Linked exchange rate

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See also Bureau de Change

A linked exchange rate system is a type of exchange rate regime to link the exchange rate of a currency to another. It is the exchange rate system implemented in Hong Kong to stablise the exchange rate between Hong Kong dollar (HKD) and United States dollar (USD).

Unlike a fixed exchange rate system, the government or the central bank does not actively interfere in the foreign exchange market by controlling supply and demand of the currency, in order to influence the exchange rate. The exchange rate is stabilised by a mechanism.

[edit] History

The linked exchange rate system has been adopted in Hong Kong since October 17, 1983 through the currency board system, of which the issue and redemption of certificates of indebtedness (for backing the banknotes) by the note-issuing banks be made against US dollars at an internal fixed exchange rate of HK$7.80:US$1<ref>Linked Exchange Rate System at Hong Kong government website</ref>.

The Hong Kong Monetary Authority (HKMA), Hong Kong's de facto central bank, authorised note-issuing banks are to issue banknotes. These banks are required to have the same amount of USD to issue banknotes. The HKMA guarantees to exchange USD into HKD, or vice versa, at the rate of 7.80. When the market rate is below 7.80, the banks will convert USD for HKD from the HKMA, HKD supply will be increased, and the market rate will climb back to 7.80. The same mechanism also works when the market rate is above 7.80, and the banks will convert HKD for USD.

In practice, the HKMA also set a lower limit at 7.80 (7.85 as an upper limit and 7.75 as a lower limit since May 18, 2005) for the HKD to flow within. The HKMA will buy or sell HKD in the market when the exchange rate is beyond the limit(s). The HKD is backed by one of the world's largest foreign exchange reserves, which is several times the amount of money supplied in circulation.