Overview of the Linked Exchange Rate System
Hong Kong's Linked Exchange Rate System (LERS) is the cornerstone of its monetary stability, pegging the Hong Kong Dollar (HKD) to the US Dollar (USD). The system maintains a strong-side convertibility undertaking at HKD 7.75 to USD 1 and a weak-side convertibility undertaking at HKD 7.85 to USD 1. When the HKD exchange rate reaches these boundaries, the Hong Kong Monetary Authority (HKMA) intervenes to ensure the rate remains within the predetermined range.
How the Strong-Side Convertibility Undertaking Works
When the HKD strengthens against the USD to the strong-side convertibility undertaking level of 7.75, it indicates strong market demand for the HKD. At this point, the HKMA sells HKD and buys USD, injecting HKD liquidity into the market. This operation directly increases the aggregate balance of the Hong Kong banking system and tends to lower the Hong Kong Interbank Offered Rate (HIBOR).
Review of 2025 Trigger Events and Capital Dynamics
In early May 2025, the HKD/USD exchange rate touched the strong-side convertibility undertaking for the first time in nearly five years, the first such occurrence since October 28, 2020. The last large-scale trigger occurred between April and October 2020, with 85 cumulative triggers, resulting in a capital inflow of HKD 383.5 billion into the banking system. The 2025 trigger was primarily driven by the following factors:
- Active Capital Market Activities: Including active initial public offerings (IPOs) and continuous inflows of southbound funds via Hong Kong stocks Connect, increasing demand for HKD.
- Listed Company Dividends: Mid-year dividend payments typically increase demand for HKD.
To address this trigger, the HKMA sold HKD 129.4 billion (approximately USD 16.7 billion) in May 2025 to maintain exchange rate stability.
Capital Flows and Interest Rate Impact
The HKMA's intervention led to a significant increase in HKD liquidity. In May 2025, the aggregate balance of the Hong Kong banking system nearly quadrupled, rising from approximately HKD 45 billion to HKD 174 billion. This was accompanied by a rapid decline in HKD interbank rates:
- The one-month HIBOR decreased from approximately 3.65% in early April 2025 to 0.96% in May.
- The overnight HIBOR decreased from approximately 3.41% in early April 2025 to 0.03% in May.
The decline in HKD interest rates significantly widened the interest rate differential between HKD and USD.
How the Hong Kong Stock Market Benefits
Market analysts generally believe that capital inflows into Hong Kong and the triggering of the strong-side convertibility undertaking are beneficial for the Hong Kong stock market. Ample HKD liquidity and declining HKD interest rates provide favorable funding conditions for Hong Kong stocks. Between January and April 2025, the Hang Seng Index rose by approximately 10%, and the Hang Seng Tech Index rose by 14%. During the same period, the average daily turnover of the Hong Kong main board exceeded HKD 270 billion, a year-on-year increase of 1.4 times. Furthermore, IPO fundraising year-to-date in 2025 has exceeded HKD 60 billion, more than six times the amount in the same period last year, ranking first globally, demonstrating market confidence in Hong Kong's capital market.
Two-Way Adjustment of the Linked Exchange Rate System and Carry Trades
Although the triggering of the strong-side convertibility undertaking led to capital inflows, the widened HKD-USD interest rate differential also stimulated carry trades. Traders tended to borrow low-interest HKD, convert it to USD, and invest in high-interest USD assets. This carry trade behavior led to a weakening of the HKD, triggering the weak-side convertibility undertaking multiple times in June and July 2025, demonstrating the two-way adjustment characteristic of the Linked Exchange Rate System. HKMA Chief Executive Eddie Yue stated that the movements in the HKD exchange rate and interest rates are "textbook" operations of the Linked Exchange Rate System, designed to maintain monetary stability.
HKMA and Market Views
The Hong Kong Monetary Authority emphasizes that it will continue to closely monitor market dynamics to ensure the orderly operation of the HKD market. Market analysts generally believe that despite potential short-term volatility due to HKMA intervention, in the medium term, under the demand for expansion and increased allocation, the liquidity environment for Hong Kong stocks will remain favorable, with resilient earnings growth, controllable downside risks, and volatility potentially offering participation opportunities for investors.
