS is the strong breakwater, or typhoon shelter, that protects us from stormy seas.
3. One of the crucial factors leading to the success of the LERS is the credibility that it has built up gradually over the years. This confidence rests on the robust design of the system in line with market disciplines, its highly transparent and rule-based mode of operation, as well as our abundant foreign reserves, strong fiscal position and dynamic economy.
4. The LERS is characterised by the Currency Board arrangement, which restricts the Monetary Authority’s discretion on matters of monetary policy. However, while principles may appear straightforward, some of the details of the actual functioning and design of the system can be more nuanced.  That was why, after gaining experience of implementing the LERS, we introduced the seven technical measures in 1998 and the three refinements in 2005, making the system more rule-based and aligned with our policy intent.  More importantly, the market has seen that the LERS functions in strict adherence to its design.  For example, the refinements in 2005 clearly defined the Convertibility Zone of 7.75 to 7.85, within which the Hong Kong dollar exchange rate moves, and established the HKMA’s commitment to the strong-side and weak-side Convertibility Undertakings (CUs).   In the almost two decades that have gone by since then, the strong-side CU was triggered 321 times, with the HKMA buying US dollars equivalent to nearly HK$1,450 billion that flowed into the Hong Kong dollar system.  The weak-side CU was triggered 84 times, resulting in outflows of US dollars equivalent to nearly HK$420 billion.   All of these in- and out-flows went like clockwork without any hiccups.
5. We firmly believe that high transparency is the only way to protect market confidence. There are two keys to the high degree of transparency of the LERS: the openness that is a feature of the system’s design and the timely and accurate disclosure of crucial data.    Whenever we entered the market to fulfil the obligations imposed by the CUs, we promptly let the market and the public know by publishing related transaction data.  We regularly publish the latest Exchange Fund balance sheet data, Currency Board account and other information about the LERS, and communicate about the LERS to the market and the public through appropriate channels.
6. But we cannot be complacent. Confidence in the LERS has been tested countless times through difficult events, such as the shocks triggered by the many financial crises, the severe challenges facing Hong Kong in recent years and the resulting tremendous pressure on the financial system, and the numerous market rumors that we have witnessed over the years, be they intentional, unintentional or even malicious.  The LERS sailed through them all.  Confidence, like Rome, wasn’t built in a day.
7. No exchange rate regime is perfect. Policy makers in every economy must take into account its unique circumstances and historical factors in deciding what arrangements best suit its needs, to obtain the biggest advantages for the lowest costs.  The exchange rate regime is an important and serious matter.  Once decided, it should not be changed lightly.  Discussions about the pros and cons and the trade-offs of any particular regime can go on forever.   Recently, as US interest rates have stayed high and the US dollar has strengthened, we have heard about two issues in relation to the LERS: the strong Hong Kong dollar and high interest rates, and how they affect the economy and livelihood of the community.
8. As the Hong Kong dollar strengthens, people often say it becomes cheaper to travel overseas, while tourists visiting Hong Kong become more cautious on their spending. Looking at it objectively, the exchange rate can indeed be part of the reason for these developments.  But there may also be some cyclical and structural factors involved too.  For example, many Hong Kong people love travelling and must have been looking forward to being able to travel again as soon as the borders were re-opened after the pandemic.  Also, there must be a sizeable number of visitors coming to Hong Kong, who are actually more keen on “in-depth travel experiences” that don’t just focus on consumption.  Looking at it from another angle, as Hong Kong is highly dependent on imports to meet our daily and production needs, a stronger Hong Kong dollar helps reduce import costs and ease some of the inflationary pressures.  Considering that many other advanced economies are battling with persistent inflationary pressures, Hong Kong is actually quite lucky in this regard.  For those with children studying overseas in non-US dollar regions, a stronger Hong Kong dollar can also help ease their burden.  The strengthening and weakening of any currency is obviously cyclical.  When the Hong Kong dollar weakens against other currencies alongside the US dollar, the effects would be in the opposite direction.  So both a stronger and a weaker Hong Kong dollar obviously have their own pros and cons. 
9. With regard to interest rates, the LERS means that Hong Kong dollar rates track their US dollar counterparts, while also being subject to the supply and demand of Hong Kong dollar funding in the local market. Since the current rate-hike cycle began in March 2022, the US has raised interest rates by a total of 5.25 percentage points.  During this period, the Hong Kong dollar interbank offered rates (HIBORs) have also gradually risen.  The one-month and three-month HIBORs once reached as high as nearly 5.5%, with the one-year rate once approaching 5.8% [see Chart].  Although the market generally expects US dollar interest rates to be near their peaks, the high interest-rate environment is likely to persist for some time.  Borrowing costs go up in a high interest-rate environment.  Meanwhile, the Hong Kong economy has not yet fully recovered and businesses and households with home mortgages are still facing difficulties.  Some people might take the view that, to some extent, this is a cost of the LERS.  Of note, though, is that many other economies and financial centres are also feeling the pain of high interest rates, even those that do not adopt a fixed exchange rate.  Whether or not Hong Kong implements the LERS does not seem to be the most critical factor.
10. Moreover, if we look more closely at the data, we can see that local interest rates have actually not risen too sharply. A sizable deposit base in the Hong Kong banking system has helped major banks control their funding costs.  Let’s take the composite interest rate, a measure of the average cost of funds of banks, as an example.  It was 2.55% at the end of August, compared with 0.24% at the end of March last year (when the US entered the rate hike cycle).  Clearly the composite interest rate has not risen by as much as the US dollar interest rates or HIBORs did.  This indirectly shows that banks increased their lending rates at a moderate pace over the past year or so.  In fact, banks’ various lending rates generally have increased by less than their US counterparts.  Take the most widely known best lending rates, or prime rates, as an example.  Since the beginning of last year, they have increased moderately by less than one percentage point.
11. Change is constant. That is even more true of the financial markets, and the implications are more far-reaching.  Our team at the HKMA must keep on top of things and always be well-prepared to embrace change.  But we must also always bear in mind the value of keeping a good system.  We keep a system not for the sake of keeping it, but because we have thought things through carefully to reach an informed decision. 
12. As we have said many times before, we have no intention and we see no need to change the LERS.

Eddie Yue
Chief Executive
Hong Kong Monetary Authority
17 October 2023