A Linked exchange rate system is a system that usually links the rate of one particular currency to another. In Hong Kong, the local currency is linked always to the USD in order to have a stabilized exchange rate. In the same way, the Macao Pataca is also linked to the Hong Kong dollar to stabilize the exchange rate.
In this exchange rate system, the central bank or any monetary institution does not interfere in the functioning of the financial market. They cannot make any changes or control the supply and demand of the currency to influence changes in the exchange rates. The main objective of the Hong Kong Monetary Authority is to maintain stability within the exchange rate stem that manages the financial market. With the help of this, they try to get a lot of things in place, like the complicated banking systems and the flexible economic structure of a country.
There was a crisis in Hong Kong named as the Black Saturday on the 17th of October, 1983. Ever since this occurred, they adopted a linked exchange rate system from the year 1983 through the currency board system. The currency board required the flow of both stock and monetary base to be backed up by huge foreign reserves. And if there were any changes in the size of the monetary base, this is automatically matched by a corresponding monetary equivalent of the foreign reserve. The crisis was a currency crisis that arose from a Sino British dispute. The dispute was concerned or revolved around the political future of Hong Kong after the year 1997. In those days the Hong Kong dollar was going down badly in the foreign exchange market. When the authorities were forced to find a solution for this problem, they came up with the linked exchange rate system that seemed to balance the commotions to an extent.
Their solution was nothing but simple pegging. Using the linked exchange rate system they linked or pegged the Hong Kong dollar to the United States dollar at the rate of 7.80. This was not something new in the financial market but this was a change for the currency board. They only did some modifications to cater to the necessities of the market and manage the crisis somehow.
The linked exchange rate system consists of a currency board in its purest form. The currency board is generally allowed to issue only domestic notes when it has an equivalent amount of designated foreign currency equivalents. These foreign currencies are usually reserves just like any monetary institution would have for the purpose of control. This in some way imposes some monetary discipline on the conduct of monetary policy because of the cash expansion. The cash expansion is one way is only possible if there are huge amount of payments that are regularly balanced. This also disciplines and stabilizes the exchange rate system. The currency boards have histories in the exchange rate management of many countries. Though the first board was established in 1849, after the wars, the currency board lost their value. Independent, new territories came up that sought financial independence, which led them to establish their own financial institutions with centralized autonomous functionalities. And most of these new territories were engaged in trying the floating exchange rate system by then. As this was happening, the central board was getting revived and few countries like Argentina, Estonia and Lithuania adopted the linked exchange rate system. These countries have been doing quite well and since this has been shown in the recent past, there is no strong reason to change the linked system to any other exchange rate regime.