Monetary Situation

Monetary conditions were generally stable in the first half of 1997. The
foreign exchange market reacted calmly to the death of Mr Deng Xiaoping
on February 20. The exchange rate stayed around the $7.740 level in the
latter part of February before easing to $7.750 in late March along with
the correction in the stock market. The Hong Kong dollar strengthened to
$7.736 in mid-May, in part reflecting an inflow of funds into the local
stock market.

Money market conditions were also steady in the first half of the year,
except on a few occasions when share subscription activities and
month-end settlement caused a temporary tightening in the market. For
most of the time, Hong Kong dollar interest rates followed closely those
of the US dollar. On March 25, the Fed Funds Target Rate was raised by
25 basis points (bps, or one-hundredths of one per cent). In line with the
move, the LAF bid and offer rates were adjusted upwards by the same
magnitude, to 4.25 per cent and 6.25 per cent respectively. The savings
deposit rate and the Best Lending Rate of major banks were also raised by
25 bps. During most of the first half of 1997, the overnight Hong Kong
Interbank Offered Rate (HIBOR) remained steady and largely moved
within the corridor set by the LAF bid and offer rates. Likewise, the
three-month HIBOR moved closely in line with the three-month Euro
dollar deposit rate. The average differential between the two rates was
only 23 bps. As regards longer term interest rates, yields of the
seven-year and 10-year Exchange Fund Notes tracked closely the
corresponding US Treasuries. The average spreads above the US
Treasuries were 39 bps and 63 bps respectively.

The foreign exchange and money markets stayed calm when China
resumed sovereignty over Hong Kong on July 1, but financial turmoil
sparked off by the floating of the Thai Baht in early July swept across the
East Asian economies in the second half of 1997. Affected by the
contagion effect of the regional financial turbulence, the Hong Kong dollar
came under selling pressure on a few occasions between July and
October, and money market conditions tightened. On August 19, money
market rates firmed up on rumours of a possible hike in the Best Lending
Rate, with the overnight HIBOR briefly touching a high of 18 per cent.
There was another brief tightening on August 28 due to renewed fears of
a possible contagion effect from the sharp falls in the region's currency
and stock markets. The overnight HIBOR then stabilised and hovered
within a range of 4.8 per cent to 7.9 per cent until mid-October.

Selling pressure on the Hong Kong dollar intensified in the week preceding
October 20 after the Taiwanese government decided not to defend the
New Taiwan Dollar. In response, the HKMA bought a substantial amount
of Hong Kong dollars on October 21 and 22. These foreign exchange
transactions were due to settle on October 23 and 24. The settlement
would involve the HKMA debiting the clearing accounts of the banks
which had sold the Hong Kong dollars to the HKMA. On October 23, the
HKMA issued a circular to all licensed banks reminding them of the need
to organise their Hong Kong dollar funding prudently and not be overly
dependent upon the LAF for last-resort liquidity support. The circular also
warned them that the HKMA might impose penal LAF rates for repeated
borrowers to discourage the use of the facility to fund a short Hong Kong
dollar position.

As the banks collectively had sold more Hong Kong dollars to the HKMA
than they could settle by using their credit balances in their clearing
accounts with the HKMA, there was a shortage of interbank liquidity
when these foreign exchange transactions were settled on October 23. As
a result, short-term interest rates were driven up and the overnight
interbank interest rate briefly touched 280 per cent. The high interest rate
reversed the capital outflow and effectively fended off speculators.

When speculators began to unwind their short positions in Hong Kong
dollar by selling US dollar, and some investors and corporates with US
dollar funding switched into HK dollar to benefit from the high deposit
rates, the HKMA picked up the US dollar and recycled the Hong Kong
dollar into the banking system in the afternoon of October 23. Short-term
interbank interest rates began to ease. By the close of day, the overnight
interbank interest rate came down to 100 per cent and towards the end of
the month, it eased further to around 7 per cent. On October 24, the
savings deposit rate and Best Lending Rate of major banks were raised by
75 bps.

As the overnight HIBOR exhibited a higher degree of volatility during this
episode, a wider LAF corridor was considered appropriate to give the
overnight interbank interest rate more room to move and to reflect
conditions in the interbank market. On October 25, the HKMA widened
the band of the LAF corridor from 200 bps to 300 bps and adjusted the
LAF bid and offer rates to 4 per cent and 7 per cent respectively.

While short-term interest rates came down quickly, term rates remained
high in late October and early November as banks conserved liquidity for
fear of another liquidity squeeze as a result of another currency attack.
The Hong Kong dollar yield curve thus assumed an unusual inverted
'U-shape', with a very steep portion running from the overnight to the
one-month area. To restore market order, on November 12 the HKMA
issued a circular to banks clarifying the definition of 'repeated borrowers'.
Helped by this measure, the term rates in the interbank market started to
come down in the third week of November.

Nevertheless, reflecting the risk premium arising from the uncertainties in
the region, the Hong Kong dollar interest rates remained at levels
considerably higher than their US dollar counterparts. The three-month
interbank interest rate fluctuated between 8.5 per cent and 12 per cent in
November and December, compared with the prevailing level of 6 to
8 per cent before the October event. As a result, the average daily
differential between the three-month Hong Kong dollar interest rate and its
US dollar counterpart widened from 61 bps in the first nine months of the
year to 408 bps in the last quarter.

The yields of seven-year and 10-year Exchange Fund Notes reached a
high of 8.91 per cent and 9 per cent respectively on October 23, along
with the hike in short-term interest rates. The yields eased gradually after
the October incident but were still at levels considerably higher than at
the beginning of the year. At the end of 1997, the yields of the seven-year
and 10-year Exchange Fund Notes stood at 9.23 per cent and 9.22 per
cent respectively, 209 bps and 181 bps above the yields at the beginning
of 1997. The average spread between 10-year Exchange Fund Notes and
10-year US Treasuries in the last quarter of 1997 also widened to
225 bps as compared with an average of 63 bps in the first nine
months of the year.

Following the successful defence of the Hong Kong dollar in October
1997, the Hong Kong dollar exchange rate remained very stable, trading
within the narrow range of $7.725 to $7.750 against the US dollar,
notwithstanding the sharp depreciation of Korean Won in November.

The overall exchange value of the Hong Kong dollar, as measured by the
trade-weighted Effective Exchange Rate Index (EERI), is predominantly
affected by the exchange rate of the US dollar vis-a-vis other major
currencies. During 1997, the US dollar strengthened against the
Deutschmark and Japanese Yen. Coupled with a stable Renminbi, the
EERI of the Hong Kong dollar rose to 137.9 at the end of the year, from
125.3 as at end-1996.

With market corrections in the asset markets, due to the firming up of the
Hong Kong dollar interest rates, credit expansion slowed down in the last
quarter of 1997. For the year as a whole, the Hong Kong dollar M1 fell by
5.1 per cent. The growth rate of Hong Kong dollar M3, the broad money
supply, decelerated to 9.9 per cent.

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