The Hong Kong Monetary Authority (HKMA) is Hong Kong's de facto central bank.
It's hardly worth posting that they've cut their benchmark rate. They automatically match movements from the Federal Open Market Committee (FOMC) of the Federal Reserve.
However, it is 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 US dollar under a linked exchange rate system (LERS), ensuring exchange rate stability and encouraging investor confidence. The peg pegs the HKD at around 7.80 per US dollar, with an allowed trading range of 7.75 to 7.85.
HKMA Exchange Rate Management Tools
The HKMA uses an automatic adjustment mechanism to keep the HKD within its permitted band:
- Currency Board System: The HKMA operates a currency board arrangement, ensuring that all HKD issued are backed by US dollar reserves at a fixed rate. This means that changes in the monetary base (amount of money in circulation and bank reserves) are directly linked to foreign exchange inflows or outflows.
- Mechanism of intervention:
- When the HKD approaches the strong side of 7.75, the HKMA sells HKD and buys US dollars, injecting liquidity into the financial system.
- When the HKD approaches the weak side of 7.85, the HKMA does the reverse – buying HKD and selling US dollars, removing liquidity.
This ensures exchange rate stability within the target band.
Interest Rate Regulation under the Peg
Under the LERS, the HKMA does not set interest rates directly. Instead, Hong Kong interest rates are affected by capital flow and exchange rate mechanisms:
- Capital outflows: When capital flows out of Hong Kong, the HKMA withdraws HKD liquidity to maintain the peg, leading to higher local interest rates.
- Capital inflows: On the other hand, capital inflows mean that the HKMA injects liquidity, which lowers local interest rates.
The peg design essentially ties Hong Kong interest rates to United States interest rates, as the HKD exchange rate must be in line with US monetary policy.
Response to Federal Reserve Rate Changes
Since the HKD is pegged to the US dollar, the HKMA effectively follows the interest rate decisions of the US Federal Reserve:
- When the Federal Reserve raises interest rates, the HKMA can also tighten liquidity conditions to ensure the HKD remains attractive, maintaining the peg.
- On the other hand, when the Fed lowers rates, the HKMA injects liquidity to prevent excessive strengthening of the HKD.
This alignment has a major impact on Hong Kong's economic situation. For example, during periods of aggressive increases in US rates, borrowing costs in Hong Kong rise, affecting property markets and consumer spending. On the other hand, US rate cuts often lead to lower borrowing costs, encouraging investment and growth.
Challenges and Outcomes
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 the recession when Hong Kong needed easier monetary policy, but US rates were rising. Likewise, during booms, Hong Kong has faced risks of overheating when US rates were too low.
Despite these limitations, the LERS has provided decades of financial stability, fostering Hong Kong's reputation as a global financial center. While the system ties the HKMA's hands to independent monetary policy, its credibility and transparency remain crucial to maintaining investor confidence in the HKD.
There is more to LERS here at the HKMA site.
