A proposal for an adaptive linked exchange rate system
Hong Kong Economic Papers
The Chinese University of Hong Kong
Since its adoption in 1983 the linked exchange rate system has been widely accepted by professionals in the financial sector as a key stabilizing factor for Hong Kong in the run-up to 1997. In fact, the operation of the linked exchange rate system can be said to have exceeded initial expectations. Apart from the rather large interest rate swings during the first few weeks of operation, interest rates in Hong Kong have been surprisingly stable. Contrary to expectations, there is no evidence that the link with the US dollar has led to larger interest rate fluctuations. However, the fact that the linked exchange rate system has functioned satisfactory from 1983 till now is not a sufficient reason for us to stick to the system with no reservation. As pointed out by Takagi, the benefit of maintaining stability against the linked currency must be comparted with the cost of greater fluctuation vis-a-vis other currencies. Moreover, the maintenance of a fixed link means that the country concerned is giving up an important tool for stabilization in the face of a major external shock. The next Section will examine some of the potential problems under the existing linked exchange rate framework. In Section III, I shall discuss the proposal of linking the Hong Kong dollar to a basket of currencies. I shall argue that effective linking of the Hong Kong dollar to a basket of currencies can be achieved by the judicious readjustment of the HK dollar—US dollar link on regular basis. Section IV will argue that the proposal in Section III is only a second-best policy under the constraint of imperfect information. The first best policy is not linking the domestic currency to any fixed basket of currencies but rather continuous relinking to the US dollar (or any other major currency) to achieve full employment. In Section V, I contend that adoption of such a rule by all the small economies of the world would automatically result in a high level of international economic coordination.
Ho, L. S. (1990). A proposal for an adaptive linked exchange rate system. Hong Kong Economic Papers, 20, 89-96.