Foreign Exchange Market

Money doesn't grow on trees

PUBLISHED : Wednesday, 27 June, 2012, 12:00am
UPDATED : Wednesday, 27 June, 2012, 12:00am


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A HK$10 note may look like a thin, shiny piece of paper, but if you think carefully, it's worth more than it looks. If dollar notes were only colour-printed handouts, none of us would need to worry about the pain caused by the 2008 global financial crisis.

Despite the continuing European financial crisis, should our supplies of money run out, we could simply print some more.

No countries would risk ending up in debt as long as they had a quality printing press; everyone could be a billionaire if they had a computer and printer ...

Of course, that is not the case; not everyone is allowed to print money.

The government keeps strict controls on money, because if Hong Kong dollars were too plentiful, they would drop in value and you might have to pay HK$3 million for a copy of Young Post.

The golden rule is, the amount of money added to a monetary system should always be equal - or at least close - to the amount that disappears.

The printing of dollar notes is usually authorised by the central bank. In Hong Kong, only three banks - Bank of China, HSBC and Standard Chartered Bank - are authorised to issue dollar notes.

In the past, to make currency valuable, the government would lock up the equivalent value of gold in banks when money was issued. The policy was called the gold standard. But it faded from use as it was impossible for every country to have enough gold. Also, gold is pretty useless except as jewellery, so who is to say what value it has?

After the Great Depression - the severe global economic recession that began in America at the end of 1929 and lasted at least a decade - this gold standard tradition remained in the US. Yet other nations tied their currency value to the US dollar - named the Bretton Woods system after the US town where talks on the policy took place.

In 1971, America gave up the gold standard and let the foreign exchange market decide its dollar value. Some nations do the same as America, while some keep their currencies tied to the US dollar.

This week, we look at different currency systems around the world.

Floating exchange rate

In countries that use a floating exchange rate, governments let the market decide their currency value. To have a currency floated, a huge demand is needed in the foreign exchange market, for the currency to be stabilised.

The strategy can be seen in many large-scale economies, such as America, Britain and Japan. The value of those currencies moves, depending on the demand for them in the foreign exchange market; if more people want the currency, its value rises. On the contrary, if less people want it, its value drops.

In the most ideal model, governments should not interfere with the value of their currencies in any way. Yet, most countries set an upper and lower limit for their currencies, and governments would step in to adjust them when they fall out of limit. This is called a managed float.

Pros and Cons

Economists believe that having a floating exchange rate can serve as a buffer. This absorbs the shock when an economy goes downhill or gets too heated.

A simple example of this could be when an economy has weakened, and the value of its currency has dropped; the situation may look doomed as the buying power of that currency decreases.

However, the country's exports would increase because they would be cheaper and more people would buy them. Eventually, the export market would pull the country's economy out of the crisis.

Yet if a currency is linked (or pegged) to another currency, the case would not be the same; when the economy slowed down, a pegged currency would still follow the value of another currency. In this case, the economic buffer won't work.

Despite all of its advantages, the downside of a floating currency means that it's all up to the market to decide the value of its currency.

Adopting such a system also requires a strong economy to back it up.


Fixed peg

Hong Kong is a typical example of fixed pegging. The Hong Kong Monetary Authority links the Hong Kong dollar to the American dollar with an exchange rate of US$1: HK$7.75-7.85. Governments adopting a fixed pegging policy should commit to keep the pegging band down to less than 1 per cent; a band is the range in which the peg is able to vary. For instance, it is acceptable for Hong Kong to have an exchange rate of US$1:HK$7.8. But if it rises to US$1: HKD$9, it would be seen as 'out of the band'.


Some countries think pegging to a single currency is unsafe, so they peg their currencies against a number of currencies. The most common pegged targets are the US dollar, British pound, the Euro and Japanese yen. Sometimes, if an economy has multiple trading partners, it prefers to use multiple pegging, too.

Crawling peg

This is similar to a fixed peg. But, unlike having a fixed exchange rate for a long term, the crawling peg needs a review and adjustment of the exchange rate every now and then.

Pegged with a band

This form of peg gives an economy more freedom to adjust its currencies. For ordinary fixed pegging, the band cannot be more than 1per cent of the set exchange rate. But some economies choose a more flexible pegged rate, allowing a wider band for currency adjustment.

Pros and Cons

Pegging allows unstable currencies to be linked to a more stabilised currency. Because the value is not decided by the market, those currencies are almost safe from an attack by speculators in the foreign exchange market. Pegging gives a less credible currency better credibility.

However, some argue a pegged exchange rate system may not be the best since it is not tailor-made for the economy that uses it. For most of the time, peg users will have to follow the monetary policy of another country; that includes adjusting interest rates. These moves do not necessarily match with what a pegged economy needs, and thus hinder its economic growth.

Nonetheless, there are many variations of pegged exchange rate systems available, to cater to the needs of different economies.


In some places, people use currencies that belong to another country as their local trading currencies.

The US dollar, for example, is used in Zimbabwe and East Timor, and the Australian dollar is used in Tuvalu and Nauru.

Places that adopt dollarisation usually have a history of political and financial instability.