It’s been a while since the launch of the Hong Kong-Shanghai stock trading programme. Weeks afterwards, we heard news about the Hong Kong Monetary Authority (HKMA) injecting a large sum of Hong Kong dollar to maintain the so-called currency peg, essentially intervening the forex market.
By the end of April, the HKMA “injected” a total of HK$71.49 billion since April 6. Apart from the fund inflows driven by cross-border stock trading activity, sending Hang Seng Index to new highs, inflows from Russia during Ukraine’s political crisis also played a part.
Rather than “injection”, perhaps it’s more accurate to say the HKMA intervenes in the forex market. It works within a pre-determined mechanism to respond to capital inflow (or outflow) that drives the Hong Kong dollar exchange rate to reach (or fall) to the upper (or lower) end of the allowed trading range, called Convertibility Zone.
Under Hong Kong’s Linked Exchange Rate System, the HKMA is responsible for maintaining Hong Kong’s exchange rate through the currency board system, which requires both the stock and flow of the monetary base to be fully backed by foreign reserves (US dollar). This means that any change in the monetary base is fully matched by a corresponding change in foreign reserves at a fixed exchange rate (HK$7.8 per US$1).
Hong Kong’s Monetary Base comprises Certificates of Indebtedness, which back the banknotes issued by the note-issuing banks; government-issued notes and coins in circulation; aggregate balance, which is the sum of balances of the clearing accounts of banks kept with the HKMA; and Exchange Fund Bills and Notes, which are issued by the HKMA on behalf of the government.
During a capital inflow, such as an influx of capital from the mainland we have witnessed in recent months, causing the Hong Kong dollar to reach the strong end of the trading range (HK$$7.75 per US dollar), the HKMA then intervenes the forex market by purchasing US dollars from the banking system to prevent further appreciation of the local currency.
By the same token, the HKMA observes the forex market and sells Hong Kong dollar when the local currency touches the lower end of the trading range (HK$7.85 per US dollar) caused by a capital outflow.
HKMA Maintains exchange through The Currency Board Mechanism
As illustrated by the flowchart above, the expansion (contraction) of the Monetary Base causes Hong Kong dollar’s interest rates to fall (rise). To minimise interest rate volatility, there is another mechanism in place called Discount Window facility, through which banks can obtain overnight liquidity from the HKMA by arranging repurchase agreements using Exchange Fund paper and other eligible securities as collateral.
The Base Rate of the Discount Window is calculated based on a formula that takes into account the US Fed rate and Hong Kong Interbank Offered Rates. That’s the reason why we often hear that Hong Kong dollar interest rates track closely those of the US dollar on the forex market.