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A Brief History of the Hong Kong Dollar: The "Impossible Monetary Triangle" Theory and the US Dollar Linked Exchange Rate System

author:That's the headline at the time

1. The theory of "monetary impossible triangle".

There is an international financial term called "Mundellian Trilemma", which means that it is impossible for an economy to achieve free capital flow, monetary policy independence and exchange rate stability at the same time.

Mundell's trilemma

Generally speaking, in order to achieve two of these corners, an economy must sacrifice one of them.

If you force both, then there will inevitably be a crisis. For example, the Peso crisis in Mexico (1994-1995), the Southeast Asian financial crisis in 1997 (1997-1998), and the financial collapse in Argentina (2001-2002).

Comparing Mundell's triadic paradox, it can be found that different economies have their own trade-offs in monetary policy.

1. In order to realize the freedom of capital flow and the independence of monetary policy, it is necessary to sacrifice the stability of the exchange rate, that is, to implement a free floating exchange rate. For example, most advanced economies use this system, including the US dollar, the euro and the Japanese yen.

2. In order to realize the independence of monetary policy and the stability of the exchange rate, it is inevitable to sacrifice the freedom of capital flow and implement capital control. For example, Malaysia after the Asian financial crisis.

3. In order to achieve the freedom of capital flow and the stability of the exchange rate, it is necessary to sacrifice the independence of monetary policy, that is, it cannot raise interest rates and cut interest rates independently, which is typical of the linked exchange rate system of the Hong Kong dollar.

2. A Brief History of Hong Kong's Currency

What is the linked exchange rate system of the Hong Kong dollar and how has the Hong Kong dollar developed?

The history of Hong Kong's currency has probably gone through three main stages: the metal standard, the pound sterling exchange standard, and the US dollar linked exchange rate.

1. The period of the metal standard

Before 1841, the Qing Dynasty stipulated that Western merchants could only trade in Guangzhou, and Hong Kong Island was so close to Guangzhou that many foreign silver dollars would flow into Hong Kong Island. As a result, the main currencies in circulation on Hong Kong Island at that time were silver taels and copper coins, as well as foreign silver dollars such as Mexican silver dollars (Eagle Ocean), Spanish silver dollars (local oceans), East India Company rupee silver dollars, and American silver dollars.

In January 1841, the British army occupied Hong Kong Island, after which the British government wanted to replace Hong Kong's metal currency with the pound standard, but the trading Xi of local residents was difficult to change, and the British government announced that the previous currencies could be mixed and circulated.

However, with the inflow of foreign silver dollars and the convenience of their use, the use of silver dollars represented by Mexican Eagle Ocean is increasing.

A Brief History of the Hong Kong Dollar: The "Impossible Monetary Triangle" Theory and the US Dollar Linked Exchange Rate System

Mexican Eagle Ocean

Beginning in 1846, there were eight private commercial banks in Hong Kong that issued banknotes, depositors deposited silver dollars of metal in banks, and banks issued banknotes to depositors, and holders of banknotes could exchange the equivalent amount of silver dollars with the banknotes at any time. The banknotes issued by these private commercial banks are also equivalent to the nature of silver dollar vouchers. In 1863, the British government began to issue Hong Kong's own metal currency.

2. The period of the exchange standard of the British pound

In 1935, the British government in Hong Kong began to issue paper money and established the British pound exchange standard.

The British government in Hong Kong recovered the silver dollars and silver from the private sector through the "Exchange Fund" and sold them to the London gold exchange to obtain pounds. Through the authorization of HSBC, Standard Chartered and Yau Yau three private commercial banks, the Hong Kong dollar issuance.

A Brief History of the Hong Kong Dollar: The "Impossible Monetary Triangle" Theory and the US Dollar Linked Exchange Rate System

Currency issued by the government in 1935

When issuing new Hong Kong dollars, the three note-issuing banks first paid the equivalent amount of sterling equivalent to the issuance amount to the Exchange Fund at a fixed exchange rate of "£1 = HK$16" in exchange for a certificate of indebtedness issued by the Exchange Fund, and then issued an equivalent amount of Hong Kong dollars.

Between 1935 and 1946, with the exception of a brief period of Japanese occupation (December 1941 to August 1945), Hong Kong generally maintained the exchange rate standard for the British pound.

3. The period of the US dollar linked exchange rate

Beginning in 1946, the Bretton Woods system, which was based on gold and centered on the US dollar, began to operate, and the British pound was pegged to the US dollar, which was therefore indirectly linked to the US dollar. With the gradual collapse of the Bretton Woods system, the Hong Kong dollar was pegged to the US dollar in 1972 from the British pound exchange standard, and since then it has been free floating with the US dollar.

In September 1982, British Prime Minister Margaret Thatcher visited China to negotiate with China on the Hong Kong issue, a political event that accelerated the depreciation of the Hong Kong dollar. In just one year, the "Hong Kong dollar" has depreciated by as much as 1/3 against the US dollar. In order to curb the further depreciation of the Hong Kong dollar, in 1983, the British government introduced the "US dollar linked exchange rate system", which is still in use today.

3. The dollar-linked exchange rate system

Under the USD-linked exchange rate system, the three note-issuing banks can purchase Certificates of Indebtedness from the Hong Kong Monetary Authority in US dollars at an exchange rate of HK$7.8 to US$1. or, conversely, return the US dollar equivalent in the form of a Certificate of Indebtedness at an exchange rate of HK$7.8 to US$1. That is, if a note-issuing bank wants to increase or decrease the money supply, it must be backed by the equivalent amount of US dollars.

In May 2005, the Hong Kong Monetary Authority (HKMA) provided a Convertibility Undertaking (HKMA), committing to sell Hong Kong dollars at the strong-side Convertibility Undertaking level of HK$7.75 to US$1 and to buy Hong Kong dollars at the weak-side Convertibility Undertaking level of HK$7.85 to US$1. This ensures that the exchange rate of the US dollar against the Hong Kong dollar fluctuates between [7.75-7.85].

A Brief History of the Hong Kong Dollar: The "Impossible Monetary Triangle" Theory and the US Dollar Linked Exchange Rate System

Hong Kong Dollar Exchange Rate Adjustment Mechanism

Fourth, the significance of the dollar-linked exchange rate

The USD-linked exchange rate mechanism has ensured the stability of Hong Kong's currency, helped Hong Kong successfully withstand the Asian financial turmoil, and laid a solid foundation for Hong Kong to become the world's freest economy.

Since the RMB market regulates the flow of capital, capital cannot flow freely, and the advantage of this is that the exchange rate can be controlled and monetary policies can be formulated independently, such as raising interest rates and cutting interest rates, without taking too much into account the exchange rate changes in the external market. The pegging of the Hong Kong dollar to the US dollar ensures exchange rate stability and free capital flow.

The combination of the renminbi and the Hong Kong dollar has, to a certain extent, made up for the shortcomings of the renminbi's inability to be freely convertible, and promoted the mainland to use the Hong Kong market to carry out bilateral trade with the rest of the world. For example, many multinational companies have logistics in mainland ports, but settlement is in Hong Kong. Many international capitals can also invest in domestic assets through the Hong Kong stock market. It can be said that the mechanism of the US dollar linked exchange rate has greatly helped Hong Kong to become an international financial centre.