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Exchange rate determination: Why has Hong Kong been pegged with USD instead of RMB?

Exchange rate is the value of a currency expressed in another currency. It is used when trades occur between countries, which means the exports and imports or the capital inflow and outflow relies on the exchange rate.

Types of Exchange Rate Systems:

1. Floating exchange rate system

The US dollar follows this floating exchange rate system. The exchange rate run in this system is determined by the private market’s supply and demand. In terms of the demand side, when exports of local goods and services increase, this increases the demand of currency. Moreover, the higher the local interest rate, the higher the return, implying that foreigners will demand more local currency. When the local economy situation has a positive future as well as a sound political condition, more foreigners will be attracted to buy the local currency. However if all the above are a decrease, the demand will diminish.

2. Fixed exchange rate system

A fixed exchange rate system fully depends on the government’s action by the central bank on maintaining the exchange rate. When the exchange rate goes up, the central bank takes an action called “revaluation”. The central bank predominantly sells its currency off the foreign exchange market to adjust back to the exact official exchange rate. When the exchange rate goes down, the central bank implements the “devaluation” action, the action of buying back the currency back to boost up until their original exchange rate price is fixed at.

3. Linked exchange rate system (LERS)

Hong Kong is the only place in the world that has applied the LERS. It is a system that has mixed characteristics of both the fixed exchange rate system and the floating exchange rate system. Hong Kong dollars (HKD) have long been pegged with USD with a conversion of 1 USD approximately equaling to 7.8 HKD. The mechanism is fully demonstrated below.

Exchange rates of USD and HKD are fully determined by the free market’s supply and demand. Under the Currency Board system, the Hong Kong Monetary Authority (HKMA) guarantees to exchange every USD with 7.8 HKD to note-issuing banks. Note-issuing banks helps HKMA maintain approximately 7.8 HKD to 1 USD using arbitrage, a buy-low-sell-high mechanism. When the exchange rate of 1 USD in the market is higher than 7.8 HKD, note-issuing banks will sell USD. On the other hand, when the exchange rate is lower than 7.8 HKD, note issuing banks will buy USD and exchange it with HKMA and earn the difference in between. In the end, the HKD is eventually fixed at an exchange rate of around 7.8 dollars to 1 USD.

So why is Hong the only place to apply the linked exchange rate system?

Hong Kong is a free economy that relies on international trade and finance. They have to stabilise exchange rates for different trades like shares, re-exports, and most importantly to attract more foreign direct investments in the market. Moreover, as the freest market in the world, Hong Kong’s market is run under capitalism. That means the government does not intervene in the market, and the market fully operates with investors investing capital in the market. Foreign investors are more likely to be attracted to invest in the market, as the government has no control of their capital.

Many have questioned why not peg with RMB instead of USD?

The Hong Kong Dollar is pegged to USD because 90% of the international trade adopts USD as the trading currency. The USA is considered as the most reliable country, hence other countries trust using the USD for trading. Besides, the business cycle of Hong Kong is very similar to the USA. Therefore it is an effective choice for Hong Kong to follow the USA's monetary policy.

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