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


Operation of the System in

Hong Kong


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.


USDs and HKDs are exchanged between licensed banks and the Exchange Fund at a fixed rate (US$1=HK$7.8)

Exchange

Fund

Certificate of

Indebtedness (CI)

Selling of USD for HKD

US$1

Licensed

Banks

HK$7.8


Exchange

Fund

US$1

Buying USD with HKD

HK$7.8 & Certificate of Indebtedness (CI)

Licensed

Banks


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

Non-bank

Public

Licensed

Banks

Buy/sell HKDs at floating rates


Arbitrage under the linked exchange rate system

--- when the market rate > linked rate

Sell US$ Buy US$

Non-bank Public

(US$1=HK$9)

USD is dearer


Licensed

Banks

=US$

Exchange Fund

(US$1=HK$7.8)

USD is cheaper

Graphical illustration --market rate > linked rate

Price of US$

(in HK$)

Foreign exchange market

S

S’

As LBs sell USD in the market, supply of USD



9.0

7.8

0

The market rate of

USD

 until it is close to the linked rate

D

Quantity of US$


Arbitrage under the linked exchange rate system

--- when the market rate < linked rate

Buy US$ Sell US$

Non-bank Public

(US$1=HK$6.5)

USD is cheaper


Licensed

Banks

Exchange Fund

(US$1=HK$7.8)

USD is dearer

Graphical illustration --market rate < linked rate

Price of US$

(in HK$)

Foreign exchange market

S

As LBs buy USD from the market, demand for USD



7.8

6.5

0


D

The market rate of

USD

 until it is close to the linked rate

D’

Quantity of

US$

Speculation under the linked rate system



A bullish speculation on HKD

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


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.


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?


Differences between arbitrage and speculation

Arbitrage

Price differential Risk involved

Exists between different markets

No

Speculation Exists between the present price and the speculated future price

Yes


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


Effects on the Economy


1. No independent monetary policies r

Hong Kong

LM

1.

LM’

When HK imposes an expansionary monetary policy

(

 money supply) r

1 r

2

IS

LM shifts rightward r in HK



Y


 Interest rate

< in HK

Interest rate in US

More capital flows from HK to US

Demand for USD



Market exchange rate of

USD




 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.


Graphical illustration r

Hong Kong

LM

LM’ r r

1

2

Exp. MP



M s

  LM shifts rightward

Arbitrage



M s

  LM shifts leftward until r restores its initial value

IS

Y

MP is completely ineffective


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 .


2. M s and r in HK follow those in the U.S.

r

The U.S.

1.

M s in the U.S.



LM

LM’ r in the U.S.

 r

1 r

2

IS

Y




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






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.


Graphical illustration r Hong Kong

LM

LM’

Arbitrage



M s

  LM shifts rightward r r

1

2 r in HK

 until it approaches the r in the U.S.

IS

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.


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.)


Before appreciation of

USD against yen

Market Rate

HK$7.8 = US$1

US$1 = JP¥ 125

HK$1 = JP¥ 16.0

HK arbitrageurs (with HKDs)

HK$7.8

US$1 JP¥ 135

After appreciation of

USD against yen

Market Rate

HK$7.8 = US$1

US$1 = JP¥ 135

HK$1 = JP¥ 16.0

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 appreciates against JPY

S’



HKD e e’

D

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).


b. When HK$ appreciates against yen e.g.

HK’s export to Japan  

Supply of JPY



Price of yen

(in HK$)

S

S’ e e’

HK$ appreciates against yen

D 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.)


Before appreciation of HKD against yen

Market Rate

HK$7.8 = US$1

US$1 = JP¥ 125

HK$1 = JP¥ 16.0

HK arbitrageurs (with HKDs)

HK$1 JP¥ 20 US$0.16

=20/125


After appreciation of

HKD against yen

Market Rate

HK$7.8 = US$1

US$1 = JP¥ 125

HK$1 = JP¥ 20.0

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

D’

(by arbitrageurs)

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 .


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.


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.


Ch 13 Linked exchange rate system

Chapter 13

International Finance II

--- The Linked Exchange

Rate System in Hong Kong

Contents:

Operation of the System in

Hong Kong

The system

Effects on the Economy

Related documents

Products

Support

Ch 13 Linked exchange rate system

Chapter 13

International Finance II

--- The Linked Exchange

Rate System in Hong Kong

Contents:

Operation of the System in

Hong Kong

The system

Effects on the Economy

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