The Hong Kong Monetary Authority (HKMA) is Hong Kong’s de facto central bank.
Its barely worth posting that they have cut their benchmark rate. They automatically match moves from the Federal Reserve's Federal Open Market Committee (FOMC).
But, its an opportunity to review how the HKMA manages the HKD and rates.
The Hong Kong Monetary Authority (HKMA) plays a vital role in maintaining the stability of the Hong Kong dollar (HKD). Since 1983, the HKD has been pegged to the U.S. dollar under a Linked Exchange Rate System (LERS), ensuring exchange rate stability and promoting investor confidence. The peg ties the HKD at approximately 7.80 per U.S. dollar, with a permitted trading range of 7.75 to 7.85.
Mechanisms of HKMA's Exchange Rate Management
The HKMA uses an automatic adjustment mechanism to keep the HKD within its allowed band:
- Currency Board System: The HKMA operates a currency board arrangement, ensuring every HKD issued is backed by U.S. dollar reserves at a fixed rate. This means changes in the monetary base (the sum of currency in circulation and bank reserves) are directly tied to foreign exchange inflows or outflows.
- Intervention Mechanism:
- When the HKD approaches the strong side of 7.75, the HKMA sells HKD and buys U.S. dollars, injecting liquidity into the financial system.
- When the HKD nears the weak side of 7.85, the HKMA does the reverse—buying HKD and selling U.S. dollars, withdrawing liquidity.This ensures exchange rate stability within the target band.
Interest Rate Management under the Peg
Under the LERS, the HKMA does not directly set interest rates. Instead, Hong Kong’s interest rates are influenced by the flow of capital and the exchange rate mechanism:
- Capital Outflows: When capital exits Hong Kong, the HKMA withdraws HKD liquidity to maintain the peg, leading to higher local interest rates.
- Capital Inflows: Conversely, capital inflows result in the HKMA injecting liquidity, which lowers local interest rates.
The peg's design inherently ties Hong Kong’s interest rates to those of the United States, as the HKD exchange rate must align with U.S. monetary policy.
Response to Federal Reserve Rate Changes
Since the HKD is pegged to the U.S. dollar, the HKMA effectively follows the U.S. Federal Reserve's interest rate decisions:
- When the Federal Reserve raises interest rates, the HKMA may also tighten liquidity conditions to ensure the HKD remains attractive, maintaining the peg.
- Conversely, when the Fed lowers rates, the HKMA injects liquidity to prevent excessive strengthening of the HKD.
This alignment has a significant impact on Hong Kong's economic conditions. For instance, during periods of aggressive U.S. rate hikes, borrowing costs in Hong Kong rise, affecting property markets and consumer spending. Conversely, U.S. rate cuts often lead to lower borrowing costs, spurring investment and growth.
Challenges and Implications
The HKMA’s reliance on the Fed’s monetary policy limits its ability to tailor interest rates to local economic conditions. This has created challenges during economic downturns when Hong Kong required looser monetary policy, but U.S. rates were rising. Similarly, during booms, Hong Kong has faced overheating risks when U.S. rates were too low.
Despite these constraints, the LERS has provided decades of currency stability, fostering Hong Kong’s reputation as a global financial hub. While the system ties the HKMA’s hands on independent monetary policy, its credibility and transparency remain vital for maintaining investor confidence in the HKD.
There is more on LERS
here at the HKMA site.
This article was written by Eamonn Sheridan at
www.forexlive.com.
