Linked Exchange Rate System Research Articles

Investigating the feasibility of the double-play strategy: evidence from Hong Kong’s speculative attacks

ABSTRACT This paper examines the ‘double-play’ strategy adopted by speculators during currency attacks in Hong Kong. We modify the speculators’ objective function to interpret how they earned potential returns from the automatic mechanism of the linked exchange rate system. Furthermore, we investigate the dynamic conditional correlations among currency, stock and derivatives markets, and identify the key determinants for these relationships during speculative attacks. Our findings offer a comprehensive insight into the behaviour of speculators during currency attacks, and provide compelling empirical support for the impact of central bank interventions on market dynamics.

The Future Development of Hong Kong Dollar Exchange Rate Regime

In the context of the developing economies, this paper examines the future outlook of Hong Kong's Linked Exchange Rate System. There is an emerging need for a re-evaluation of the system after a 40-year stable period of operation. This paper adopts a qualitative analysis to evaluate the current merits and dilemmas of the Hong Kong Dollar and its link with the Renminbi. It examines the possibility of pegging the Hong Kong Dollar to the Renminbi and the pre-conditions to be met for implementation. As well as the implications of such reform for both Hong Kong and the Mainland.

People’s Republic of China—Hong Kong Special Administrative Region

After coping with another year of large COVID-related disruptions, economic activity is normalizing with the re-opening of the border, including with Mainland China. Strong fiscal policy support has helped the economy navigate through multiple shocks over the last few years, while strong institutional frameworks and financial buffers have allowed the financial system to remain resilient and continue to operate smoothly, including the Linked Exchange Rate System. The economy is facing macro-financial challenges amid rising interest rates, spillovers from strains in Mainland China’s real estate sector, adjustment in the local property market, and global economic slowdown.

The Bet of HK Currency Board System: Peg to US Dollar Gives Way to Peg to RMB

Given that the exchange rate of Hong Kong Dollar (HK Dollar) has repeatedly touched the exchange guarantee of the weak and the strong side during recent years beginning from 2008, some scholars began to hold suspicion to its stability. After studying the economic fundamentals, among them the nominal GDP growth rates and inflation rates, the author found that there are endogenous contradictions in economic basis between Hong Kong (HK) and the United States (US), making the linked exchange rate system expose its underbelly. This paper aims to explore the possibility that HK Dollar turns to peg to renminbi (RMB) by studying economic interactions between mainland China and Hong Kong. With the purpose of providing a clear vision in studying how the economic interactions have impacts on their capital flux, and how the mass of capital floods therefore affects the possibility of the peg of the two currencies, this study attempts to divide economic exchanges into direct and indirect factors, the former including goods trade, tourism services and direct investment and the latter mainly including entrepot trade. Based on the detailed data analysis, this research arrives at the conclusion that HK Dollar should peg to RMB also by conceiving the internationalism of RMB as the booster.

People’s Republic of China—Hong Kong Special Administrative Region: 2022 Article IV Consultation Discussions-Press Release; and Staff Report

Hong Kong SAR’s economy is recovering strongly as ample policy space has allowed the enaction of swift and bold policy responses to address the unprecedented crisis emanating from multiple shocks, including notably the pandemic. But the recovery remains uneven, with private consumption lagging, owing, in part, to a zero- COVID tolerance approach. The financial sector has remained resilient supported by significant buffers, strong institutional frameworks, and a well-functioning Linked Exchange Rate System (LERS). Increasing financial linkages with Mainland China bring both opportunities and challenges for growth and financial stability.

How Rational Are the Option Prices of the Hong Kong Dollar Exchange Rate?

The authors developed a simple regime-switching model of Hong Kong’s linked exchange rate and provide a formula for its option prices. The formula can be used to back out from option prices the implied risk-neutral probability of the abandonment of Hong Kong’s Linked Exchange Rate System. For the option price data for the period from July 1, 2005, to February 28, 2020, the risk-neutral probability is estimated to have a mean of 9.82%. When contrasted with the fact that Hong Kong’s Linked Exchange Rate System has not failed since 1983, the objective probability of that event is less than 0.1% even for high levels of risk aversion. Their finding suggests that although the abandonment of the Linked Exchange Rate System is a significant risk, it cannot explain the risk premium seen in the option prices. TOPICS:Currency, derivatives, options Key Findings ▪ The data on HKD/USD exchange rate option prices are consistent with the view that the current pegged exchange rate regime in Hong Kong is not credible. ▪ The premium implied in the option prices for hedging that risk seems excessively high. ▪ The evidence documented in this article calls for better modeling of how investors formulate their beliefs.

THE REGIME-DEPENDENT EVOLUTION OF CREDIBILITY: A FRESH LOOK AT HONG KONG'S LINKED EXCHANGE RATE SYSTEM

An estimated Markov-switching DSGE modeling framework that allows for parameter shifts across regimes is employed to test the hypothesis of regime-dependent credibility of Hong Kong's linked exchange rate system. The baseline model distinguishes two regimes with respect to the time-series properties of the risk premium. Regime-dependent impulse responses to macroeconomic shocks reveal substantial differences in spreads. To test the sensitivity of the results, a number of robustness checks are performed. The findings contribute to efforts at modeling exchange rate regime credibility as a nonlinear process with two distinct regimes.

HOUSING MARKET DYNAMICS UNDER A PEGGED EXCHANGE RATE – A STUDY OF HONG KONG

This study explores the major determinants of prices and rents of properties in the mass housing market and in the luxury housing market of Hong Kong. The findings show that property price (and rental) dynamics are primarily driven by demand factors, rather than by housing supply. While macroeconomic factors and the provision of subsidized homeownership, to varying degrees, influence housing prices and/or rents, it is the result of U.S. monetary policy which has directly (through changes in money supply) and indirectly (through the wealth effect from a bullish stock market fuelled by unconventional monetary policy such as Quantitative Easing (QE) triggered the current affordability issue. Some policy implications with reference to recent U.S. monetary policy developments as well as to the Linked Exchange Rate System between Hong Kong Dollar and U.S. Dollar are then discussed.

Residential housing bubbles in Hong Kong: identification and explanation based on GSADF test and dynamic probit model

We aim to investigate whether the current high housing price in Hong Kong contains a bubble and to identify the causes of such housing bubble if it exists by combining the generalised sup augmented Dickey–Fuller (GSADF) test and dynamic probit models. Empirical results indicate that the current Hong Kong housing market contains a bubble, and it’s the investors’ speculative demand and the increase of monetary supply that lead to the housing bubbles in Hong Kong. Moreover, speculative investors would prefer the mass markets to the luxury ones considering the outstanding performance of the former. Such preference would contribute to more bubbles in the mass markets than in the luxury ones. In view of these, Hong Kong Government should retrospect the linked exchange rate system and be alert to the impacts of the US monetary policies on Hong Kong residential market. To offset the housing bubble, a targeted and effective approach to the Hong Kong Government is to constrict the speculative demand from investors particularly in the mass markets.

Weakness in HK Currency Board System and Trading Opportunities in Betting A De-Peg of the Hong Kong Dollar

Hong Kong (HK) adopted the Linked Exchange Rate (LER) system in 1983, and it has been operating successfully for more than three decades. However, the maintenance costs for the LER system have grown exorbitantly and could outpace the costs of an exit, especially under the combined influence of a slow-down of the Chinese economy and a possible interest rate hike in the U.S. The HK government currently holds much more foreign reserves than it did preceding the 1997 Asian Financial Crisis. The HK government is also facing political unrest and growing anger of low income residents towards wealth inequality. This opposition could eventually force the HK government to abandon the Currency Board System. At present, the cost of exiting the LER ­system is small thanks to a strong HKD sustained by large capital inflows from mainland China. However, the time frame for such a low-cost exit is short.In our view, the HK government is likely to maintain the current system, even at high social and economic costs, in the expectation that changing external factors, such as the rebound of the Chinese economy, will relieve the de-pegging pressure. In this report, we explore several approaches to gauge the timing and risks of a de-pegging of the HKD and the collapse of the Chinese housing bubble. At the same time, we analyze the potential impact of a de-pegging on HK’s local companies and the most vulnerable parts of the system.

The International Transmission of Monetary Policy Through Financial Centres: Evidence from the United Kingdom and Hong Kong

This paper explores the cross-border transmission of monetary policy by comparing and contrasting the results for two major international financial centres: Hong Kong and the United Kingdom. We examine the effect of monetary policy in the US, euro area and Japan, on UK and Hong Kong-resident banks’ domestic lending behaviour, using individual bank-level data. Focusing on financial interconnections and other balance sheet characteristics as a transmission mechanism, we find that both of these factors play an important role in the transmission of foreign monetary policy. We are able to establish evidence for both a bank funding and bank portfolio channel of monetary policy, for both Hong Kong and the United Kingdom. There are important differences between the two countries; in particular, the currency denomination of lending appears to play a major role only in the United Kingdom, which probably reflects Hong Kong’s linked exchange rate system by which the HK dollar is pegged with the US dollar. These results contrast to the largely inconclusive results from previous studies, whose aggregate nature may have masked offsetting individual bank effects.

The International Transmission of Monetary Policy Through Financial Centres: Evidence from the United Kingdom and Hong Kong

This paper explores the cross-border transmission of monetary policy by comparing and contrasting the results for two major international financial centres: Hong Kong and the United Kingdom. We examine the effect of monetary policy in the US, euro area and Japan, on UK and Hong Kong-resident banks’ domestic lending behaviour, using individual bank-level data. Focusing on financial interconnections and other balance sheet characteristics as a transmission mechanism, we find that both of these factors play an important role in the transmission of foreign monetary policy. We are able to establish evidence for both a bank funding and bank portfolio channel of monetary policy, for both Hong Kong and the United Kingdom. There are important differences between the two countries; in particular, the currency denomination of lending appears to play a major role only in the United Kingdom, which probably reflects Hong Kong’s linked exchange rate system by which the HK dollar is pegged with the US dollar. These results contrast to the largely inconclusive results from previous studies, whose aggregate nature may have masked offsetting individual bank effects.

Hong Kong In-Depth Research Report Series - Monetary Policy Section

Hong Kong (HK) adopted the Linked Exchange Rate system in 1983 and it has been operating successfully for more than three decades. However, the maintenance costs of the system have become huge and they might outpace the exit costs, especially under the combined influence of a slow-down of the Chinese economy and an interest rate hike in the U.S. Compared with the Asian Financial Crisis in 1997, the HK government owns much larger foreign reserves at present than it did then. The HK government is also facing a much more severe populist political environment and the anger of low income residents towards wealth inequality. The anger of low income residents could be “the last straw that breaks the camel’s back” in terms of the HK government maintaining the Currency Board System. At present the cost of exiting the Linked Exchange Rate system is small thanks to capital inflows from Mainland China. However, the time horizon for the existence of such a good exit opportunity is short. There are two ways in which investors can speculate on an exit from the Currency Board System but political reasons weigh the most heavily. If investors speculate on a de-pegging strategy at present and bet on a strengthening HKD, their actions are “politically correct” and they might receive less hostility or even acquiescence from the HK government. Consequently, investors have a much greater chance of success compared to adopting a “double down” strategy to capitalize on the HKD depreciating when the Chinese economy experiences a hard landing.

The dynamics of housing demand under a linked-exchange rate system

A recovering economy, along with loose credit in the wake of the U.S. quantitative easing (QE) measures, has boosted Hong Kong's economic activities in the last couple of years. Nonetheless, it is not altogether positive, as Hong Kong, under the linked exchange rate system (to the U.S. dollar), essentially does not have its own monetary policy, and is thus highly susceptible not only to U.S. monetary policies but also to hot money from abroad. The latter helps create a more uncertain, and riskier, market environment. In response, investors' portfolio selections change, and financial institutions adjust the supply of loans which essentially determines consumption and investment behaviours, including housing demand. In light of such an intertwined nature between these markets, this paper, using a vector autoregression (VAR) model, examines the inter-relationships between housing transaction volume and a variety of factors, such as money supply, housing price, banks' loan-to-deposit ratio, stock market returns, and best lending rate. The findings reveal that all those factors do have a one-directional long-run relationship with transaction volume, and that shocks in property price contribute the most to the forecast errors of property transactions. Interestingly, housing transaction volume responds to shocks in money supply negatively, rather than positively as usually reported in western literature. The reason can be attributed to the fact that the supply of money in Hong Kong, due to the linked exchange rate, is primarily subjected to the influx of hot money; and that investors, in response, prefer the stock market for its liquidity and lower cost over the property market. Then, as stock price increases, so does housing demand (transaction volume) due to the wealth effect. Policy implications, with reference to such effect, are then discussed.

The Regime-Dependent Evolution of Credibility: A Fresh Look at Hong Kong's Linked Exchange Rate System

An estimated Markov-switching DSGE modelling framework that allows for parameter shifts across regimes is employed to test the hypothesis of regime-dependent credibility of Hong Kong’s linked exchange rate system. The model distinguishes two regimes with respect to the time-series properties of the risk premium. Regime-dependent impulse responses to macroeconomic shocks reveal substantial differences in spreads. These findings contribute to efforts at modelling exchange rate regime credibility as a non-linear process with two distinct regimes.

The Regime-Dependent Evolution of Credibility: A Fresh Look at Hong Kong S Linked Exchange Rate System

An estimated Markov-switching DSGE modelling framework that allows for parameter shifts across regimes is employed to test the hypothesis of regime-dependent credibility of Hong Kong's linked exchange rate system. The model distinguishes two regimes with respect to the time-series properties of the risk premium. Regime-dependent impulse responses to macroeconomic shocks reveal substantial differences in spreads. These findings contribute to efforts at modelling exchange rate regime credibility as a non-linear process with two distinct regimes. Keywords: Markov-switching DSGE models, exchange rate regime credibility, Hong Kong. JEL-Classification: E32, F41, C51, C52

Transmitted unemployment under the linked exchange rate system: Evidence from Hong Kong

This paper explores a link between exchange rate and unemployment at the aggregate level. We find that 1% increase in the US unemployment rate transmits, on average, 0.53% increase in Hong Kong unemployment under the linked exchange rate system.

The Credibility of Hong Kong's Link from the Perspective of Modern Financial Theory

Hong Kong’s linked exchange rate system (LERS) has been in operation since 1983, during which time many other fixed exchange rate systems have succumbed to shocks and/or speculative attacks. This paper investigates how market participants assessed changes made to the LERS by using the tools of modern finance to extract information from financial asset prices about market expectations. These changes have been characterized as making the system less discretionary over time. We find that decreasing the discretionary element of the LERS led to an increase in credibility of the arrangement.

Dynamics of Fokker–Planck Equation with Logarithmic Coefficients and Its Application in Econophysics

We demonstrate that Fokker–Planck equations with logarithmic factors in diffusion and drift terms can be straightforwardly derived from the class of “constant elasticity of variance" stochastic processes without appealing to any symmetry argument. Analytical closed-form solutions are available for some special cases of this class of Fokker–Planck equations. The dynamics of the underlying stochastic variables are examined. These Fokker–Planck equations have found a rather wide range of applications in various contexts. In particular, in the field of econophysics we have demonstrated their immediate relevance to modelling the exchange rate dynamics in a target zone, e.g. the linked exchange rate system of the Hong Kong dollar. Furthermore, the knowledge of exact solutions in some special cases can be useful as a benchmark to test approximate numerical or analytical procedures.

Do Derivative Markets Contain Useful Information for Signaling 'Hot Money' Flows?

This study examines whether information from derivative markets is useful for signaling “hot money” and other large capital flows in an economy where the monetary authority pursues a policy of exchange rate stability. Specifically, this study examines the information content of various Hong Kong traded derivative securities for signaling changes in the aggregate balance of the Hong Kong banking system during a period of intense IPO activity and speculation on the revaluation of the renminbi. The impact of the introduction of the Hong Kong Monetary Authority’s (HKMA) Convertibility Undertakings on the dynamic relationships among capital flows, stock market volatility and stock market turnover is also examined. Finally, the implications for monetary policymakers in potentially using information from derivative markets are assessed.The results show that derivative markets contain useful information for signaling “hot money” flows. Granger causality tests from a VAR model show that Hong Kong dollar forward and RMB non-deliverable forward (NDF) prices predict future variation in the aggregate balance. Moreover, changes in aggregate balance has a significant impact on Hong Kong’s interbank rates. The findings also suggest that the introduction of the May 18, 2005 Convertibility Undertakings may have increased the credibility of the Linked Exchange Rate System by discouraging the use of the Hong Kong dollar and Hong Kong dollar denominated assets as speculative vehicles on RMB denominated assets.