© Pilot Publishing Company Ltd Chapter 13 International Finance II --- The Linked Exchange Rate System in Hong Kong

© Pilot Publishing Company Ltd Contents: Operation of the system in Hong Kong Effects on the economy

© Pilot Publishing Company Ltd Operation of the System in Hong Kong

© Pilot Publishing Company Ltd The system  The linked exchange rate system in Hong Kong is actually a currency board system.  Through the note-issuing mechanism, the fixed and the flexible exchange rate systems are linked together by licensed banks.

© Pilot Publishing Company Ltd USDs and HKDs are exchanged between licensed banks and the Exchange Fund at a fixed rate (US$1=HK$7.8) US$1 Certificate of Indebtedness (CI) HK$7.8 Licensed Banks Exchange Fund Selling of USD for HKD

© Pilot Publishing Company Ltd HK$7.8 & Certificate of Indebtedness (CI) US$1 Buying USD with HKD Licensed Banks Exchange Fund

© Pilot Publishing Company Ltd USDs and other currencies are exchanged between licensed banks and the non-bank public at flexible rates (determined by market demand and supply) Licensed Banks Non-bank Public Sell/buy foreign currencies at floating rates Buy/sell HKDs at floating rates

© Pilot Publishing Company Ltd Arbitrage under the linked exchange rate system --- when the market rate > linked rate Licensed Banks Non-bank Public (US$1=HK$9) USD is dearer Exchange Fund (US$1=HK$7.8) USD is cheaper Sell US$ =US$ Buy US$

© Pilot Publishing Company Ltd Price of US$ (in HK$) Quantity of US$ S D S’ Graphical illustration --- market rate > linked rate As LBs sell USD in the market, supply of USD  The market rate of USD  until it is close to the linked rate The market rate of USD  until it is close to the linked rate Foreign exchange market 0

© Pilot Publishing Company Ltd Arbitrage under the linked exchange rate system --- when the market rate < linked rate Licensed Banks Non-bank Public (US$1=HK$6.5) USD is cheaper Exchange Fund (US$1=HK$7.8) USD is dearer Sell US$ Buy US$

© Pilot Publishing Company Ltd Price of US$ (in HK$) Quantity of US$ S D D’ Foreign exchange market 0 Graphical illustration --- market rate < linked rate As LBs buy USD from the market, demand for USD  As LBs buy USD from the market, demand for USD  The market rate of USD  until it is close to the linked rate The market rate of USD  until it is close to the linked rate

© Pilot Publishing Company Ltd Speculation under the linked rate system Speculate that HKD to appreciate Buy HKD now and sell it after its revaluation  A bullish speculation on HKD D for HKD  S of USD  = Market rate of USD  i.e., HKD appreciates as speculated (self-fulfilling) Market rate of USD  i.e., HKD appreciates as speculated (self-fulfilling)

© Pilot Publishing Company Ltd  Once the market rate falls below the linked rate, licensed banks will make an arbitrage. A bullish speculation on HKD LBs will buy USDs from (sell HKDs to) the market and sell USDs to (buy HKDs from) the Exchange Fund until the market rate approaches the linked rate again.  As LBs sells HKDs to the market, money supply of HKD increases and r in HKDs falls. The interest rate differential thus created will discourage the capital inflow & relieve the revaluation pressure.

© Pilot Publishing Company Ltd Q13.1: What will happen if there is a bearish speculation against the HKD? What can the government do to relieve the devaluation pressure brought by speculators?

© Pilot Publishing Company Ltd Differences between arbitrage and speculation Price differentialRisk involved ArbitrageExists between different markets No SpeculationExists between the present price and the speculated future price Yes

© Pilot Publishing Company Ltd Differences between the linked exchange rate system and the fixed exchange rate system Market exchange rate Maintained by Linked exchange rate system Variable but close to the linked rate Arbitrage of licensed banks Fixed exchange rate system Fixed and equal to the pre-announced rate Intervention of the government

© Pilot Publishing Company Ltd Effects on the Economy

© Pilot Publishing Company Ltd No independent monetary policies r Y IS LM LM’ r1r1 r2r2 Hong Kong r in HK  LM shifts rightward When HK imposes an expansionary monetary policy (  money supply) When HK imposes an expansionary monetary policy (  money supply) 1.

© Pilot Publishing Company Ltd More capital flows from HK to US Demand for USD  Market exchange rate of USD  Interest rate in HK < Interest rate in US 

© Pilot Publishing Company Ltd Market rate of USD > Linked rate of USD  As LBs sell HKD to the Ex Fund, supply of HKD  HK’s licensed banks buy USD from the Exchange Fund and sell it to the market --- arbitrage r in HK  until it is close to that in U.S.

© Pilot Publishing Company Ltd r Y IS LM r1r1 r2r2 Hong Kong Graphical illustration LM’ Exp. MP  M s   LM shifts rightward Exp. MP  M s   LM shifts rightward Arbitrage  M s   LM shifts leftward Arbitrage  M s   LM shifts leftward until r restores its initial value MP is completely ineffective

© Pilot Publishing Company Ltd  The monetary authority cannot determine the money supply or the interest rate independently. Under the linked exchange rate system (or fixed exchange rate system)  The monetary policy is completely ineffective.

© Pilot Publishing Company Ltd M s and r in HK follow those in the U.S. r Y IS LM LM’ r1r1 r2r2 The U.S. M s in the U.S.  1. r in the U.S. 

© Pilot Publishing Company Ltd Interest rate in HK > Interest rate in the U.S.  More capital flows from the U.S. to HK Supply of USD  Market exchange rate of USD 

© Pilot Publishing Company Ltd Market rate of USD < Linked rate of USD  HK’s licensed banks buy USD from the market and sell it to the Exchange Fund --- arbitrage As LBs buy HKD from the Ex Fund, supply of HKD  r in HK$  until it is close to that in U.S.

© Pilot Publishing Company Ltd r Y IS LM LM’ r1r1 r2r2 Hong Kong Graphical illustration r in HK  until it approaches the r in the U.S. r in HK  until it approaches the r in the U.S. Arbitrage  M s   LM shifts rightward Arbitrage  M s   LM shifts rightward

© Pilot Publishing Company Ltd  Hong Kong has to follow the monetary policy of the U.S. passively. Under the linked exchange rate system (or fixed exchange rate system)  HK’s money supply & interest rates will change simultaneously with those in the U.S.

© Pilot Publishing Company Ltd Exchange Values of Other Currencies in HK Dollars Follow Their Corresponding Values in US Dollars It is cheaper to buy JPYs with USDs than with HKDs. As there exists a price differential, arbitrageurs will buy Jap. yens where they are cheaper (with USD) and sell Jap. yens where they are dearer (for HKD). HK arbitrageurs (with HKDs): Sell HKDs for USDs  Buy yens (cheaper) with USDs  sell yens (dearer) for HKDs (to reap P diff.) a. When US dollar appreciates against Japanese yen

© Pilot Publishing Company Ltd Before appreciation of USD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 16.0 Before appreciation of USD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 16.0 After appreciation of USD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 135 HK$1 = JP¥ 16.0 After appreciation of USD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 135 HK$1 = JP¥ 16.0 HK$7.8 US$1 JP¥ 135 HK$8.44 =135/16 Gain HK$0.64 HK arbitrageurs (with HKDs)

© Pilot Publishing Company Ltd Price of yen (in HK$) Quantity of yen S D S’ e e’ HK arbitrageurs supply JPY for HKD  HKD appreciates against JPY Graphical illustration--- For. Ex. market between Jap. yen & HKD

© Pilot Publishing Company Ltd Under the linked (or fixed) exchange rate system, If the exchange value of a currency in US dollar changes, its exchange value in HK dollar must follow (until the price differential approaches zero).

© Pilot Publishing Company Ltd b. When HK$ appreciates against yen e.g. HK’s export to Japan   Supply of JPY  Price of yen (in HK$) Quantity of yen S D S’ e e’ HK$ appreciates against yen

© Pilot Publishing Company Ltd When HKD appreciates against Jap. yen, it is cheaper to buy JPYs with HKDs than with USDs. As there exists a price differential, arbitrageurs will buy Jap. yens where they are cheaper (with HKD) and sell Jap. yens where they are dearer (for USD). HK arbitrageurs (with HKDs): Sell HKDs for JPYs (cheaper)  Sell JPYs (dearer) for USDs  sell USDs for HKDs (to reap P diff.) HK arbitrageurs (with HKDs): Sell HKDs for JPYs (cheaper)  Sell JPYs (dearer) for USDs  sell USDs for HKDs (to reap P diff.)

© Pilot Publishing Company Ltd Before appreciation of HKD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 16.0 Before appreciation of HKD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 16.0 After appreciation of HKD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 20.0 After appreciation of HKD against yen Market Rate HK$7.8 = US$1 US$1 = JP¥ 125 HK$1 = JP¥ 20.0 HK$1 JP¥ 20 US$0.16 =20/125 HK$1.248 =0.16x7.8 Gain HK$0.248 HK arbitrageurs (with HKDs)

© Pilot Publishing Company Ltd Price of yen (in HK$) Quantity of yen S S’ D D’ e e’ HK arbitrageurs buy JPY with HKD  HKD depreciates against JPY until the initial value is restored Graphical illustration--- For. Ex. market between Jap. yen & HKD (by arbitrageurs) (by exporters)

© Pilot Publishing Company Ltd Under the linked exchange rate system, If the exchange value of a currency in US dollar remains unchanged, its exchange value in HK dollar cannot be varied.

© Pilot Publishing Company Ltd Correcting Misconceptions: 1. The non-bank public can buy and sell US dollars with the Exchange Fund at the linked rate. 2. Arbitrage is the same as speculation. 3. The linked exchange rate system is the same as the fixed exchange rate system.

© Pilot Publishing Company Ltd The interest rates in Hong Kong are always equal to the interest rates in the U.S. 5. The exchange rates of currencies other than the US dollar are flexible and are freely determined by the market. Correcting Misconceptions: