B1How are local interest rates set in Hong Kong, and what is their relationship with their US counterparts?
Interbank interest rates in Hong Kong normally follow closely the movements of their US counterparts under the Linked Exchange Rate system (LERS). The size of the interest rate spread between the Hong Kong dollar and US dollar mainly reflects the premium (be it positive or negative) that investors demand on the Hong Kong dollar. Should the interest rate differential get out of line with market expectation, funds will flow to the currency with relatively higher interest rates to reap the arbitrage profits.
Retail interest rates, including time deposit rates, are determined by market forces. Likewise, the best lending rate, which is the benchmark interest rate offered by banks on their loans to customers, is subject to commercial decisions by individual banks. Given that interbank funding is a major source of funding for the banking system, retail interest rates will be influenced by movements in interbank interest rates.
B2What distinguishes a currency board system from other forms of pegged exchange rate systems?
A currency board system is a rule-based monetary regime encompassing two distinct features: full reserve-backing requirement of the monetary base, and an explicit commitment of the currency board or monetary authority to convert the domestic currency into a reserve currency at a prescribed fixed exchange rate.
The backing rule forbids central bank’s creation of unbacked monetary liabilities through lending to the public or the private sector. The monetary discipline so imposed, together with the explicit commitment to the fixed exchange rate between the domestic currency and the reserve currency, adds credibility to the currency board system, and has led to the perception that it is a particularly robust form of fixed exchange rate system.
B3When and how will the HKMA conduct market operations within the Convertibility Zone? Are there any rules governing the conduct of discretionary market operations?
The HKMA operates within the Convertibility Zone taking into account market conditions, including the exchange rate, interest rates, the Aggregate Balance and other relevant market information. It will also monitor whether there are market anomalies that may arise from time to time, which may affect the smooth functioning of the LERS.
In its meeting in July 2005, the Exchange Fund Advisory Committee Currency Board Sub-Committee endorsed four broad principles that should govern operations within the Convertibility Zone: (i) all operations should be carried out in strict accordance with Currency Board rules; (ii) the primary objective of any operations should be to preserve exchange rate stability implied by the LERS and to maintain confidence in the system; (iii) operations might be undertaken to support such interest rate adjustments as would maintain exchange rate stability under the LERS and would avoid destabilising behaviour in interest rates; and (iv) operations might also be undertaken in order to remove market anomalies. While these four principles should be generally applicable for the time being, they will be kept under review in the light of experience and changing conditions.
B4Will the Hong Kong dollar be replaced by the renminbi when the renminbi becomes fully convertible?
The principle of “one country, two systems” is clearly enshrined in the Basic Law. Article 111 stipulates that “The Hong Kong dollar, as the legal tender in the Hong Kong Special Administrative Region, shall continue to circulate.” We do not envisage any change to the legal tender status of the Hong Kong dollar when the renminbi becomes fully convertible.
B5Why is the LERS particularly suitable for Hong Kong?
The LERS suits Hong Kong as it is a small and open economy. As Hong Kong’s economic growth is driven mainly by external factors, the cost of a more volatile exchange rate will be much larger than the cost of a volatile domestic sector. The LERS has been the anchor of Hong Kong’s monetary and financial stability for more than 30 years and has proved highly resilient in a series of regional and global financial crises during this period.
Separately, even though central banks operating under a floating exchange rate regime can deploy independent monetary policy to conduct macroeconomic management theoretically, such benefits may not be realisable for small and open economies. Theoretically, they could raise interest rates or let their currency appreciate to mitigate inflation. But according to the experience of many emerging market economies, the resultant widening of interest rate spread or the appreciation of domestic currency might heighten speculations for further currency appreciation, attracting capital inflows and hot money, and thus weakening or even offsetting the effectiveness of monetary policy tightening. As such, it could intensify risks to financial markets and the wider economy by intensifying the currency appreciation pressure in the short term and hence heightening the risk of subsequent sharp currency depreciation upon abrupt reversal of fund flows. Hong Kong, being a small and open economy and international trade and financial centre, may see large fluctuations in the exchange rate of its currency should a floating exchange rate regime be adopted. This is not conducive to external trade and cross-border investment.
The effectiveness of the LERS is helped by a number of economic attributes enjoyed by Hong Kong:
First, the structure of Hong Kong economy is flexible and responsive. Markets such as the labour market, property and retail markets respond quickly to changing circumstances: this flexibility facilitates adjustments in internal prices and costs, which in turn bring about adjustments to external competitiveness without the necessity of moving the exchange rate.
Secondly, Hong Kong’s banking system is strong and solvent, and well able to cope with the fluctuations in interest rates which may arise under the LERS.
Thirdly, the Hong Kong SAR Government pursues a prudent fiscal policy, with large accumulated fiscal surpluses and a target of budgetary balance over the medium term. Thus there is no fear that the exchange rate system might be undermined by monetary financing of government expenditure.
Fourthly, Hong Kong possesses ample foreign currency reserves including sufficient US dollar assets for supporting the LERS. Hong Kong’s official foreign currency reserve assets cover about seven times the currency in circulation and are among the highest in the world.
B6What’s the limitation of the LERS?
The LERS rules out the use of nominal exchange rate movements as a mechanism of adjustment. Thus, shocks to the economy triggered by external or domestic events, such as sharp depreciations of the currencies of Hong Kong’s competitors or recession in export markets, may necessitate more adjustments of the internal cost/price structure than would be needed if the exchange rate were free to adjust. While such internal adjustment is slower than rapid adjustment by the exchange rate, the process may be accompanied by more durable and necessary structural adjustments within the real economy. The LERS leaves little scope for an autonomous interest rate policy to achieve the objectives of price stability or promotion of economic growth. Nevertheless, the flexible economic structure in Hong Kong enables its economy to adapt quickly to changing circumstances. Hong Kong’s economic growth performance has been impressive under the LERS since 1983.
B7Is the LERS the main driver of inflation rate in Hong Kong?
Hong Kong’s inflation depends on a number of domestic and external factors. The LERS has not been the main factor in driving inflation higher in Hong Kong. The pick-up of inflation in the past few years was partly due to global factors such as weather and imbalance of supply and demand, which had no direct relationship with the exchange rate regime. In addition, Hong Kong spends more on services than goods. Goods (including those imported) constitute only about a quarter of Hong Kong’s consumption basket. Therefore, the exchange rate has not been a key factor in driving Hong Kong’s inflation.
B8Is the LERS the culprit of high property prices in Hong Kong?
Movements in local asset prices are subject to various factors. For example, property prices are determined by factors such as interest rates, demographic structure, land and housing supply, the prospect of household income, etc. Many emerging market economies with more flexible exchange rate regimes are not immune from the problem of influx of capital and asset bubbles in the past few years.
Many research studies find that monetary policy is not the most effective tool for targeting asset prices as it is difficult to confine the impact of discretionary interest rate policy to individual asset markets while leaving other financial markets and the broader economy unaffected. If used to tackle the overheated property market, interest rates may have to be raised substantially and this may cause damage to other economic sectors. Targeted and sector-specific policies relating to housing supply, and macro-prudential and demand management measures would be more appropriate tools for tackling property market overheating.
B9Should the Hong Kong dollar be pegged to a basket of currencies?
LERS remains appropriate for Hong Kong, being a small and open economy (see 5). Although pegging to a basket of currencies has the benefit of being less exposed to sharp swings in the exchange rate and interest rates of a single anchor currency, Hong Kong has already benefited from a largely stable monetary environment in the US and the credibility of US monetary policy. Moreover, pegging to a basket of currencies lacks not only an independent monetary policy, but also the transparency, simplicity and operational efficiency as compared with the existing LERS under the Currency Board system.
B10Even though a fixed rate regime continues to serve Hong Kong well, is the USD still the best anchor currency?
The USD continues to be the most appropriate anchor currency of the HKD for the following reasons:
First, the anchor currency for the HKD must be fully convertible and can be traded freely in very large amounts in the foreign exchange market. The anchor currency should also be an international reserve currency that can facilitate foreign exchange operations and reserves management. The USD is the most commonly used currency for international trade and financial transactions. The US financial markets as well as those financial markets with transactions settled and denominated in the USD rank first in the world in terms of depth, breadth and liquidity. Moreover, having maintained low inflation in the US for over 30 years, the US Federal Reserve has a good track record in fostering price stability.
Second, the economy of the anchor currency and the Hong Kong economy should have synchronised business cycles. Our empirical research results show that Hong Kong’s business cycles are still more synchronised with those of the US than with Chinese Mainland despite the increasing economic integration between Hong Kong and Chinese Mainland. Hong Kong as an international trade and financial centre has mainly been playing a bridging role between Chinese Mainland and the rest of the world. Its business cycles are therefore very much affected by trade and fund flows between the Mainland and the advanced economies, and less by fluctuations in the Mainland’s domestic economy. As the ultimate goal of monetary policy, including exchange rate policy, is to reduce the volatility of business cycles, a peg to USD continues to be the most appropriate arrangement for Hong Kong.
B11Even if the LERS is judged to be the best choice for Hong Kong, is there any scope for further refinements to enhance the LERS, such as a revaluation against the USD or a widening of the band to allow more flexibility?
Re-pegging to the USD at a new level or widening the exchange rate band will likely fail to influence fund flows or asset prices. It may however invite market speculations on the likelihood of further band-widening or re-pegging in the future, thereby undermining the credibility of the LERS and encouraging more speculative flows into or out of Hong Kong.
In response to the Asian financial crisis, the HKMA introduced seven technical measures in September 1998 to strengthen the Currency Board arrangements to make them less susceptible to manipulation by speculators. Furthermore, in May 2005, the HKMA introduced three refinements to the operations of the LERS, which aimed at removing uncertainty about the extent to which the HKD exchange rate might strengthen under the LERS. In the light of changing market environment, the HKMA will from time to time review the operations of the LERS and would not rule out introducing measures to optimise the system if necessary. Nonetheless, we do not see any need to introduce such measures at present. The LERS has been working according to its design and the HKMA will continue to ensure its effective operation.
Notes (5-8): A merchant acquirer or a merchant may, in accordance with the rules of the respective credit card association, accept or reject a chargeback request. Where the merchant acquirer or the merchant rejects the chargeback request but the card issuing bank or consumer does not agree with the decision, the card issuing bank may in accordance with the rules of the respective credit card association submit the disputed transaction to the credit card association for arbitration.
Consumers should note that, chargeback requests raised by card issuing banks on customers’ behalf are subject to the rules of the respective card associations (including the chargeback time limits within which consumers must file the requests, information showing a dispute is valid, etc.). Chargeback requests which do not fulfil the relevant requirements may be rejected. Consumers can visit the webpages of card issuing banks for relevant information or directly contact the card issuing banks to understand the details of chargeback protection and the relevant rules that may apply to a specific credit card transaction.
