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The dollar peg plays an important role in the economy because of its role as an anchor. A fixed exchange rate is more optimal for a major financial centre like Hong Kong because of the 100% stability in the exchange rate. Hong Kong needs to maintain its reputation as a major financial centre in Asia. Investors benefit from the stability in the exchange rate because they can gauge the return on their investments accurately, and this leads to an increased level of confidence in the economy. Movements in capital caused by speculative attacks on the currency are also easier to prevent. The fixed exchange rate also helps to divert attention away from the exchange rate to other areas of the economy which are less easily influenced by fluctuations in the financial system.

Hong Kong has a small and open economy. That means that the business cycle is heavily influenced by what happens outside the local economy. Floating exchange rates may not lead to much monetary independence because local interest rates may not be too different from those in the US. For instance, studies show that there was hardly any difference between the 3 month HIBOR and the USD LIBOR in both cases of floating and fixed exchange rates.

What should be done? Hong Kong needs to think about whether the peg should be maintained, and if so, what level do we maintain it at? It is clear that the peg has served Hong Kong well in the past, but are there other systems which may be more useful for us given the changes in market conditions? The HKMA has repeatedly stated that it has no intention of de-linking the peg for its part, but analysts say some modifications will have to be made in future if the system is to remain in place. Several proposals have been put forward. •

Re-peg the local currency to the US Dollar at a higher rate given the appreciation of the local currency against the US Dollar in recent times. It is important to note that re-pegging the currency at a different rate is a lot easier said than done in reality. This is because the current system mandates that the local currency is issued at a fixed rate. Any decision to re-peg requires a change in the current framework, and careful thought over the exact level at which the currency should be re-pegged at. Any movements to re-peg the local currency could also be interpreted as a sign of a lack of commitment on the part of the government to maintain its firm commitment to the peg. This could therefore lead to an increase in capital flight, and a decline in confidence in the local economy as well as the Hong Kong Dollar.

Switch to a floating exchange rate system. The exchange rate is thus primarily determined by the market forces of supply and demand. Such a system would require the presence of an independent central bank that is capable of exercising monetary policy to affect the economy in an effective manner. Whilst it is true that the current central bank is already capable of making such decisions, it needs to be able to function in an independent and autonomous manner free from any political interference from the Financial Secretary. The government would need to think carefully about how to carry out this switch, and how this system would be viewed both locally and internationally. Evidence indicates that confidence in the local government is extremely low at this point in time. The government needs to be able to prove that it is fully capable of implementing important policies such as this before it can attempt this type of switch, otherwise the currency will only be more vulnerable to more speculative pressure in future. A floating exchange rate system would also lead to increased unpredictability in exchange rates and a fall in investor confidence in the local currency.

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HONG KONGS DOLLAR PEG  

• Pressure on the exchange rate is a signal that the market believes that changes in monetary policy may be needed to sustain the rate of ec...

HONG KONGS DOLLAR PEG  

• Pressure on the exchange rate is a signal that the market believes that changes in monetary policy may be needed to sustain the rate of ec...

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