Introduction:In this essay I will attempt to examine the recent arguments provided by the public, to debate whether if a reform is necessary through evaluating the current Hong Kong economy and how it is affected by the linked exchange rate. This essay would contain a cost-benefit analysis of both the current linked system and the possible scenario if we adopt a new linked exchange rate of HKD to RMB as suggested by researchers of Atradius.This is worthy of an economic analysis as it will provide reasons whether or not the Hong Kong currency should be reformed.Methodology:As this is an essay on currency amongst nations, the research question would be answered using secondary research. Sources include:University research papersBooks and publications in the libraryNews and opinion articles Other online sourcesSecondary research – TheoryIn order to evaluate and determine whether the linked exchange rate system is suitable for Hong Kong or not, we must first look at the characteristics of Hong Kong’s economy: (1) International financial center, (2) small open economy, (3) large financial sector, and (4) depends on trade. These are influenced by the following economic theory from the syllabus:Exchange rates Macro-economic objectives Balance of paymentPrice stabilityGovernment Intervention – Monetary policyExchange rate:Definition: “The ratio at which a unit of the currency of one country can be exchanged for that of another country.”E.g HKD 7.8 = 1 USDAppreciation: is when a currency has a rise in value when compared to another currency D will shift to D1, shifting equilibrium from (Q,P) to (Q1,P1), raising the value of the currency.Depreciation: is when a currency has a fall in value when compared to another currency. When there is an increase supply of the currency, S will shift to S1, shifting equilibrium from (Q,P) to (Q1,P1) lowering the value of the currency.Factors affecting exchange rate:Exports and imports:Just like the cash flow of a company, the exports and imports of a country determines the reliability of a nation producing the currency. This is because the act of exchanging currency will occur during the trading of goods/services. This relates with exchange rates as it affects the PED for the imports and exports of a country. An appreciation of a country’s currency will lead to a trade deficit as it would be more expensive for other countries to buy goods from the country, shifting AD to AD2 on the graph on the left, but cheaper for the country to import goods as foreign currencies are cheaper when exchanged shifting AS to AS1 in the graph on the right, thus less exports from the country and more imports for the country. A depreciation of a country’s currency will lead to a trade surplus as it would be cheaper for other countries to buy the goods of the country shifting AD to AD2 on the graph on the left, but imports would as a result be more expensive thus shifting AS to AS2 on the graph on the right, thus resulting in more exports from the country and less imports for the country.Relative interest rates:Higher interest rates attract investors to hold a country’s currency as they will get a return for holding the currency. This will in return increase the demand for the currency compared to other currency. Relative inflation rates:As users of any currency seek consistency of value to calculate for proper trading, currency with fluctuating inflation rates may affect the value of the currency as confidence of it falls.Investment:Investment refers to the purchase of financial capital like bonds, shares, derivatives and foreign exchange. An increase in investment from abroad will increase demand for the country’s currency, putting upward pressure on its value. Speculation:A lot of currency is held by traders on behalf of investment banks and funds. This because it is possible to exploit the differences in the buying and selling prices of currencies, as well as being able to bet on the future price of currencies. Traders buy or sell currency in an attempt to gain profit and this will create pressure on currency values. Politics:A country’s politics dictates its economic growth. The government have control over many monetary and trade policies, like interest rates and import taxes. A government that support open markets and less trade barriers would gain confidence on both local and foreign investors as trading the nation’s currency has less loss (taxation), thus more people will hold and use the currency causing it to appreciate.Macro-Economic objectives:Definition: These are economic policies that countries are attempting to achieve for the embetterment of the society. There are several macro-economic objectives, but these are the ones affected by a nation’s currency. Balance of payment: Is a method countries use to monitor all international monetary transactions at a specific period.Price stability: To keep inflation to a minimum and consumer confidence over the nation’s currency.What is inflation?Inflation is “Economics. a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency” Basically functioning like in a basic demand and supply of a good, the increase in supply resulted in a decline in demand, thus a lost in value of the currency.Cost push inflation is essentially a increase in the cost of production for the producers thus increasing the price of the good sold. This is often caused by a decrease or a shock in the aggregate supply. (Supply shock is an unexpected turn of events causing a change in the supply of a product). This is seen on diagram shown on the left where AS,had shift to the left.Employment rate: Putting people in jobs and contributing society, it is ideal to keep the national employment rate as high as possible.Raising real GDP: GDP represents the total dollar value of all goods and services produced over a specific time period; you can think of it as the size of the economy. It is essential for an nation to keep GDP growing exponentially. These objectives would be what I am going to base my cost-benefit analysis on.Government intervention:Monetary policies: A policy that a government would apply to change the supply of money. Which they often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency. This has direct correlation to employment, high inflation results in lower unemployment ceteris paribus. This theory was designed and displayed through the use of a Phillips curve, made by William Phillips who had discovered the relationship.The government has control over this, thus it is often approached when attempting to reach the macro-economic objectives.Secondary research – Background InformationOverview of crisis Black Saturday crisis: The Hong Kong dollar was floated before the transfer of sovereignty, in November 1974. The currency itself was strong and was performing well in comparison to other currencies in the first three years. Only during the late 1997/1998 that the Hong Kong dollar began to drop significantly. The Black Saturday crisis of 1983 was a result of political conflict between UK and China. The conflict originated all the way back to the opium wars, where a treaty was signed where parts of Hong Kong was made under British crown rule from 1841 to 1997. The handing over of Hong Kong from the United Kingdom back to China was a major political event, this had meant that Hong Kong was soon returning to be governed of the Republic of China. The changing of government had led to people distrusting Hong Kong’s economy and many investors pulling out from Hong Kong’s financial market. Hong Kong’s economy was worsened as Hong Kong was barraged with propaganda from communist Chinese press, causing major anxieties for both its economy and political stance. These issue could have been contained if Hong Kong had not become a floating currency, as its new policies meant that the supply of money was not controlled, making it too volatile and risky for investors.Plummeting confidence over Hong Kong’s future in 1982-83 led to a further depreciation of the Hong Kong dollar. During the Sino-British negotiation, investors become more anxious about Hong Kong’s future in 1997, leading to a loss of confidence in the local currency, leading to its value to fell sharply. This peaked on 24th of 1983 after a decline of Hong Kong dollar in the period of just two days, reaching its lowest level of HK$9.60. In order to cope with the currency panic, on October 17th of 1983 the government followed Hong Kong’s financial secretary Sir John Bremiridge’s scheme, to introduce a new policy to stabilize the currency. Thus resulted in the link between the Hong Kong dollar to the US dollar at the rate of HK$7.8 to one US dollar. Overview of what the recent the US,FED has done in regarding of inflation policy and how it had affected the HKD: In December 10th 2016, the US central bank’s forecast for a monetary policy to control inflation rates, increasing interest rates to set inflation rate to the FED’s target 2%. This forecast released by the FED has caused major conflict in the market damaging HKD and the Hong Kong market in a whole.”The currency fell as low as $7.7985 per dollar on Tuesday, its weakest level since January 2016 and down from an intra-day level of $7.8004 on Monday.” This is considered a lot in the modern finance world in especially for a linked exchange rate.Under the linked exchange rate system, the Hong Kong Monetary Authority (HKMA), the central bank of Hong Kong, is obliged to buy and sell US dollars to prevent the currency from breaching either side of a trading band between $7.75 and $7.85.Pro-RMB debateThe permanent and fixed link of the Hong Kong Dollar to USD has been perceived not to be beneficial to Hong KongThe current link requires Hong Kong to follow the US monetary policy and made Hong Kong’s monetary policy limited to achieve price stability and economic growth. The current exchange rate system has served the economy well, but local residents have to cope with periods of falling wages, unstable property prices and also periods of rapid inflation. These price swings occur because Hong Kong imports suffer from the USD pegging monetary policy, even though the US and Hong Kong economies may not have the same economic cycle. Many had perceived that this link between the two currencies had not been beneficial to Hong Kong and although the link was created to provide stability for the currency, it had allowed a rise in the practice of runaway inflation.In 2011, the United States government had sent complaints of RMB’s low exchange rates. With the economic recovery (from 2008 crash) in the United States running out of steam, the United States had implanted an expansionary monetary policy (to increase the money supply and lower interest rates). Under the linked exchange rate, the HKD had suffered alongside with the USD, resulting in a rise in the cost of all the imports.RMB is the best alternative solution as it is not suitable for Hong Kong to adopt floating exchange rate system because it would be better for Hong Kong as an international financial centre and trade dependent economy to have a reserve currency. Having a reserve currency would not only attract foreign investors, it would also help balance the current, financial and capital accounts. Whenever there is large inflows and outflows of goods/service and securities in Hong Kong, it will not only make the exchange rate become more volatile, but also make the financial market becomes more volatile. Having too much exports will cause appreciation, thus lowering aggregate demand in goods and services of the economy, ceteris paribus. Having a fixed exchange rate in this case will prevent the change of trades elastic demand. 2.) The RMB had recently gain attraction and trust amongst investors and business executiveRecently John Tsang, Financial secretary of Hong Kong has announced that “We are now the world’s largest offshore renminbi business centre, as well as the largest renminbi bond market outside the Mainland. As economic and trade ties between the Mainland and the Belt & Road economies grow stronger, the renminbi will become even more widely used worldwide. ” Following the internationalisation of the RMB, there has been many debates on whether or not the HKD should be reformed to peg to RMB instead of the USD. As the RMB is moving toward becoming a convertible and free floating currency, Hong Kong must consider what to do with the Peg once that is achieved. Politician of the libertarian party of Hong Kong Alan Hoo (A degree in law from LSE) , believed that “the future of Renminbi is both strong and positive. Up to the end of 2010, the RMB had revaluated by almost 25% against the USD and by 14% against the Euro.”Studies shows, while the Hong Kong’s financial and economic links are increasingly dominated by mainland China, and previous concerns about the openness of China’s capital account are slowly receding, if China continues to open its capital account, the world reserve currency could shift from United States dollar to renminbi.A poll conducted last year by the London Business School and Hong Kong University for business executives in South East Asia, 62 per cent reckoned the Hong Kong dollar would simply be phased out eventually, as the renminbi internationalised.There is no doubt that, with China’s economy having exponential growth, that the RMB will eventually have its place as a currency accepted as hard currency (one of the few being most tradable currency on the market) by international markets. The RMB has been added by the IMF to special drawing Rights basket contributing to the international reserve basket, joining the USD, euro, yen and GBP. Hong Kong should somehow link the HKD to RMB due to further economic and financial integration. By then, China will become the most influential force to our economy and dominate our economic cycle, replacing the US. This integration would also benefit Hong Kong politically and ease up the recent tension. Therefore, the HKD should peg to the RMB instead of the USD, or peg to a basket of currencies dominated by the RMB, or Hong Kong should simply replace the HKD with the RMB.Anti-RMB debateAlthough a change in the linked exchange rate seems to be beneficial to Hong Kong economy, every monetary system has its own advantages and disadvantages with no exception to the current linked exchange rate system.Even with the recent changes and damages to the Hong Kong dollar due to US policy changes: 1.)Hong Kong is a financial center and any major change in the currency may cause an economic fluctuation. This is evident in the recent Indian rupee scraps on November of 2016. The prime minister of India had announced that the 500 and 1000 rupee banknotes will be demonetized (withdrawn from the financial system) overnight. The supply shock of the currency caused major damages to domestic factors, many who earn wages daily and small traders who only use cash, lost income due to the absence of liquid cash. It would also impact the consumption, as the drop of supply means the appreciation of the currency, people will hold onto the currency hoping that it would continue to rise, will result in a drop in consumption. Which in a long run would slow down the economy.A similar situation happened in the late 1990’s of Zimbabwe economy, an event where drove its economy to the ground. Where they confiscation of private farms from landowners, towards the end of Second Congo War causing a withdrawal from foreign investors and hyperinflation in the Zimbabwe economy. During the height of inflation from 2008 to 2009, it was difficult to measure Zimbabwe’s hyperinflation because the government of Zimbabwe stopped filing official inflation statistics. However, Zimbabwe’s peak month of inflation is estimated at 79.6 billion percent in mid-November 2008. Recent article of 2017 revealed that Zimbabwe has reached 95% unemployment rate and GDP of $600-$700 USD per capita.Although a change of the exchange system won’t be as damaging as the rupee change or the Zimbabwe political change, as it is not a liquidity shock, it will still cause a welfare loss on those who are holding the currency. If a change in the linked exchange system is announced, it will suffer a belief of change in volatility from speculators. (Volatility is a measure of risk of a security) Those who hold HKD due to its stability will lose confidence on the HKD may start to remove it from their portfolio resulting in a depreciation and inflation of the currency. Depreciation of a currency will lead to a surplus of trade as goods of Hong Kong would be cheaper, but Hong Kong BoP is already on a surplus, if HKD depreciates any further, it would only push the BoP further from balancing. Those who mainly hold HKD, the people of Hong Kong, will suffer the most from inflation and the loss of confidence on the economy in a whole. 2.)The linked exchange of HKD to USD allows more freedom in terms international trade, Chinese market policies might not be appropriate for the Hong Kong market.The USD is the most traded currency in the world, this is because the US market is considered the largest and most reliable in the world. The US market is considered the largest open market that without protectionism, international commodities such as gold and petroleum (petrodollar) are standardly priced in USD, thus it is used as the current universal reserve currency.A direct linked exchange had allowed Hong Kong dollar to be also considered a universal currency, thus had allowed the Hong Kong market to soared in growth within the recent decade. Under the linked exchange rate, foreign investors had heavily invested in the Hong kong economy as exchange rate risks are removed. The exchange rate has been stable even through political and financial turmoils and had made Hong Kong into the home of “asia’s financial center” today.As RMB is merely entering the state of a free floating currency, a change in the linked exchange system, impacts would be rather difficult to predict thus losing consumer confidence. A change without proper trust and confidence will cause major chaos on Hong Kong markets. Speaking of which, the RMB lacks the reputation that the USD has, it has a history of currency manipulation and fluctuation. Articles had state that in 2015, the chinese government has forcefully devalue its own currency to improve its own trade. (A depreciation of the currency means that exports would be cheaper, but an increase in trades means a trade surplus, thus a higher demand for the currency making a stronger.A stronger currency means it is more expensive to purchase goods, which in turn will be replaced by weaker cheaper currency as they are more advantages in trade.) The act of currency manipulation means that china does not suffer the consequences of a strong currency, by buying massive amounts of foreign currency. It is the currency equivalent of dumping (export by a country or company of a product at a price that is lower in the foreign market than the price charged in the domestic market.) which had made manufacture competitors lose jobs.