What it means
Hong Kong adopted the system in October 1983, after a period of sharp swings in its currency. The Hong Kong Monetary Authority (HKMA), the territory's de facto central bank, runs it as a currency board arrangement, meaning that the monetary base is fully backed by foreign currency reserves held at a fixed rate.
The system works through the note-issuing banks. When one of them wants to issue more Hong Kong banknotes, it must hand US dollars to the Exchange Fund at the fixed rate, and when notes are returned it gets US dollars back.
This mechanism, combined with the HKMA's willingness to trade at fixed rates, keeps the market rate close to the target. Since 2005 the HKMA has operated a narrow trading band around the central rate of 7.80, with the strong-side limit at 7.75 and the weak-side limit at 7.85.
At the weak edge the HKMA buys Hong Kong dollars and sells US dollars, and at the strong edge it sells Hong Kong dollars and buys US dollars, so the rate cannot drift far outside the band. A consequence is that Hong Kong gives up control of its own interest rates.
If money flows out and the currency weakens, the HKMA's intervention drains Hong Kong dollars from the banking system and interest rates rise automatically. If money flows in, rates fall, so local rates tend to follow US rates.
For businesses, the system gives exchange rate certainty when trading or borrowing in US dollars, and it makes budgeting simple. The trade-off is that the economy cannot use its exchange rate to adjust to shocks, so adjustment has to come through prices, wages and interest rates.
Companies that trade with countries whose currencies float still face exchange rate risk on those flows.
In practice
Real-world examples.
Example
A Hong Kong exporter prices a $500,000 contract in US dollars. Because the currency link makes the local value predictable, the finance director records the sale in Hong Kong dollars at about 7.80 without buying a currency hedge.
Example
A multinational opens a regional treasury office in Hong Kong and funds it with US dollars. The treasurer notes that local borrowing costs follow US rates closely, so the company plans interest expense using US rate forecasts. She also keeps a small buffer in the budget in case the rate moves to the edge of the band.
Example
An analyst compares the Hong Kong dollar with a floating currency. During a period of capital outflows, the floating currency falls, while the Hong Kong dollar stays inside its band because of central bank intervention. The analyst notes that the cost of this stability is higher and more volatile local interest rates.
Formula
Calculation
Hong Kong dollar amount = US dollar amount x exchange rate (HK$ per US$).
Suppose a company holds US$100,000 and the rate is the central rate of 7.80. Hong Kong dollar amount = 100,000 x 7.80 = HK$780,000. At the weak-side limit of 7.85, the same US$100,000 is worth 100,000 x 7.85 = HK$785,000. The difference between the two is 785,000 - 780,000 = HK$5,000, which is about 0.64% of HK$780,000 and shows how little the rate can move inside the band.Case study
Seen in the real world.
Pearlbay Trading is an illustrative, fictional company based in Hong Kong that imports electronics priced in US dollars and sells to local retailers in Hong Kong dollars. Because the two currencies are linked, the finance team can set shelf prices months ahead with little worry about the exchange rate.
When the same company opened a sales office in a neighbouring country with a floating currency, margins began to swing with the exchange rate, and the team needed forward contracts to protect them. The contrast showed how much simplicity the link provided in its home market.
In this illustrative case the finance director noted that the link was not a free lunch. When US interest rates rose, the company's local borrowing costs rose too, even though the Hong Kong economy was growing slowly. She now reviews the company's floating-rate loans each time US rates change.
Watch out
Common mistakes.
- Believing the Hong Kong dollar is pegged to a single exact number, when it trades within a narrow band that is defended at the edges.
- Assuming a pegged currency has no risk, when the link transfers US interest rate moves into the local economy.
- Confusing the system with the Chinese yuan's management, which operates on a different basis and a different framework.
Questions
People also ask.
Who runs the system?
The Hong Kong Monetary Authority manages it through the Exchange Fund and the note-issuing banks.
Why does Hong Kong keep it?
It provides stability and confidence for a financial centre that handles large flows of international money.
What would break the link?
A loss of confidence in the reserves, a major capital flight or a policy decision to change the regime, though the authorities have repeatedly stated their commitment to maintain it.
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