What is a Currency Board and should Hong Kong maintain it?

Klinsmann Lee

Oct 3, 2023

4 min read

Updated: Mar 11, 2025

What is a Currency Board and should Hong Kong maintain it?

Writer: Klinsmann Lee

What is a Currency Board:

A fixed exchange rate is when the value of a foreign currency can be exchanged for a set value of domestic currency. For example, the Saudi Riyal (SAR) is pegged to the US dollar. The official exchange rate is 3.75 Saudi Riyal for 1 US dollar.
Currency Board is a more extreme form of a fixed exchange rate and is satisfied under 3 conditions: [1]
- The domestic currency is fixed to a foreign currency.
- The ability to exchange domestic currency at the specified exchange rate.
- Long-term commitment to the system.
Reserve: To achieve credibility, the Central Bank needs to back each dollar of domestic currency with foreign currency at the official exchange rate. For example, the Hong Kong Monetary Reserve should hold at least 1 US dollar for every 7.8 Hong Kong dollar in supply as this is the official exchange rate.

The advantages and disadvantages of the Currency Board:

Advantages: [2]

Anti-inflationary system: Strong commitment to the fixed rate system helps lower the inflation rate (domestic currency can only be expanded when foreign reserve expands).
Stable Exchange Rate: The currency board helps to minimise currency risk and helps promote trades and investment.
Credibility: Improve financial market stability by reducing currency devaluation risk and speculative attacks. It helps promote transparency by removing monetary policy discretion from the government and the Central bank.

Disadvantages: [3] [4]

Speculative attack: When the currency is overvalued and under speculative attack, the peg can be broken due to unlimited exchange of domestic currency for foreign currency. This will result in the exhaustion of foreign reserves and the inability to defend the peg.
Monetary Policy: The Central Bank cannot use its monetary policy such as adjusting the domestic interest rate or altering the money supply to counter economic shocks.
Lender of Last Resort: The Central Bank cannot act as the “lender of last resort” due to foreign reserve requirements. This means that the Central Bank cannot act as a “guarantor” to the banking system. It can only make emergency loans from an emergency fund set aside from Central Bank Profits.

A look at Hong Kong’s Currency Board:

Hong Kong is pegged to the US dollar at an official rate of HK$7.8 to US$1 since October 1983. Since 2005, the official rate is between HK$7.75 - HK$7.85 to US$1. [5]
The dollar peg has successfully withstood multiple financial shocks since its inception including the Asian Financial Crisis (1998), the SARS outbreak (2003), the Global Financial Crisis (2008) and the Covid-19 outbreak (2020).
Strong Financial Buffer: In July 2023, the total foreign currency reserve assets of US$421.6 billion represent over 5 times the currency in circulation. [6]
As the Hong Kong Dollar is pegged to the US dollar, the city moves its benchmark interest rate with the changes made by the US Federal Reserve.

The mechanism behind Hong Kong Linked Exchange Rate System (LERS)

The Hong Kong LERS is designed to maintain stability in the exchange rate through the adjustments of bank liquidity and local interest rate.
Exchange rate moves to the upper limit of 7.75: Hong Kong Dollar strengthens. HKMA will sell Hong Kong dollars to banks. This will increase the liquidity in the banking system, putting downward pressure on the domestic interest rate (an increase in the supply of money will lower the interest rate as there is more money available to lend). A lower interest rate creates a capital inflow as the lenders is better at lending money overseas with a higher interest rate.
Exchange rate moves to lower limit of 7.85: Hong Kong Dollar weakens. HKMA will buy Hong Kong dollars from banks. This will decrease the liquidity in the banking system, putting upward pressure on the domestic interest rate (a decrease in the supply of money will increase the interest rate as there is less money available to lend). High-interest rate attracts capital inflow as depositors are interested in lending money at the higher interest rate.
On the Hong Kong Monetary Authority (HKMA)’s website, there is a wonderful article, “How Does the LERS Work” that also illustrates the stabilisation of the Hong Kong dollar exchange rate. [7]

Should Hong Kong maintain its currency board:

Klinsmann’s Opinion: Yes
- Maintaining a peg with the US dollar provides a stable exchange rate that improves trade and investments for the city.
- As Hong Kong is an International Financial Hub, its financial system is subject to interest rate and exchange rate fluctuation and changes from other major economies. Therefore, without the currency board, Hong Kong will still never have full control over its monetary policy.
- The U.S. Dollar continues to be the preferred currency in global trade and capital transactions. By pegging its currency to the US dollar, this helps encourage transactions to occur in Hong Kong.
- The peg encourages foreign investment in Hong Kong as it helps to minimise currency risk. The competitive advantage of Hong Kong’s financial system is that it is an open economy without imposing foreign exchange control.
However:
- As Hong Kong moves its benchmark interest rate according to changes made by the US Federal Reserve, this creates a mismatch in policy. Aggressive rate hikes by the US Federal Reserve in recent months mean that Hong Kong's interest rate also increased. However, this is when Hong Kong is recovering from COVID-19 restrictions and interest rates should be kept low to stimulate the economy. [8]
- At the same time, there is no alternative for the Hong Kong dollar to peg against. China’s currency is subject to capital control. [9]

Summary:

A currency board is an extreme form of a fixed exchange rate that usually requires the total supply of domestic currency to be backed by foreign reserves at the official fixed exchange rate.
The advantage of adopting a currency board includes a stable exchange rate, improved credibility and a lower inflation rate.
The disadvantage of adopting a currency board includes being subject to speculative attacks, loss of direct monetary policy and the Central Bank’s position of being the lender of last resort in the banking system.
Hong Kong’s dollar peg began in 1983 and there are many good reasons to continue to maintain this peg.

Other Information:

Reference: Please see the “references” section to acknowledge the sources used in this article. For any mistakes made in this article, feel free and let me know.

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