Monetary Policy

Hong Kong's monetary policy objective is currency stability. Given the
highly externally oriented nature of the Hong Kong economy, this
objective is further defined as a stable external value for the currency in
terms of a fixed exchange rate against the US dollar at the rate of $7.80 to
US$1.

This clear monetary policy objective is achieved through what has been
referred to as the linked exchange rate system. This system was
introduced in October 1983 after a nine-year period in which the Hong
Kong dollar floated and the exchange rate was volatile. Without an
effective monetary anchor or any mechanism for monetary control, due
to the absence of any institutional arrangement that enabled the authorities
to influence the supply or price of money, there was sharp depreciation in
the exchange rate towards the end of the nine-year period when
uncertainties about the political future of Hong Kong affected confidence
in the currency. The linked exchange rate system introduced an external
anchor for the currency and restored confidence in it.

The linked exchange rate system, as structured in 1983, required the issue
and redemption of bank notes, through the note-issuing banks, to be made
against US dollars at the fixed exchange rate of $7.80 to US$1.
Certificates of Indebtedness, which authorise the note-issuing banks to
issue bank notes, are issued and redeemed against the US dollar at that
fixed rate and for the account of the Exchange Fund. Under this influence,
and the fact that deposit money is convertible to bank notes, the exchange
rate for the Hong Kong dollar in the foreign exchange market stays close
to the level of the fixed rate.

The linked exchange rate system is what is known academically as a
currency board system which theoretically requires the monetary base to
be backed by a foreign currency at a fixed exchange rate. The monetary
base is normally defined as the sum of the amount of bank notes issued
and the balance of the banking system (the reserve balance or the clearing
balance) held with the currency board for the purpose of effecting the
clearing and settlement of transactions between the banks themselves, and
also between the currency board and the banks. The monetary base
increases when the foreign currency (in Hong Kong's case, US dollars),
to which the domestic currency is linked, is sold to the currency board
for the domestic currency (capital inflow). It contracts when the foreign
currency is bought from the currency board (capital outflow). The
expansion or contraction in the monetary base leads interest rates for the
domestic currency to fall or rise, respectively, creating the monetary
conditions that automatically counteract the original capital movement,
ensuring stability of the exchange rate throughout the process.

In October 1983, when the linked exchange rate system was introduced,
there was no institutional arrangement whereby banks in Hong Kong
maintained clearing accounts with the currency board. Thus that part of
the monetary base represented by the clearing balance of the banking
system was initially not subject to the discipline imposed by a currency
board system. Action was taken to correct this in 1988 through
arrangements which required the Management Bank of the Clearing House
of the Hong Kong Association of Banks to maintain a clearing account
with the government's then Monetary Affairs Branch for the account of
the Exchange Fund. This was replaced by another arrangement, when the
RTGS system was introduced for interbank transactions in Hong Kong
towards the end of 1996. These reform measures subjected the whole of
the monetary base to the discipline of the currency board arrangement
and strengthened the linked exchange rate system of Hong Kong in
ensuring exchange rate stability.

By assuming responsibility over the clearing system for money, the
HKMA also became responsible for the provision of last-resort lending for
banks with day-to-day shortage of liquidity. A mechanism to facilitate the
performance of this important role was instituted through the Exchange
Fund Bills and Notes Programme, which started in 1990, and the
introduction of LAF in 1992. The former served, among other things, to
provide a money market instrument which banks could use to obtain
liquidity by selling them in an active secondary market or pledge them for
liquidity from the HKMA at the end of the day through the latter.

The HKMA maintains the strict discipline of the currency board system
when engaging in any activity that has the effect of altering that part of
the monetary base represented by the clearing balance of the banking
system, and when issuing and redeeming Certificates of Indebtedness that
give authority to the note-issuing banks to issue currency notes.

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