Demystifying the HKMA's Exchange Rate System

Table of Contents

1. Introduction
2. The Hong Kong Dollar Exchange Rate System
3. The Design and Expectation of the System
4. Conducting Relevant Operations
5. Honoring Commitments and Market Experience
6. Capital Inflows and Outflows
7. The Role of Aggregate Balance
8. Hong Kong's Monetary Base and Foreign Reserves
9. The Impact of the Aggregate Balance on Banks and Interest Rates
10. Savings and Mortgage Interest Rates

The Hong Kong Dollar Exchange Rate System: Stability and Realities

In this article, we will explore the intricacies of the Hong Kong dollar exchange rate system, its design, and how it has been maintained for nearly 40 years. We will discuss the role of the Hong Kong Monetary Authority (HKMA) in managing the exchange rate and ensuring financial stability. Additionally, we will address common concerns and misconceptions surrounding the recent buying of Hong Kong dollars by the HKMA. This article aims to provide a comprehensive understanding of the mechanics and realities of the Hong Kong dollar exchange rate system.

1. Introduction

The stability of a country's exchange rate is crucial for maintaining economic confidence and attracting investment. Hong Kong's exchange rate system, introduced in 1983, has been a cornerstone of its financial stability for almost four decades. The system ensures that the Hong Kong dollar remains stable within a specific range against the US dollar, thereby providing stability for businesses, investors, and the public.

2. The Hong Kong Dollar Exchange Rate System

Under the Hong Kong dollar exchange rate system, the currency is closely linked to the US dollar. The exchange rate is maintained within a comfortability zone of 7.75 to 7.85 Hong Kong dollars to one US dollar. This narrow range provides stability while allowing for minor fluctuations in response to market conditions.

3. The Design and Expectation of the System

To understand how the HKMA maintains the exchange rate within the prescribed range, we need to Delve into the concept of Convertibility Undertaking (CU). The CU acts as a boundary for the exchange rate corridor, with a strong side CU at 7.75 Hong Kong dollars and a weak side CU at 7.85 Hong Kong dollars against the US dollar.

4. Conducting Relevant Operations

The HKMA operates like a super money changer, ensuring the exchange rate remains within the defined corridor. When either CU level is reached, the HKMA conducts operations to honor the CU. For capital inflows, the HKMA buys US dollars and sells Hong Kong dollars, preventing the exchange rate from exceeding 7.75 Hong Kong dollars. Similarly, for capital outflows, the HKMA sells US dollars and buys Hong Kong dollars to maintain the exchange rate above 7.85 Hong Kong dollars.

5. Honoring Commitments and Market Experience

The HKMA has a long history of honoring its commitments and conducting relevant operations under the exchange rate system. Over the years, these operations have ensured that the interbank Hong Kong dollar exchange rate stays within the 7.75 to 7.85 range. This track Record instills confidence in the system's ability to maintain stability and alleviate any worries about recent developments in the market.

6. Capital Inflows and Outflows

Capital inflows and outflows can significantly impact the Hong Kong dollar exchange rate system. When capital inflows occur, the exchange rate remains below the strong side CU due to the HKMA's commitment to buying US dollars and selling Hong Kong dollars without limit. Conversely, during capital outflows, the exchange rate does not fall below the weak side CU, as the HKMA undertakes to sell US dollars and buy Hong Kong dollars in a similar manner.

7. The Role of Aggregate Balance

The aggregate balance is a vital component of Hong Kong's monetary base, representing the funds held by banks with the HKMA. It acts as a buffer to manage liquidity and stabilize the exchange rate. The size of the aggregate balance depends on various factors, including monetary policy and market demand.

8. Hong Kong's Monetary Base and Foreign Reserves

While the aggregate balance is an important component of Hong Kong's foreign reserves, it is just one part of a much larger financial ecosystem. Hong Kong's foreign reserves comprise numerous assets, including certificates of indebtedness, government-issued bonds, and exchange fund bills and notes. This extensive financial support system ensures stability, with foreign reserves currently around 1.7 times the monetary base.

9. The Impact of the Aggregate Balance on Banks and Interest Rates

The movement of the aggregate balance does not directly affect banks' daily operations or public deposits. However, changes in the aggregate balance can influence interest rates. When the balance decreases, interest rates tend to increase, narrowing the interest rate differential between the US dollar and the Hong Kong dollar. This, in turn, reduces the incentive for carry trades and stabilizes the aggregate balance.

10. Savings and Mortgage Interest Rates

Banks play a significant role in determining savings and mortgage interest rates. While some banks have recently raised their Prime cap for highball-Based mortgages, the decision to adjust rates depends on various factors, including funding costs and market conditions. It is essential for individuals to carefully assess and manage risks when making property-related decisions.

In conclusion, the Hong Kong dollar exchange rate system has proven to be a robust mechanism for maintaining financial stability over the years. The HKMA's commitment to fulfilling its CU obligations, along with its market experience, ensures that the exchange rate remains within the prescribed range. With a strong financial ecosystem supported by foreign reserves, Hong Kong's exchange rate system is firmly backed, providing investors, businesses, and the public with confidence in its stability.