Reforms of the Linked Exchange Rate System of Hong Kong Dollar

The HK Dollar linked exchange system was established on 17th Oct 1983. The HK authorities established a foreign exchange fund. Banks which issue HK currency must lodge 100 % US dollar militias which work as the footing for publishing HK currency at the fixed exchange rate. The coupled exchange rate system of Hong Kong has been implemented till now. It has played a positive function in keeping stableness and economic development of Hong Kong. However, the linked system besides has some defects. We can reason from three facets. First of wholly, the militias can non vouch the stableness of HK currency and hard currency demands. Second, the involvement rate arbitrage mechanism may neglect under the linked exchange system. Finally, under the linked system both the pecuniary and financial policy are limited. The pecuniary policy is no longer independent and the map of financial policy is rather limited.

There are besides three possible ways to reform current linked exchange rate exchange system of Hong Kong. First manner is to set up basket exchange rate government. Second manner is to implement RMB linked exchange rate system alternatively of the US Dollar linked system. Third manner is to organize an optimum currency country. As in history, the constitution of a individual currency system by and large has two basic manners: First, good money ( strong currency ) merges bad money ( weak currency ) , such as the former West Germany Mark merged the former East Germany Mark. Second is set uping the optimum currency country, such as the Euro theoretical account. With the existent state of affairs in China, it is difficult to state HK Dollar and RMB which is better. So the first manner is non suited for China. The 2nd manner draws a batch of attending in recent old ages. Make Hong Kong and China satisfy the demands of a possible optimum currency country? It remains to be explained in item subsequently in this paper.

The construction of this paper is arranged as followers:

Defects of coupled exchange rate system are in Section 2 ; possible reform methods are in subdivision 3 ; statistic cogent evidence of demands of possible optimum currency country is in Section 4 and decision is in Section 5.

Defects of Linked Exchange Rate System of HK

2.1 The militias can non vouch the stableness of HK currency and the hard currency demands

Hong Kong ‘s coupled exchange rate system requires a fixed exchange rate of HK Dollar and US Dollar as the publishing readying between exchange fund and note-issuing Bankss. As a consequence, the linked exchange rate system can merely vouch 100 % militias for base money M0, but it can non guarantee a sufficient militias for the full pecuniary system M3. The ratio of Hong Kong ‘s foreign exchange militias and M3 is shown in Table 1.1.1 and Figure 1.1.1.

Table 1.1.1 Part of the Foreign Reserve ( FR ) /M3 and M0 Table


FR/HK M3 ( % )

FR/HK M0 ( Times )


























































Figure 1.1.1 Ratio of Foreign Reserve and M3/M0

From Figure 1.1.1, we can see that M3 is merely approximately 40 % -50 % of the foreign militias. If the market loses assurance in HK Dollars, a batch of HK Dollars will be exchanged to US Dollars. But the bing US Dollar militias are unable to back up the linked exchange rate, that is, the nog will crash. Therefore, the linked exchange rate system is impossible to wholly trust on foreign currency militias. It is the good economic chances of market assurance that guarantees the stableness of the linked exchange rate system.

2.2 The involvement rate arbitrage mechanism may neglect under the linked exchange system

Interest rate arbitrage mechanism requires Hong Kong involvement rate must alter in measure with US involvement rate. Any interest-rate spread will be eliminated by capital flows through foreign exchange market, so the HK Dollar involvement rate will meet to that of US Dollar. However, the fact is that the involvement rate of HK Dollar has a gradual outgrowth of going from the tendency of US Dollar involvement rate.

Then what is the cause of this going? We can happen a sensible account from the strong outlook of the grasp of RMB. The grasp of RMB attracts a big figure of international financess. But because of the capital limitations of China market, foreign capitals can non successfully flux in the mainland China market. Hong Kong, the off-shore fiscal Centre of mainland China, has an progressively close relationship with mainland ‘s economic system. As a consequence, the big figure of the inflow foreign capitals caused by the grasp outlook force per unit area makes the financess of Hong Kong pecuniary system well increase in a short clip, which leads to the uninterrupted bead of bank nightlong rate and sedimentation involvement rate.

2.3 Both the pecuniary and financial policies are limited

As is said before, the linked exchange rate system of Hong Kong is under great force per unit area. Harmonizing to Trilemma, Hong Kong need maintain the fixed exchange rate system every bit good as leting the free flow of capital. Interest rate is an of import instrument to set economic development under the market status. However, Hong Kong can neither incorporate rising prices nor stimulate investing and ingestion by involvement rate under the linked exchange rate system. With the development of Chinese economic system, if there is a divergence between the concern rhythm of China and US, the economic basicss in Hong Kong may conflict with the exchange rate, as the Hong Kong authorities can non set economic system by pecuniary policy. Then it is inevitable for HK currency going the end of international speculators.

At the same clip, non merely the pecuniary policy is non independent under the linked exchange rate system, but besides the financial policy is limited. Harmonizing to Mundell-Fleming Model, the pecuniary policy is comparatively uneffective under the fixed exchange rate system, but financial policy is comparatively effectual. Hong Kong has a extremely unfastened economic system, and any policy of exciting domestic demand will change over to the addition of import in big proportion every bit good as the impairment of the balance of international payments. So Hong Kong authorities seldom use financial policy to command aggregative demand and to press short-run economic fluctuations. Therefore, the map of financial policy in Hong Kong is really restricted.

The Reform methods

As is mentioned above, while the US economic system is in the crisis, the Chinese economic system is developing really fast. The defects of Hong Kong linked exchange rate system are more and more obvious. At present the interaction between Hong Kong and mainland China economic system has already surpassed that between Hong Kong and US economic system, so the impacts of RMB on HK Dollar can non be neglected. There are two future waies for Hong Kong exchange rate system. One is the 1 basket currency exchange rate system ; the other is the RMB linked exchange rate system. But both the reforms of coupled exchange rate system require free trade of RMB. Therefore, it is non mature for the reforms now. Merely when internationalisation advancement of RMB is smooth and the capital may interchange freely, so the reforms of Hong Kong linked exchange rate system can be both practical and executable.

Basket exchange rate government

We can larn from the basket exchange rate government in Singapore. HK Dollar can be pegged to a basket of currencies, which may include US Dollar, RMB and some other currencies. If this system is implemented, the struggles between Hong Kong economic basicss and exchange rate under the original linked system are solved.

But there is a important defect of the basket exchange rate government. As Hong Kong economic basicss are closely related to the economic conditions of mainland China, RMB should be considered into the basket government. However, RMB is non to the full exchangeable, so the exchange rate mechanism is non absolutely formed, and at the same clip the exchange rate is really hard to be determined. As a consequence, this reform is non executable at present.

Linked exchange rate system pegged to RMB

The linked exchange rate system pegged to RMB will run into the demand of close synchronism and relationship between the Hong Kong and the Mainland China economic system. At the same clip, the RMB linked system besides considers the US Dollar as a factor since current exchange rate system of China nog to a basket of currencies which include the US Dollar.

Equally long as RMB can non be freely exchanged, the linked exchange rate system pegged to RMB is non realistic. In add-on, market assurance of RMB can non compare with that of US Dollar. The international study of Bank of China one time proposed that HK Dollar can nail down to RMB alternatively of US Dollar. However, that proposal resulted in unnatural fluctuations in foreign exchange rate. As a consequence, both the Hong Kong Government and IMF expressed support for the original US Dollar linked exchange rate system to stabilise the market after so. This shows that in position of RMB is non freely exchangeable and the mainland ‘s fiscal system is non perfect, the execution of the RMB linked exchange rate system need clip.

The optimum currency country

Forming a currency country is besides a possible manner work outing the jobs caused by the current Hong Kong linked exchange rate system. In the currency country, all the states or parts use the one currency merely like the Euro manner. However, the forming of currency country requires some conditions. Merely when these conditions are satisfied can the states or parts have the ability to organize a possible currency country. We will discourse the currency country in item in following subdivision.

Optimum Currency Area

Background theory debut

After the subprime mortgage crisis of US in 2007, we must see the possible impact of the US economic system recession on China through foreign exchange militias every bit good as the impact on Hong Kong through the linked exchange rate system. That is the ground of showing the construct integrating of RMB and HK Dollar.

The GG- LL Model

The GG- LL theoretical account proposed by Krugman is the representative theory to explicate the hereafter development of the optimum pecuniary country theory along with the economic integrating of assorted states. This theory is characteristic of the generalised analysis with the cost and income within the currency country. Now we analyse the integrating cost of Hong Kong Dollar and RMB with GG-LL theoretical account.

( 1 ) Seigniorage loss ;

( 2 ) Cost of giving up the independency of pecuniary policy ;

( 3 ) Loss of economic stableness.

The integrating income can be concluded in following five facets:

( 1 ) Reduce dealing cost and the impact of bad capital, and extinguish the exchange rate hazard ;

( 2 ) Save foreign exchange modesty and cut down the reserving cost ;

( 3 ) Enhance the monetary value transparence and increase the welfare income ;

( 4 ) Derive the dynamic efficiency earning ;

( 5 ) Promote the international standing of RMB.

Confronting the daze of the recent planetary fiscal crisis, the first two incomes are better proved compared with the latter three points.

The General Purchasing Power Parity ( GPPP ) Theory

To corroborate whether the Hong Kong and China can be treat as an optimum currency country, we must turn out the existent exchange rates ( RERs ) of HK Dollar and RMB against US Dollar satisfy the generalize buying power para ( G-PPP ) theory.

The theory of G-PPP was proposes by Enders and Hurn ( 1994 ) in the paper Theory and Trials of Generalized Purchasing – Power Parity: Common Trends and Real Exchange Rates in the Pacific Rim. GPPP theory explains the exchange rate behaviors of different currencies across parts. Mundell ( 1961 ) besides proposed in his work A Theory of Optimum Currency Areas that one most possible necessary status for a currency brotherhood is that dazes hitting the economic system system should be symmetric instead than idiosyncratic. From the above two documents on GPPP theory, we can sum up the the sufficient conditions for G-PPP Hypothesis:

All RERs are nonstationary ;

All RERs are cointegated, which means two or more series are themselves non-stationary, but a additive combination of them is stationary.

Now we use Eviews and comparative Data to reiterate the statistic work done by Hong Liang ( 1999 ) . But the information we use update to Oct 2010. So the numeral consequence is a small different, but the decision will non alter.

Empirical Test of The G-PPP Hypothesis

4.4.1 Definition and Data

The existent exchange rate ( RERs ) is defined as below

( 1 )


is the natural logarithm of exchange rate, and are the natural logarithm of the basal state and domestic monetary value indices.

We use monthly informations of monetary value index and exchange rate ( 1980-10 to 2010-10 ) to run the arrested development. All informations are obtained from IMF for Hong Kong, China, Japan and US.

4.4.2 Unit Root Test

We use Eviews to make the unit root trial — Augmented Dickey-Fuller Test ( ADF ) and Phillips-Perron Test ( PP ) . We take PP Test for illustration:

Table 4.4.1 PP Test For, ,



PP Statisticss

Prob. *










From Table 4.4.1, we can reason that all the RERs of HK Dollar, CNY and JPY ( place currency is US Dollar ) can non reject the PP Test void hypothesis of a unit root at 5 % degree. That is to state the existent exchange rates of these three parts are nonstationary. It satisfies the first sufficient status of the G-PPP hypothesis. We need to take the first difference to obtain the stationary series. Then take the unit root trial for the first difference of the bluish green exchange rates of HKD, CNY and JPY, the trial consequences are shown below.

Table 4.4.2 PP Test For, ,


PP Statisticss

Prob. *







We can see from Table 4.4.2 that all the first differences of existent exchange rates are strongly rejected on 5 % degree. It means that take the first difference we can obtain the stationary series of the existent exchange rate.

4.4.4 Cointegration Analysis

To corroborate if Hong Kong and China can represent a possible currency country, we still need to take another trial, the cointegration trial. We use the Johansen Cointegration Test in Eviews to prove if there are any cointegration vectors between two of Hong Kong, Chian and Japan. The consequences of the Johansen Cointegration Trials are shown in the tabular array below.

Table 4.4.3 Johansen Cointegration Test across Hong Kong, China and United States


No. of

CE ( s )

Trace Statisticss

0.05 Critical Value

Max-Eigen Statisticss

0.05 Critical Value




A 20.26184

A 12.80997

A 15.89210


A 9.164546

A 3.814497

A 9.164546

From Table 4.4.3 we can see that neither the hint statistics nor the max-eigen statistics can reject the void hypothesis of no cointegration vectors between the existent exchange rates of Hong Kong and China. As a consequence, the G-PPP cointegration hypothesis does non keep among Hong Kong, China and United States, the place state. So Hong Kong, China and United States can non represent a currency country.

Table 4.4.4 Johansen Cointegration Test across Hong Kong, Japan and United States


No. of

CE ( s )

Trace Statisticss

0.05 Critical Value

Max-Eigen Statisticss

0.05 Critical Value



A 15.78876

A 20.26184

A 9.908066

A 15.89210

A 5.880689

A 9.164546

A 5.880689

A 9.164546

Similarly, from Table 4.4.4 we can see that neither the hint statistics nor the max-eigen statistics can reject the void hypothesis of no cointegration vectors between the existent exchange rates of Hong Kong and Japan. As a consequence, the G-PPP cointegation hypothesis does non keep among Hong Kong, Japan and United States, the place state. So Hong Kong, Japan and United States can non represent a currency country.

Table 4.4.5 Johansen Cointegration Test Across HK SAR, China and Japan


No. of

CE ( s )

Trace Statisticss

0.05 Critical Value

Max-Eigen Statisticss

0.05 Critical Value



A 25.96535

A 35.19275

A 14.40004

A 22.29962

A 11.56530

A 20.26184

A 7.850943

A 15.89210

A 3.714361

A 9.164546

A 3.714361

A 9.164546

From Table 4.4.5, we can see that both the hint statistics and max-eigen statistics indicate there exists one coinntegration vector. The void hypothesis of no cointegration is rejected at 5 % degree. So the G-PPP cointegration hypothesis holds. That is to state Hong Kong, China, Japan and United States together can represent a possible currency country.


The Hong Kong authorities has established the linked exchange rate system of HK Dollars to US Dollars since 1983. This system contributes a batch to the stableness of HK currency. However, as the fast development of China ‘s economic system and the grasp outlook of RMB have brought HK Dollars great force per unit area under the USD linked exchange rate system.

This paper focuses on the defects of the US Dollar linked exchange rate system and the comparative reform methods. Three possible ways have been proposed in this paper, Basket Exchange Rate Regime, RMB linked exchange rate system, and Dwelling an Currency Area with China.

Presents, these three ways are all non realistic compared with the US Dollar linked exchange system. The basket exchange rate government can do it hard to settle the exchange rate. Equally long as RMB is non exchangeable, HK Dollars can non nail down on it. And the bilateral existent exchange rate between Hong Kong and China is affected by a batch of states in the possible currency countries.

However, there is a important tendency for RMB going an international currency. Although the optimum currency country theoretical account has inspired a batch treatment, cogent evidence above indicates Hong Kong and China entirely can non run into the demands of possible currency country. A batch of other states must be besides considered to represent an optimum currency country. And this is merely one factor, the execution of a currency country is still hard. As a consequence, a more proper manner of reforming is that HK Dollar bit by bit transfers to the RMB linked exchange rate system with a sustainable issue and militias system.