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A linked exchange rate system is a type of exchange rate regime to link the exchange rate of a currency to another. It is the exchange rate system implemented in Hong Kong to stabilise the exchange rate between the Hong Kong dollar (HKD) and the United States dollar (USD). The Macao pataca (MOP) is similarly linked to the Hong Kong dollar.
Unlike a fixed exchange rate system, the government or central bank does not actively interfere in the foreign exchange market by controlling supply and demand of the currency in order to influence the exchange rate. The exchange rate is instead stabilised by an exchange mechanism, whereby the Hong Kong Monetary Authority (HKMA) authorises note-issuing banks are to issue new banknotes provided that they deposit an equivalent value of US dollars with the HKMA.
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As a response to the Black Saturday crisis in 1983, the linked exchange rate system was adopted in Hong Kong on October 17, 1983 through the currency board system[1]. The redemption of certificates of indebtedness (for backing the banknotes) were sent out by note-issuing banks to peg the domestic currency against the US dollar at an internal fixed rate of HKD 7.80 = USD 1[2].
The Hong Kong Monetary Authority (HKMA), Hong Kong's de facto central bank, authorised note-issuing banks are to issue banknotes. These banks are required to have the same amount of USD to issue banknotes. The HKMA guarantees to exchange USD into HKD, or vice versa, at the rate of 7.80. When the market rate is below 7.80, the banks will convert USD for HKD from the HKMA, HKD supply will be increased, and the market rate will climb back to 7.80. The same mechanism also works when the market rate is above 7.80, and the banks will convert HKD for USD.
In practice, the HKMA also set a lower limit at 7.80 (7.85 as an upper limit and 7.75 as a lower limit since May 18, 2005) for the HKD to flow within. The HKMA will buy or sell HKD in the market when the exchange rate is at (or extremely close) the lower limit and upper limit respectively. The HKD is backed by one of the world's largest foreign exchange reserves, which is several times the amount of money supplied in circulation.