Besides, the convertibility of US$ and HK$ is partial only, only changing coins and notes, deposits are not included. So, the forces of competition and arbitrage between markets will ensure that the FX market exchange rate stabilizes at a level close to the fixed rate of 7.80, without the intervention from the EF.
.
Suppose now in a speculative attack, speculators sell Hong Kong dollars and buy U.S. dollars, and drive the market exchange rate above 7.8. Any such slight deviation, however, will give private banks incentive to arbitrage: they buy Hong Kong dollars from the market at 7.81, say, and sell it to the Exchange Fund at 7.8 for a profit. This arbitrage process decreases the supply of the Hong Kong dollar and brings back the market exchange rate in line with the peg. The Hong Kong Monetary Authority (HKMA) undertakes to convert the HK$ in licensed banks clearing accounts maintained with the HKMA into US$ at the fixed exchange rate of HK$ 7.75 to US$ 1. The rate will move to 7.80 by 1 pip each calendar day starting from 1 April 1999. In fact, trading of HK$ relates very much to the confidence of local people & investors since if they worry about the future and withdraw capital from HK, then the government will have to spend heavily from its foreign exchange reserves to buy up HK$ in the market to support the rate. Nevertheless, the linked system was very effective in stabilizing HK$ during the Asian financial turmoil, which was triggered in Thailand in June 1997.
PROS.
Cushion an economy against shocks.
The link has proved its resilience against waves of shocks: 1987 stock market shock, the June 4 crackdown in 1989, 1990 Gulf War, the collapse of BCCI in 1992, Mexican currency crisis and the most severe one, the currency crisis in Asia in mid and late 1997.
The Adjustment Process.
The linked system transfers the impact of any adjustment to the balance of payment (BOP) pressures away from the exchange rate and onto the banking system.