How Hong Kong Defends Its Peg, and Why Britain in 1992 and Switzerland in 2015 Let Go

Hong Kong’s Linked Exchange Rate System is a currency board, and the cases below cover Britain’s 1992 exit from the ERM and Switzerland’s 2015 removal of its euro floor.

The International Monetary Fund publishes an annual classification of how its member countries manage their exchange rates. The most recent edition checked for this article is dated 19 December 2024 and covers 2023. That report also covers restrictions on international trade and payments and capital controls. The classification has been published since 1998, and the IMF revised its method in 2009 to make the classifications more consistent and transparent across countries.

The IMF Revised Its Exchange Rate Classification in 2009

The IMF’s 2009 working paper, dated 1 September 2009, describes the revisions made to that classification in early 2009.

The paper says the classification had been published since 1998. Its stated goals were consistency and objectivity across countries, a faster process with resource savings for staff, and greater transparency.

Swiss Floor Removed in 2015
On 15 January 2015 the Swiss National Bank discontinued its minimum exchange rate of CHF 1.20 per euro and lowered the interest rate on sight deposit balances to −0.75%.

Hong Kong’s Band Shows How a Peg Is Defended

On 18 May 2005 the Hong Kong Monetary Authority announced three refinements to its Linked Exchange Rate System. It added a strong-side convertibility undertaking, under which it buys US dollars from licensed banks at 7.75, effective immediately. It also moved the weak-side undertaking from 7.80 to 7.85, so the two levels sat symmetrically around the 7.80 linked rate.

Financial Secretary Henry Tang said the refinements would contribute to monetary and financial stability and that the government had no plan or intention to change the system. HKMA Chief Executive Joseph Yam said the refinements took into account changing market conditions and recent experience in the operation of the system.

The weak-side change was phased in over five weeks. The rate rose by 100 pips each Monday: 7.81 on 23 May 2005, 7.82 on 30 May, 7.83 on 6 June, 7.84 on 13 June and 7.85 on 20 June. The area between the two undertakings is called the Convertibility Zone. Inside it, the HKMA may run market operations that support the system’s smooth functioning. According to the release, the strong-side level was meant to remove uncertainty about how far the currency could strengthen and to reduce speculation tied to a possible renminbi revaluation.

The Undertakings Work Through the Monetary Base

The HKMA describes the system as a currency board. The monetary base is fully backed by US dollar assets in the Exchange Fund, so any change in the base is matched by a corresponding change in those assets. When demand for Hong Kong dollars exceeds supply and the rate reaches 7.75, the HKMA sells Hong Kong dollars. The Aggregate Balance expands, Hong Kong dollar interest rates fall and the rate is pushed back into the zone. At 7.85, supply exceeds demand, the HKMA buys Hong Kong dollars, the Aggregate Balance contracts and rates rise, which again moves the rate back toward the zone.

Banks start the transactions at the undertaking levels, and the HKMA does not. Inside the zone, the HKMA can act on its own initiative when it judges market conditions warrant, aiming to bring the link between the exchange rate and interbank interest rates back into line. As of late 2007, such operations had happened only twice since May 2005. After purchases in late October 2007, the HKMA estimated that the Aggregate Balance had risen from about HK$1.3 billion on 23 October to HK$10.6 billion on 2 November.

Reserves and Interest Rates Are the Two Levers

When the market rate reaches an undertaking, the central bank deals in its own currency and its reserves. The 2005 Hong Kong release says deals at an undertaking affect the Aggregate Balance, the Hong Kong-dollar clearing balances banks hold with the HKMA. The HKMA said it would announce any such impact immediately and report it in its monthly Currency Board reports.

Interest rates are the second lever. Britain’s 1992 episode, covered below, shows a central bank raising interest rates during a defence.

This meant that the minimum exchange rate was no longer sustainable.

Black Wednesday Ended Britain’s ERM Membership in 1992

Britain left the European Exchange Rate Mechanism on Wednesday, 16 September 1992. According to a King’s College London Strand Group account drawing on declassified files, the Bank of England spent £3.3 billion trying to keep sterling inside the mechanism. The same account says government attempts to exert control over currency markets were shown to be well and truly over. There were two interest rate rises in one day, though the second was not implemented. The exit took effect by the end of that day.

The account draws on prime ministerial files, PREM 19/4484 and PREM 19/4079, released under the Public Records Act. It also covers a note by Alex Allan on a bilateral meeting on 14 September 1992. The note reached the Treasury in June 1993, nine months after the meeting.

The meeting was between Major and Lamont, and Sarah Hogg and Terence Burns also attended. Its subjects were sterling’s position, the French referendum on Maastricht and when Britain could leave the ERM. Major framed the options as devaluing or leaving the mechanism, while Lamont argued for being seen to fight to stay in. Allan wrote that he never made a formal record of the meeting, as far as he could discover, and it is unclear whether he had been asked not to record it or whether events overtook it. On 14 June 1993 he sent a very lightly edited transcript of his notes to Sir Terence Burns, the Treasury’s Permanent Secretary.

Switzerland Dropped Its Euro Floor in January 2015

On 15 January 2015 the Swiss National Bank discontinued its minimum exchange rate of CHF 1.20 per euro. In a speech on 24 April 2015 at the bank’s general meeting of shareholders in Berne, Thomas Jordan, chairman of the Governing Board, said enforcing the floor had required permanent currency interventions of rapidly increasing magnitude. He said the bank’s international environment had changed dramatically, owing to the sustained weakening of the euro during the first half of January 2015.

When it discontinued the minimum exchange rate, the bank lowered the interest rate on sight deposit balances to −0.75%. The speech describes the franc as significantly overvalued and expects a correction over time. It says the interest rate gap between the franc and foreign currencies had fallen to almost zero by late 2014. The SNB added that it remains willing to intervene in the foreign exchange market as needed.

The speech says interest rates abroad had fallen more sharply during the financial crisis than in Switzerland. With the gap between foreign-currency and Swiss-franc investments nearly closed, the franc had become more attractive to domestic and foreign investors.

Because foreign rates were near or below zero, the speech says, Swiss rates could not stay at zero. They had to turn negative to restore the usual differential, which made holding francs costlier than holding other currencies. The bank still factors the exchange rate into its monetary policy and monitors foreign exchange markets closely.

Photo: VeronicaTherese · CC BY-SA 3.0