As international investors diversify away from US dollar assets and amid the rise of internationalisation of the yuan, there are calls for reviewing the Hong Kong dollar’s peg. Here is what to know about the system.
Why is the Hong Kong dollar pegged to the US dollar?
The birth of the peg is closely tied to market uncertainties. The currency was once freely traded and in September 1983 slumped by 48 per cent to a record low of HK$9.60 per dollar when a crisis of confidence occurred as the Chinese and British governments began negotiations for the 1997 handover.
Hong Kong pegged its currency at HK$7.80 per dollar on October 17, 1983, under the Linked Exchange Rate System, in order to stop the swing.
A trading band was then introduced in May 2005 to allow the local currency to swing between HK$7.75 and HK$7.85.
How does the peg operate?
The Hong Kong Monetary Authority (HKMA), the city’s de facto central bank, will intervene in the market to ensure the currency trades within the range.
When the Hong Kong dollar trades at the weak end of HK$7.85 per dollar, the HKMA reserves of it, held by banks, reduce liquidity and push interbank market interest rates up to attract money back into Hong Kong dollars.
As the city sees capital outflow and the Hong Kong dollar strengthens, the HKMA does the opposite – selling Hong Kong dollars to banks, increasing bank liquidity and lowering market interest rates to discourage inflows and push the dollar exchange down.
The currency is backed by a war chest of around HK$4.463 trillion (US$569 billion), one of the world’s largest foreign exchange reserves and held in the city’s Exchange Fund, which can be used to defend the currency.