Optimal currency pegging in light of OCA hypothesis: An analysis of the relationship of HKD with USD and CNY.

Due to the Linked Exchange Rate System (LERS), Hong Kong’s monetary policy is effectively tied to the United States, however, trade and the real economy's increased integration with China raise debate on LERS rationality. The Optimum Currency Area (OCA) hypothesis suggests that the degree of trade and economic integration across economies is crucial for optimal currency pegs, we, therefore, employ multiple measures to determine the most favourable currency for pegging with the Hong Kong dollar (HKD) in light of the OCA theory. Our study indicates that Hong Kong is relatively more integrated with Mainland China than the United States, which is crucial for a currency peg. We measure the factors influencing business cycle synchronisation using principal component analysis (PCA) and find that Hong Kong, the United States, and China have common factors that led to the economic cycle synchronisation. We also employ the structural vector auto-regression (SVAR) to measure the shock transmission among economies and find that China’s shocks have a relatively lower impact on the output and price changes in Hong Kong compared to the United States. Our findings also suggested that Hong Kong and Mainland China shared similar internal shocks and gradually increasing economic integration as well as a greater degree of business cycle synchronisation. JEL classification D04,E00,F3,F4, O24