Chapter 13 International Finance II --- The Linked Exchange Rate System in Hong Kong

1. Chapter 13 International Finance II --- The Linked Exchange Rate System in Hong Kong

2. Contents: • Operation of the system in Hong Kong • Effects on the economy

3. Operation of the System in Hong Kong

4. The system The linked exchange rate system in Hong Kong is actually acurrency board system.  Through the note-issuing mechanism, the fixed and the flexible exchange rate systems are linked together by licensed banks.

5. US$1 Exchange Fund Licensed Banks Certificate of Indebtedness (CI) HK$7.8 USDs and HKDs are exchanged between licensed banks and the Exchange Fundat a fixed rate (US$1=HK$7.8) Selling of USD for HKD

6. HK$7.8 & Certificate of Indebtedness (CI) Exchange Fund Licensed Banks US$1 Buying USD with HKD

7. Sell/buy foreign currencies at floating rates Buy/sell HKDs at floating rates 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

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

9. S’ 7.8 Graphical illustration --- market rate>linked rate Price of US$ (in HK$) Foreign exchange market As LBs sell USD in the market, supply of USD  S 9.0 The market rate of USD  until it is close to the linked rate D Quantity of US$ 0

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

11. 7.8 D’ Graphical illustration --- market rate<linked rate Foreign exchange market Price of US$ (in HK$) As LBs buy USD from the market, demand for USD  S The market rate of USD  until it is close to the linked rate 6.5 Quantity of US$ D 0

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

13. A bullish speculation on HKD • Once the market rate falls below the linked rate, licensed banks will make an arbitrage. 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.

14. 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?

15. Differences between arbitrage and speculation

16. Differences between the linked exchange rate system and the fixed exchange rate system

17. Effects on the Economy

18. When HK imposes an expansionary monetary policy ( money supply) 1. LM’ LM shifts rightward r2 1. No independent monetary policies Hong Kong r LM r1 r in HK  IS Y

19. Interest rate in HK Interest rate in US < More capital flows from HKto US Demand for USD  Market exchange rate of USD 

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

21. LM’ r2 MP is completely ineffective Graphical illustration Exp. MP  MsLM shifts rightward r Hong Kong LM Arbitrage  MsLM shifts leftward r1 until r restores its initial value IS Y

22. Under the linked exchange rate system (or fixed exchange rate system) • The monetary authority cannot determine • the money supply or the interest rate • independently. • The monetary policy is completely ineffective.

23. 1. Ms in the U.S.  LM’ r in the U.S.  r2 2. Ms and r in HK follow those in the U.S. r The U.S. LM r1 IS Y

24. > 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 

25. 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.

26. LM’ r in HK until it approaches the r in the U.S. r2 Graphical illustration Arbitrage  MsLM shifts rightward r Hong Kong LM r1 IS Y

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

28. 3. Exchange Values of Other Currencies in HK Dollars Follow Their Corresponding Values in US Dollars a. When US dollar appreciates against Japanese yen It ischeaper tobuy JPYs with USDsthan 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.)

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

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

31. 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).

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

33. WhenHKDappreciatesagainst Jap. yen, it ischeaper tobuy JPYs with HKDsthan 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.)

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

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

36. 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.

37. 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.

38. Correcting Misconceptions: 4. 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.