Download Ch 13 Linked exchange rate system

Chapter 13
International Finance II
--- The Linked Exchange
Rate System in Hong Kong
© Pilot Publishing Company Ltd. 2005
Contents:
• Operation of the system in Hong Kong
• Effects on the economy
© Pilot Publishing Company Ltd. 2005
Operation of the System in
Hong Kong
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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.
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USDs and HKDs are exchanged between licensed banks
and the Exchange Fund at a fixed rate (US$1=HK$7.8)
Selling of USD for HKD
US$1
Exchange
Fund
Licensed
Banks
Certificate of
Indebtedness (CI)
HK$7.8
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Buying USD with HKD
HK$7.8 & Certificate
of Indebtedness (CI)
Exchange
Fund
Licensed
Banks
US$1
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USDs and other currencies are exchanged between
licensed banks and the non-bank public at flexible
rates (determined by market demand and supply)
Sell/buy foreign
currencies at
floating rates
Licensed
Banks
Non-bank
Public
Buy/sell HKDs at
floating rates
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Arbitrage under the linked exchange rate system
--- when the market rate > linked rate
Buy US$
Sell US$
Licensed
Banks
Exchange Fund
Non-bank Public
(US$1=HK$9)
USD is dearer
(US$1=HK$7.8)
USD is cheaper
=US$
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Graphical illustration --- market rate > linked rate
Price of US$
(in HK$)
Foreign exchange market
S
As LBs sell USD
in the market,
S’ supply of USD 
9.0
7.8
The market rate of
USD  until it is
close to the linked rate
D
0
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Quantity
of US$
Arbitrage under the linked exchange rate system
--- when the market rate < linked rate
Sell US$
Buy US$
Non-bank Public
(US$1=HK$6.5)
USD is cheaper
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Licensed
Banks
Exchange Fund
(US$1=HK$7.8)
USD is dearer
Graphical illustration --- market rate < linked rate
Price of US$ Foreign exchange market
(in HK$)
As LBs buy USD
S
7.8
from the market,
demand for USD 
The market rate of
USD  until it is close
to the linked rate
6.5
D’
0
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D
Quantity of
US$
Speculation under the linked rate system
 A bullish speculation on HKD
Speculate
that HKD to
appreciate
Buy HKD now and
sell it after its
revaluation
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D for HKD
=
S of USD
Market rate of USD 
i.e., HKD appreciates as
speculated (self-fulfilling)
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.
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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?
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Differences between arbitrage and speculation
Price differential
Arbitrage
Exists between
different markets
Speculation Exists between the
present price and
the speculated
future price
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Risk involved
No
Yes
Differences between the linked exchange rate
system and the fixed exchange rate system
Market exchange
rate
Linked exchange Variable but close
rate system
to the linked rate
Fixed exchange
rate system
Maintained by
Arbitrage of
licensed banks
Fixed and equal to Intervention of
the pre-announced the government
rate
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Effects on the Economy
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1. No independent monetary policies
When HK imposes an
1.
r
Hong Kong
LM
LM’
r1
expansionary
monetary policy
( money supply)
LM shifts rightward
r2
r in HK 
IS
© Pilot Publishing Company Ltd. 2005
Y

Interest rate
in HK
<
Interest rate
in US
More capital flows from HK to US
Demand for USD 
Market exchange rate of
USD 
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
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.
© Pilot Publishing Company Ltd. 2005
Graphical illustration
r
Exp. MP 
Ms  LM
shifts rightward
Hong Kong
LM
LM’
r1
r2
Arbitrage 
Ms  LM
shifts leftward
until r restores
its initial value
IS
YMP is completely
ineffective
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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.
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2. Ms and r in HK follow those in the U.S.
r
1. Ms in the U.S. 
The U.S.
LM
LM’
r in the U.S. 
r1
r2
IS
Y
© Pilot Publishing Company Ltd. 2005

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 
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
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. 2005
Graphical illustration
r
Arbitrage 
Ms  LM
shifts rightward
Hong Kong
LM
LM’
r in HK  until it
approaches
the r in the U.S.
r1
r2
IS
© Pilot Publishing Company Ltd. 2005
Y
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.
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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 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.)
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Before appreciation of
USD against yen
After appreciation of
USD against yen
Market Rate
Market Rate
HK$7.8 = US$1
US$1 = JP¥ 125
HK$1 = JP¥ 16.0
HK$7.8 = US$1
US$1 = JP¥ 135
HK$1 = JP¥ 16.0
HK arbitrageurs (with HKDs)
HK$7.8
US$1
JP¥ 135
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HK$8.44
=135/16
Gain HK$0.64
Graphical illustration--- For. Ex. market between Jap. yen & HKD
Price of yen
(in HK$)
S
HK arbitrageurs supply
JPY for HKD  HKD
appreciates against JPY
S’
e
e’
D
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Quantity
of yen
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).
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b. When HK$ appreciates against yen
e.g. HK’s export to Japan  Supply of JPY
Price of yen
(in HK$)
S
e
e’
S’
HK$ appreciates
against yen
D
© Pilot Publishing Company Ltd. 2005
Quantity
of yen
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.)
© Pilot Publishing Company Ltd. 2005
Before appreciation
of HKD against yen
After appreciation of
HKD against yen
Market Rate
Market Rate
HK$7.8 = US$1
US$1 = JP¥ 125
HK$1 = JP¥ 16.0
HK$7.8 = US$1
US$1 = JP¥ 125
HK$1 = JP¥ 20.0
HK arbitrageurs (with HKDs)
HK$1
JP¥ 20
US$0.16
=20/125
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HK$1.248
=0.16x7.8
Gain HK$0.248
Graphical illustration--- For. Ex. market between Jap. yen & HKD
Price of yen
(in HK$)
S
HK arbitrageurs buy JPY with
HKD  HKD depreciates
against JPY until the initial
value is restored
S’ (by exporters)
e
e’
D’ (by arbitrageurs)
D
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Quantity
of yen
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. 2005
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. 2005
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.
© Pilot Publishing Company Ltd. 2005