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 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.

The linked exchange rate system is in essence a currency board system with two distinctive features: i) full backing of the monetary base; and ii) convertibility between the monetary base and the reserve currency at the fixed exchange rate (i.e. HK$7.80 = US$1). In Hong Kong, the monetary base includes the amount of bank notes and coins issued, the Aggregate Balance (which is the sum of the clearing balances of the licensed banks held with the HKMA for the purpose of effecting the clearing and settlement of transactions between the banks themselves and also between the HKMA and the banks), and the outstanding amount of Exchange Fund Bills and Notes.

Since the inception of the linked exchange rate system in October 1983, the issuance and redemption of bank notes, through the note-issuing banks, are required to be made against US dollars at the fixed exchange rate of $7.80 to US$1. Specifically, Certificates of Indebtedness, which authorise note-issuing banks to issue banknotes, are issued and redeemed against US dollars at that fixed rate and for the account of the Exchange Fund. In other words, the Certificates of Indebtedness, which are cover for banknotes, are fully backed by US dollars and are convertible into US dollars at the fixed rate of HK$7.80 to US$1. Similarly, the issue and withdrawal of coins in circulation are conducted against US dollars at a fixed exchange rate of 7.80.

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 balances 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 that 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. Since then, all licensed banks have had to maintain direct clearing accounts with the Exchange Fund. As part of a package of technical measures introduced in September 1998 to strengthen the currency board arrangements, a clear undertaking was made by the HKMA to licensed banks to convert Hong Kong dollars in their clearing accounts into US dollars at the prescribed convertibility rate. The convertibility rate was initially set at HK$7.75 to US$1, taking into account the then prevailing market exchange rate. Starting from April 1, 1999, the convertibility rate moved from 7.75 by 1 pip (i.e. HK$0.0001) per calendar day. It converged with the convertibility rate applicable to the issuance and redemption of Certificates of Indebtedness at HK$7.80 on August 12, 2000. Since then, the convertibility rate has remained at HK$7.80.

By assuming responsibility for the interbank clearing system, the HKMA also became responsible for the provision of lending to any banks experiencing day-to-day shortages of liquidity. A Liquidity Adjustment Facility (LAF) was set up in 1992 for this purpose. This was replaced in September 1998 by the Discount Window arrangement under which banks have unrestricted access to day-end liquidity through repurchase agreements using Exchange Fund Bills and Notes as collateral. A two-tier structure of Discount Rates has been adopted to ensure that interest rates are adequately responsive to capital flows, while avoiding excessive interest rate volatility if liquidity shortages are only modest. Banks are charged the Base Rate with respect to the first 50 per cent of their holding of Exchange Fund Bills and Notes. For the next 50 per cent, the charge is the Base Rate plus 5 per cent, or the overnight Hong Kong Interbank Offer Rate (HIBOR) of the day, whichever is higher. The Base Rate is set at the higher of the simple average of the five-day moving averages of overnight and one-month HIBORs, and the US Federal Funds Target Rate plus an adjustment factor, currently set at 150 basis points.

Under the currency board system, Hong Kong dollar exchange rate stability is maintained through an interest rate adjustment mechanism. 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 (inflow into the Hong Kong dollar). It contracts when the foreign currency is bought from the currency board (outflow from the Hong Kong dollar). 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.

To strengthen the institutional framework for the operation of the currency board system in Hong Kong, a Subcommittee on Currency Board Operations was established under the Exchange Fund Advisory Committee (EFAC) in August 1998. The subcommittee has been entrusted with the responsibility of overseeing the operation of the currency board system in Hong Kong and may, where appropriate, recommend measures to the Financial Secretary through the EFAC to enhance the robustness and effectiveness of Hong Kong's currency board arrangements.

The HKMA pursues a policy of transparency to ensure that the financial industry and the wider public are fully informed of the currency board operations. The Aggregate Balance has been disclosed on a virtually real time basis since December 1996, when the RTGS system was launched. Forecast changes to the Aggregate Balance attributable to the currency board's foreign exchange transactions have also been published daily since June 1998. Since November 1998, the size of the monetary base and its components have been published daily. The records of the meetings of the Subcommittee on Currency Board Operations have been published within six weeks of each meeting. The Currency Board Account has also been published monthly since March 1999.

The Government is fully committed to the maintenance of the linked exchange rate system, which is a cornerstone of Hong Kong's monetary and financial stability, and to the strict discipline of the currency board arrangement under that system.