As appreciation pressure, which developed in late 2004, subsided, the Hong Kong dollar exchange rate gradually drifted back towards the linked rate of $7.80 in the early part of the year. The exchange rate stayed close to the linked rate in the first four months of 2005, with the weak-side Convertibility Undertaking being triggered occasionally, prompting the HKMA to buy 12 billion of Hong Kong dollars. The Hong Kong dollar exchange rate started to strengthen in late April, due to market expectations on a reform of the renminbi exchange rate regime.

To make the interest rate and exchange rate adjustments more efficient, the HKMA announced three refinements to the operation of the Linked Exchange Rate System on May 18 aimed at removing uncertainty about the strong-side potential of the Hong Kong dollar. The initial response of the foreign exchange and money markets suggested that the three refinements were effective. On the announcement of the new measures, market expectations on Hong Kong dollar appreciation diminished and the weak-side Convertibility Undertaking of $7.80 was triggered on May 18, prompting the HKMA to buy 3.12 billion Hong Kong dollars from banks. On July 21, when the People's Bank of China announced a reform of the renminbi exchange rate regime, the Hong Kong dollar exchange rate reacted calmly, suggesting that the three refinements were effective in anchoring exchange rate expectations on the strong side.

Hong Kong dollar interbank interest rates rose sharply during the year, owing to tightened interbank liquidity following intermittent activation of the weak-side Convertibility Undertaking in the early part of the year, the introduction of the three refinements to the Linked Exchange Rate System in May, and increases in the US federal funds target rate throughout the year. For the year as a whole, one-month interbank interest rates rose by 3.91 percentage points to close the year at 4.06 per cent. Following a cumulative hike of 2 percentage points in the US federal funds target rate during the year, the best lending rate quoted by major banks in Hong Kong was raised to 7.75 per cent. The average of saving deposit rates quoted by major banks increased to 2.32 per cent.

The yields on Exchange Fund paper largely followed those on US Treasuries, with those of the seven-year and 10-year Notes closing the year at 4.15 and 4.18 per cent respectively. Yields on Exchange Fund paper increased across different maturities. The negative yield differentials between the Exchange Fund Notes and US Treasuries narrowed markedly during the year, to -21 basis points and -19 basis points for seven-year and 10-year paper respectively.

The overall exchange value of the Hong Kong dollar, as measured by the trade-weighted Effective Exchange Rate Index (EERI), was mostly influenced by the exchange rate of the US dollar vis-a-vis other major currencies. Reflecting a rebound in the US dollar against other major currencies, the EERI increased from 96 at the end of 2004 to 98.4 at the end of 2005.

Hong Kong dollar narrow money (HK$M1) decreased by 15.6 per cent, while broad money (HK$M3) expanded by 5.7 per cent along with robust economic growth in 2005. The divergence in growth of HK$M1 and HK$M3 partly reflected a shift away from liquid monetary assets to term deposits. Specifically, the share of liquid deposits (i.e. demand and savings deposits) in total Hong Kong dollar deposits declined from a high of around 65 per cent in early 2005 to about 45 per cent at end-December, probably brought about by a rise in deposit rates.

Following a 6.3 per cent increase in 2004, loans for use in Hong Kong expanded by 7.8 per cent in 2005, reflecting increased demand for credit. Analysed by major usage, lending grew in most sectors in 2005. Trade financing and loans to finance the manufacturing sector, and property development and investment registered notable increases. The outstanding stock of residential mortgage loans increased slightly in 2005, due to an expansion in new mortgage lending activities. As the rate of increase in Hong Kong dollar loans was higher than that in Hong Kong dollar deposits, the Hong Kong dollar loan-to-deposit ratio rose from 82.6 per cent at the end of 2004 to 84.3 per cent at the end of 2005.