The Hong Kong dollar and interest rates softened on Thursday, as liquidity released by the territory’s currency board over the past week at last had its intended effect.

The territory’s currency weakened to HK$7.7567 against the greenback by 15:00 GMT on Thursday. On Wednesday, it was standing at HK$7.7498 to the US dollar, just before the Hong Kong Monetary Authority bought US dollars to defend the currency’s trading band. Meanwhile, the three-month Hong Kong dollar interbank rates, helped along by the US Federal Reserve’s 25 basis point cut on Wednesday, fell from 4.67 per cent to 4.28 per cent.

Until last week, it had been more than two years since the invisible hand that governs Hong Kong’s monetary system had been forced to swing into action. On October 23, the HKMA, the territory’s de facto central bank, initiated the first in a series of US dollar purchases totalling US$1.2bn. The HKMA actions offered a rare glimpse at the workings – and self-correcting nature – of one of the world’s most durable currency boards.

Joseph Yam, HKMA chief executive, said on Thursday: “We again reaffirm that the [Hong Kong] government has been clear in its financial policy and is committed to maintaining the peg.”

Mr Yam, head of the HKMA since its establishment in 1993, is that rarest of central bankers: one who, because of the territory’s currency board, does not have to set interest rates. On Thursday, the HKMA cut its base rate by 25 basis points to 6 per cent, matching the Fed’s overnight move.

Mr Yam’s real job is to exude credibility. Everything he says and does is aimed at bolstering market confidence in the territory’s financial system generally – and the peg specifically.

The Hong Kong dollar’s famous peg to its US counterpart, set at HK$7.8 to the US dollar in 1983, is something of a misnomer. Since an adjustment was introduced in May 2005, the Hong Kong dollar is not pegged to the greenback so much as it is corralled within a narrow trading range of HK$7.75- HK$7.85.

Last month the Hong Kong dollar began to test the upper limits of this band for the first time since it was established, driven in part by overseas demand for shares listed on the Hong Kong stock exchange. The benchmark Hang Seng Index has been trading at record highs. Investors are also keenly awaiting next week’s debut of Alibaba.com, which will raise US$1.5bn. Alibaba’s offering attracted US$223bn in demand from institutional and retail investors.

Investor-led demand for the Hong Kong dollar in turn invited speculation that the government would adjust or even abandon the peg entirely, allowing it to strengthen against the greenback. Because of its tie to a declining US dollar, Hong Kong has been importing inflation from China. The Chinese renminbi has appreciated 5.5 per cent against the Hong Kong dollar this year alone.

Inflation, however, re­mains modest. This year the prices of Chinese consumer goods and foodstuffs im­ported into Hong Kong have risen 3.5 per cent and 3.9 per cent respectively. The territory is also well acclim­atised to volatile asset price cycles – the trade-off for Hong Kong’s currency stability. Peter Churchouse, director at Lim Advisors, estimates there have been five property booms and busts – with troughs ranging from 15 to 70 per cent – in Hong Kong since 1981.

More importantly from a currency board-operations perspective, it is relatively easy for the HKMA to defend the Hong Kong dollar at the strong end of its trading band. In theory, there is no limit to the amount of US dollars the authority can take in.

It can simply create all the Hong Kong dollars it needs to buy them.

The mechanism is also self-correcting. As the supply of Hong Kong dollars arising from such purchases grows, interest rates fall, depressing demand for the local currency.

Defending against Hong Kong dollar weakness, as the territory’s government was forced to do in 1998 during the Asian financial crisis, could be more difficult. At $170bn, Hong Kong’s foreign exchange reserves are large but ultimately finite. Here too, however, the currency board should self-correct. As the government buys back Hong Kong dollars, liquidity shrinks and interest rates soar, restoring demand for the currency.

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