Bulletin Spring‧Summer 1995

To Peg, or Not to Peg? A Study of Hong Kong's Exchange Rate P o l i c y Current Policy i n Hong Kong During the last currency crisis in 1983, Hong Kong abandoned the floating exchange rate system which had been in place since 1974. The new system linked the HK dollar to the US dollar in the ratio of HK$7.80 to US$1. In effect, this meant that every additional HK dollar issued must be covered by an equivalent value of US dollar at the official rate. In practice, the system has been fairly successful in stabilizing the HK dollar. This success is as good a reason as any in the choice of exchange rate and monetary systems. Still , some of the theoretical and practical aspects of the current system merit closer examination. The Specie-flow Mechanism: Justification for the Current Policy One of the justifications for the fixed exchange rate system hinges on an automatic adjustment mechanism which is presumed to exist in the economy. If a country exports more than it imports, its foreign currency reserves wi l l increase. Exporters wi ll sell the foreign currency to buy the local currency, and hence local money supply w i l l increase. Consequently, domestic spending and therefore prices (inflation) will rise. Over time, the exporters will become less competitive as costs rise, and will gradually lose their export business. Ultimately, the country may even suffer a trade deficit, leading to a reduction in foreign currency reserves. This will reduce domestic spending and prices, thereby raising international competitiveness. This automatic mechanism is more often known as the specie-flow mechanism in the field of international monetary economics and dates back to Research 29