[MUSIC] A variety of central banks around the world set the exchange rate at the operational target of monetary policy. In effect, the central bank will set the desired exchange rate and adjust the liquidity to achieve that rate. How do central banks fix the exchange rates? In this segment, we will examine the operation of Hong Kong's fixed exchange rate peg, which has set a target for the Hong Kong dollar exchange rate for more than 30 years. Under this currency board system, the central bank commits to buying and selling US dollars at the target rate. This unsterilized intervention, likewise, causes domestic liquidity to adjust, to keep Hong Kong dollar interest rates at levels similar to those set by US monetary policy. Liquidity adjustment occurs passively though an automatic pilot system. After viewing this segment, you should be able to one, model the effects of fixed exchange rates on the domestic monkey markets. During the early 1980s, the Hong Kong dollar was rapidly depreciating against the US dollar and losing almost half its value. In response, the authorities decided to peg the Hong Kong dollar against the US dollar at a rate near 7.8 Hong Kong dollars per US dollar, where it has stayed ever since. Hong Kong's monetary policy is called the convertibility undertaking. The Hong Kong Monetary Authority stands ready to exchange any amount of US dollars against Hong Kong dollars at the exchange rate levels defined by the strong side and weak side convertibility undertakings. Offering to sell US dollars at a price of 7.85 Hong Kong dollars per US dollar and to buy US dollars for a price of 7.75 Hong Kong dollars. By making these offers, the central bank can ensure that the spot exchange rate will stay within this narrow corridor. No trader would sell their US dollars in the market at a Hong Kong dollar price lower than 7.75 since they could sell to the central bank and no one ever would pay a market price greater than 7.85 since they would prefer to buy from the central bank at a cheaper rate. Combine two theories, interest parity and expectations theory of the forward rate. Interest rate parity says the forward rate will adjust and equalize the cost of borrowing in two countries. Assuming the forward rate is the expectations of the future spot rate, then we see that the domestic interest rate is the foreign interest rate plus the future path of the exchange rate. If you have a fixed exchange rate which the market finds credible, the market will project the future spot rate to be equal to the current spot rate. This will imply that the foreign interest rate will equal the domestic interest rate. Let's return to our liquidity preference theory to demonstrate the operation of monetary policy in Hong Kong. The convertibility undertaking causes the Hong Kong Inter-bank Offered Rate or HIBOR to be set as if by automatic pilot. Suppose the supply of liquidity was sufficiently tight that the equilibrium interest rate in the Hong Kong money market was above US interest rates. This would give money managers an incentive to move their investments into Hong Kong dollars and out of US dollars. Banks would be willing to sell US dollars to the monetary authority to get more reserves to lend in Hong Kong. Under the convertibility undertaking, the Hong Kong Monetary Authority will make these reserves available. This extra liquidity could help push down interest rates. There's an incentive to switch into Hong Kong dollars until enough liquidity has been extended to push local interest rates down to US levels. Suppose the supply of liquidity in Hong Kong was too high and Hong Kong interest rates were below US levels. This would give money managers an incentive to switch from Hong Kong dollars to US dollars. The convertibility undertaking of the monetary authority would allow banks to convert their Hong Kong dollar reserve accounts into US dollars. The declining liquidity would increase Hong Kong interest rates until they reached US levels. The automatic pilot creates endogenous fluctuations in domestic liquidity. Suppose demand for reserve liquidity were to increase for some reason. This would put pressure on Hong Kong interest rates above the US dollar rate, which would attract funds to Hong Kong dollars. Currency inflows would cause the Hong Kong dollar to appreciate until one US dollar could only bring 7.75 Hong Kong dollars. At the strong side of the band, banks will then prefer to buy Hong Kong dollars for the monetary authority. As they did this, domestic bank reserves would increase and actual liquidity would bring down inter-bank rates until interest rates with the US dollar has been equalized. Likewise, if reserve demand falls, this would put downward pressure on Hong Kong interest rates, which would make the Hong Kong dollar money market less attractive to international investors. Currency outflows would cause the Hong Kong dollar to depreciate until it was attractive to sell at the rate of 7.85 Hong Kong dollars. Hong Kong dollars are sold to the monetary authority. As this occurs, domestic bank reserves tighten, until interest rate pressures with the US dollar have been equalized. In addition to the automatic pilot, the monetary authority may sometimes actively intervene to reduce excess liquidity in Hong Kong dollars. The central bank issues longer term securities, to manage the liquidity available on the inter bank market. For example, if inter-bank interest rates are too low, the central bank might sell some securities called the change fund bill to local banks. They will also debit the reserve accounts of domestic banks, which will tighten the lending conditions. Under normal circumstances, the functioning of the Hong Kong pegged exchange system causes the Hong Kong inter-bank rate to track the US dollar monetary policy rates. Consider if the US Central Bank raises policy rates there. This will cause investors to switch funds towards the US dollar and away from Hong Kong dollars. Banks will have an incentive to convert some of their Hong Kong dollar reserve holdings into higher yielding US dollars. The resulting drain of liquidity will cause domestic interest rates to rise. When rates equalize with the US dollar rate, the market will settle at the new equilibrium. A cut in the US policy rate will have a mirror effect. A lower benchmark US interest rate will make the Hong Kong dollar money market more attractive. Local banks would increase their liquidity holdings to allow the domestic interest rate to track the US interest rate downward. We see that in broad terms, the Hong Kong interest rate has tracked the US monetary policy rate, called the Fed Funds Rate. However, since the millennium, the Hong Kong dollar rate had frequently been below US interest rates, including in the current period. Why is that? Interest rates do not equalize with US dollar interest rates if the market believes that the exchange rate will change in the future. Use the forward exchange rate as a proxy for the expected direction of the exchange rate. It's helpful to think about the forward premium as a growth rate. Add and subtract S from the numerator. Separate out the ratio of S to S, which we could see is equal to 1. We then find the percentage difference between the forward and spot rate as the net forward premium. Go back to interest rate parity. We can write this in a longer form. Multiply through on the right side. The product of the net forward premium and the interest rate is a fraction of a fraction, and could be treated as approximately 0 for illustrative purposes. Cancel the 1 so the domestic interest rate could be the foreign rate plus the forward premium. We see that since the turn of the millennium, the forward premium has been persistently and substantially negative in Hong Kong. Indicating the possibility that the market believes that the Hong Kong dollar may appreciate against the US dollar in the future. The negative forward premium has an impact on domestic money markets. When US dollars can be sold today at price S, and repurchased again at a lower rate F in the future, then an investor can make gains simply by parking their funds in Hong Kong dollars. If HIBOR rates are equal to US interest rates, an investor should prefer Hong Kong dollars to US dollars in order to achieve this gain. The convertibility undertaking allows banks to acquire more reserves. The inflow of Hong Kong dollars should push Hong Kong inter-bank rates downward. However, this should desist once local interest rates are pushed down until they match the negative forward premium. At this rate, investors can make equal gains holding either US or Hong Kong dollars and equilibrium is reached. The effect can be seen in an episode in September of 2007, which Hong Kong faced a persistently negative forward rate. Hong Kong dollars were attractive to investors, attracting financial in flows. The financial inflows caused the Hong Kong dollar to appreciate. The quantity of reserves stayed stable until the exchange rate reached the boundary of 7.75. Then commercial banks began to buy Hong Kong dollars from the monetary authority. Reserve went from 1.2 billion Hong Kong dollars to more than 10 billion within two business days. This influx of liquidity in the inter-bank market brought the HIBOR overnight rate down from above 5% to less than 2%. The exchange rate then recovered. During the global financial crisis, US monetary authorities cut the policy interest rate to near 0, much as we saw in Japan in the previous module. While US interest rate attracted funds to Hong Kong, Hong Kong liquidity increased and brought the HIBOR rate to 0 in parallel. However, there was still a negative forward premium on Hong Kong dollars. When both interest rates are 0 and the forward premium is negative, it becomes more attractive to hold Hong Kong dollars attracting even more inflows. In normal times, this process might have stopped when Hong Kong interest rates were pushed down sufficiently. However, with interest rates at zero, there are no further to fall and the financial inflows were large. How large? Prior to the financial crisis, the banking system operated with reserves of near 2 billion. After the financial crisis, reserve increased by more than 100 fold, peaking at 400 billion Hong Kong dollars. The actual liquidity in the Hong Kong money market has kept the Hong Kong interest rate low even as US interest rates have risen. To reiterate, Hong Kong operates a monetary policy framework in which the central bank uses unsterilized intervention to hit a target for the exchange rate. The US dollar also fills the role of intermediate target, as the central bank has maintained this publicly announced target for more than 30 years. The central bank emphasizing exchange rate stability as its goal, due to Hong Kong's role as a trading port and international financial center. Because the interest rate in Hong Kong is not set based on Hong Kong economic conditions, the central bank cannot use it as a tool to achieve price stability. As a result, inflation is fairly unstable, varying as high as double digits and undergoing an extended period of deflation, or negative inflation right after the year 2000. So exchange rate stability may have some cause in terms of other potential stabilization goals. After viewing this segment, you should be able to one, model the effects of fixed exchange rates on domestic money markets. Let's summarize by answering the key question. How do central banks fix the exchange rate? One way of implementing an exchange rate target is through a currency board, passively offering to buy or sell foreign exchange whenever the exchange rate deviates from the target. This automatic, unsterilized intervention effectively changes domestic liquidity conditions to keep the interest rate near the US monetary policy rate. However, under conditions when doubts arise around the permanence of the exchange rate peg, domestic interest rates may deviate from the anchor currency. Now, let's jump to the summary video for this module.
