- The Linked Exchange Rate System (LERS) has worked well in its existence of nearly 40 years, having weathered many economic and interest rate cycles. It is the cornerstone of Hong Kong’s monetary and financial stability. Recently, there have been some rumours about the LERS. Although these rumours do not affect the operation of the LERS and have been quickly dismissed by many market participants due to the lack of factual basis, we would like to take this opportunity to revisit the key aspects of the LERS so that the public will not be misled.
- According to the LERS, when market demand for Hong Kong dollars increases and the HKD exchange rate strengthens to the strong-side Convertibility Undertaking (CU) level of HK$7.75 per US dollar, the HKMA will, upon request by banks, buy US dollars from and sell Hong Kong dollars to banks. This will cause the Aggregate Balance (AB, which is a component of the Monetary Base) to rise and HKD interbank rates to decline, stabilising the HKD exchange rate within the band of 7.75 to 7.85. When market demand for Hong Kong dollars decreases and the HKD exchange rate weakens to the weak-side CU level of HK$7.85 per US dollar, the HKMA will, upon request by banks, buy Hong Kong dollars from and sell US dollars to banks. This will cause the AB to decline and HKD interbank rates to rise, stabilising the HKD exchange rate within the 7.75-7.85 band.
- Over the many years of implementing the LERS, the HKMA has always kept the HKD exchange rate stable through the aforesaid interest rate automatic adjustment mechanism and our firm commitment to honour the CUs. Triggering of the strong-side or weak-side CU is not new to us. The market also has sufficient understanding and operational experience of, as well as strong confidence in, the LERS.
Triggering of the weak-side CU and the corresponding decline of the AB
- The US has entered its rate-hike cycle this year. Since March, the Federal Open Market Committee of the Federal Reserve has raised the target range for the federal funds rate consecutively after three meetings. So far it has raised interest rates by 150 basis points, and will probably continue to raise interest rates at its meeting next week. As the differentials between the higher US dollar interbank rates and the lower Hong Kong dollar interbank rates widened, according to the design and operation of the LERS, there have been more carry trades in the market. Coupled with the subdued local demand for Hong Kong dollars in recent months, the weak-side CU has been triggered multiple times since May. The HKMA bought Hong Kong dollars and sold US dollars according to the mechanism. As of yesterday (21 July), the HKMA has bought over HK$170 billion and the AB will decline to about HK$165 billion accordingly. According to the operation of the LERS, with the triggering of the weak-side CU, funds flow out from the HKD system and the interest rate automatic adjustment mechanism will kick in. The HKD interbank rates will gradually rise, offsetting the incentives for carry trades, slowing down fund outflows from the HKD market, and ultimately stabilising the Hong Kong dollar within the 7.75-7.85 band.
- It is clear from the above that the triggering of the weak-side CU and the decline of the AB are completely consistent with expectations under the LERS. Also, these operations are conducted in a credible and transparent manner. The HKMA discloses CU transaction data on the same day and the daily changes in the AB through our website as well as the major financial information platforms. In fact, a similar situation occurred during the US’s last rate-hike cycle in 2015 to 2018. All these are within the design and expectations of the LERS, notwithstanding that, compared with the last rate-hike cycle, the market generally expects the US’s rate-hike cycle this time to be quicker and more aggressive, the weak-side CU might be triggered more frequently and at a larger scale, and the AB will decline with a quicker pace.
- Over the years, the HKMA has built up strong buffers and resilience in the financial and banking systems. Hong Kong’s massive foreign currency reserves (reaching US$440 billion), equivalent to about 1.7 times Hong Kong’s Monetary Base, is the solid foundation of the LERS. The HKMA has the capability and resolve to maintain the LERS and Hong Kong’s monetary and financial stability. Hong Kong has no need and no intention to change the LERS.
- As the US will continue to raise interest rates, we might see more reports about the HKMA buying Hong Kong dollars and the lowering of the AB going forward. As mentioned above, all these are within the design and expectations of the LERS. There is no need to worry.
Interest rate outlook
- Under the LERS, the HKD interbank rates will generally track the US dollar interest rates, and are at the same time also influenced by the local market supply and demand of Hong Kong dollars. Drawing reference from experiences which included those from the US’s last rate-hike cycle in 2015 to 2018, HKD interbank rates might not necessarily follow USD interest rates immediately and entirely. It is normal phenomenon under the LERS for HKD interbank rates to follow USD interest rates to rise gradually, and there is no need to worry. Another point to note is that although the AB is an important indicator of banking sector liquidity, whether or not the HKD interbank rates would rise is not entirely contingent on a specific level of AB. This is because the situations and market factors in each rate-hike cycle may be different. Therefore, it is not appropriate to draw a sweeping conclusion.
- As for banks’ commercial interest rates, banks will decide whether to adjust them, when to adjust them and by how much having regard to their own funding cost structures and other relevant considerations. The public should carefully assess and manage the relevant risks when making property purchase, mortgage or relevant decisions.
- The design and operation of the LERS is simple and easy to understand. Having said that, we should still be aware of irresponsible and deceiving commentaries, such as those portraying a “causation” between the persistent declines of the AB as well as the issues faced by Mainland property developers, and the collapse of the LERS. Recently, some people even described the enhancement measures we introduced earlier this month to our currency swap agreement with the People’s Bank of China (PBoC) as a major risk factor to the LERS, alleging that Hong Kong dollars would be “submitted” to the PBoC under the said agreement. The fact of the matter is, the key objective of the currency swap agreement between the PBoC and the HKMA is to support the sustainable development of Hong Kong’s offshore renminbi market, with nothing to do with the LERS. It is a common practice for central banks and monetary authorities around the world to enter into currency swap agreements with each other. As far as the renminbi is concerned, the PBoC has over the years entered into bilateral local currency swap agreements with central banks or monetary authorities of 40 other countries or regions.
- In the face of macro and market changes, we must all stay vigilant in assessing and managing risks, including carefully distinguishing well-grounded facts from groundless or even malicious rumours, so as not to be misled. My colleagues at the HKMA and I will, as always, continue to explain our work in maintaining Hong Kong’s monetary and financial stability.
Hong Kong Monetary Authority
22 July 2022