The mechanism of the Linked Exchange Rate System.
The linked exchange rate regime was originated for a one-time need to contain the sharp depreciation of HK$ on 17 October 1983, in reaction to a currency crisis arising from the Sino-British dispute concerning the political future of HK after 1997. Capital were flowing out of HK and led to a further loss of confidence in HK dollar. In fact, there are other countries that are engaged in similar fixed exchange rate regime, like Argentina, Bulgaria, Estonia and Lithuania.
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Back to Hong Kong, under the pegged system, she enjoyed an annual per capita GDP growth of 5% from 83-92. The foreign currency assets of HK, including those held in the Land Fund, were US$ 98.1 billion at the end of January 1998. According to Professor Milton Friedman, "a small country is better off linking its own currency to that of a major country, particularly one with which it has close economic relationship, which is a major trading partner". The more flexible an economy is, the more suitable is a fixed exchange rate to it, because there is no need to change nominal prices through exchange rate movements to offset external shocks. The running of the link and the argument for and against the link will be shown clearly in the coming sections.
The Mechanism of the Linked Exchange .
The new arrangement centres on Certificates of Indebtedness (CI), which are issued by the Exchange Fund (EF) to the 3 note-issuing banks (HK Bank, Standard Chartered Bank and Bank of China). Payments are now made in US$ at a fixed exchange rate of US$1 = HK$7.80. Thus an inter-bank market for HK$ notes at the exchange rate was created.
In practice, in foreign exchange (FX) market, the exchange rate is allowed to float freely by market demand and supply. The rationale behind is related to the operation of the system's underlying arbitrage mechanism. First, the CI is not accessible to all parties in the economy; second, banks must keep certain cash ratio to meet customers' withdrawal demands and thus impossible for them to cash in all their holdings of HK$ banknote when arbitraging.